**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

 
| **o**      | ** ** | **Quarterly Report Pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934.**  |
|------------|------------|----------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                               |
| **OR**     |
| ** ** | ** ** | ** **                                                                                               |
| **ý** | ** ** | **Transition Report Pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934.** |
| ** ** | ** ** | **For the three month transition period from  January 1, 2005 to March 31,2005.**              |

** **

**Commission File Number:  001-13748**

 

**ZiLOG, Inc.**

(Exact name of registrant as specified in itscharter)

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

 

**532 Race Street, San Jose,California, 95126**

(Address of principal executive offices)

 

Registrant’s telephone number, including areacode:

**(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

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of 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 December 31, 2005 there were16,557,684 shares of the Company’s Common Stock, $0.01 par value outstanding.

 

 

----

 

FORWARD-LOOKING STATEMENTS

 

Someof the statements under sections entitled “Risk Factors” and “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andelsewhere in this Transition Report on Form 10-Q constituteforward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995, Section 27A of the Securities Act of 1933and Section 21E of the Securities Exchange Act of 1934. These statementsrelate to future events or our future financial performance and involve knownand may involve unknown risks, uncertainties and other factors that may causeour actual results, levels of activity, performance or achievements to bematerially different from any future results, levels of activity, performanceor achievements expressed or implied by forward-looking statements including,but not limited to prospects for future market growth, statements relating tothe general direction of our business, our expected liquidity, capitalexpenditures 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, youcan identify forward-looking statements by terminology such as “may,” “will,” “should,”“expects,” “anticipates,” “believes,” “estimates,” “potential,” “continue,” orthe negative terms or other comparable terminology. These statements includeestimates of our stock based compensation expense, the success of our lowergeometry fab processes, estimates of market growth, capital expenditures, theadequacy of available cash, the cost or outcome of any litigation pending orthreatened, the cost of compliance with environmental laws and estimates of thefair value of the land and building associated with MOD II. In evaluating thesestatements, you should specifically consider various factors, including therisks outlined under “Risk Factors.”

 

Althoughwe believe that the expectations in the forward-looking statements contained inthis Transition Report on 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.

 

Basedin San Jose, California, we were incorporated in California in October 1981and reincorporated in Delaware in April 1997. In this report, “ZiLOG,” “theCompany,” “our,” “us,” “we,” and similar expressions refer to ZiLOG, Inc.and its subsidiaries. However, when these expressions are used throughout thisreport in connection with ZiLOG, Inc.’s reorganization under Chapter 11 ofthe U.S. bankruptcy code, they are referring only to the parent company, ZiLOG, Inc.,and not to any of its subsidiaries. ZiLOG, eZ80, Z8 Encore! and Z80 are registered trademarks of ZiLOG, Inc.and eZ80Acclaim! is a trademark of ZiLOG, Inc.

 

2

----

 

**ZiLOG, INC.**

**TRANSITIONREPORT ON FORM 10-Q FOR THE THREE MONTH PERIOD ENDED March 31, 2005**

**TABLE OFCONTENTS**

 
| ** **                             | ** **                                                                                                                                                 | ** ** | **Page** |
|----------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| **PART I. FINANCIAL INFORMATION** | ** **                                                                                                                                                 | ** ** |
| Item 1.                                | Financial Statements                                                                                                                                       |       |     |
|                                   | Unaudited Condensed  Consolidated Statements of Operations for the three months ended  March 31, 2005 and the three months ended March 31, 2004  |       | 4        |
|                                   | Unaudited Condensed Consolidated  Balance Sheets at March 31, 2005 and December 31, 2004                                                         |       | 5        |
|                                   | Unaudited Condensed  Consolidated Statements of Cash Flows for the three months ended  March 31, 2005, and the three months ended March 31, 2004 |       | 6        |
|                                   | Notes to Unaudited Condensed  Consolidated Financial Statements                                                                                            |       | 7        |
| Item 2.                                | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                                                                |       | 17       |
| Item 3.                                | Quantitative  and Qualitative Disclosures About Market Risk                                                                                                |       | 40       |
| Item 4.                                | Controls and Procedures                                                                                                                                    |       | 40       |
|                                   |                                                                                                                                                       |       |     |
| **PART II. OTHER INFORMATION**    | ** **                                                                                                                                                 | ** ** |
| Item 1.                                | Legal Proceedings                                                                                                                                          |       | 43       |
| Item 2.                                | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                               |       | 43       |
| Item 3.                                | Defaults  Upon Senior Securities                                                                                                                           |       | 43       |
| Item 4:                                | Submission  of Matters to a Vote of Security Holders                                                                                                       |       | 43       |
| Item 5.                                | Other Information                                                                                                                                          |       | 43       |
| Item 6.                                | Exhibits and Reports on  Form 8-K                                                                                                                     |       | 44       |

 

3

----

 

### **PART I**

**FINANCIALINFORMATION**

 

**Item 1.  FinancialStatements**

 

**ZiLOG, INC.**

**UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(inmillions except per share data)**

 
| ** **                                                                     | ** ** | **Three Months Ended**  | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                     | ** ** | **March 31, 2005** | ** ** | **March 31, 2004** | ** ** |
| Net sales                                                                      |       | $                       | 20.2       |   | $ | 26.0 |   |
| Cost of sales                                                                  |       | 12.5                    |       | 12.6 |   |
| Gross margin                                                                   |       | 7.7                     |       | 13.4 |   |
| Operating expenses:                                                            |       |                    |       |   |   |
| Research and development                                                       |       | 5.2                     |       | 5.1 |   |
| Selling, general and administrative                                            |       | 7.4                     |       | 6.8 |   |
| Special charges and reorganization items                                       |       | 0.4                     |       | 0.5 |   |
| Amortization of intangible assets                                              |       | 0.6                     |       | 1.1 |   |
| Total operating expenses                                                       |       | 13.6                    |       | 13.5 |   |
| Operating loss                                                                 |       | (5.9                    | )          | (0.1 | ) |
|                                                                           |       |                    |       |   |   |
| Other income (expense):                                                        |       |                    |       |   |   |
| Interest income                                                                |       | 0.1                     |       | 0.1 |   |
| Interest expense                                                               |       | —                  |       | (0.1 | ) |
| Other, net                                                                     |       | —                  |       | (0.1 | ) |
| Loss before provision (benefit) for income  taxes                              |       | (5.8                    | )          | (0.2 | ) |
| Provision (benefit) for income taxes                                           |       | 0.8                     |       | (0.2 | ) |
| Net income (loss) attributable to common  stockholders                         |       | $                       | (6.6       | ) | $ | — |   |
| Basic net income (loss) per share                                              |       | $                       | (0.41      | ) | $ | — |   |
| Diluted net income (loss) per share                                            |       | $                       | (0.41      | ) | $ | — |   |
| Weighted-average shares used in computing  basic net income (loss) per share   |       | 16.2                    |       | 14.7 |   |
| Weighted-average shares used in computing  diluted net income (loss) per share |       | 16.2                    |       | 15.3 |   |

 

See accompanying notes to condensed unauditedconsolidated financial statements.

 

4

----

 

**ZiLOG, INC.**

**UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS**

**(inmillions)**

 
| ** **                                                                                                                    | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                    |       |                     |       |                        |       |
| Current assets:                                                                                                               |       |                     |       |                        |       |
| Cash and cash equivalents                                                                                                     |       | $                        | 33.6       |                        | $          | 37.7 |   |
| Accounts receivable, less allowance for  doubtful accounts of $0.2 at March 31, 2005 and $0.3 at  December 31, 2004 |       | 12.5                     |       | 10.0                        |       |
| Inventories                                                                                                                   |       | 10.6                     |       | 12.1                        |       |
| Deferred income taxes                                                                                                         |       | 2.7                      |       | 2.7                         |       |
| Prepaid expenses and other current assets                                                                                     |       | 2.8                      |       | 4.0                         |       |
| Total current assets                                                                                                          |       | 62.2                     |       | 66.5                        |       |
|                                                                                                                          |       |                     |       |                        |       |
| MOD II assets held for sale                                                                                                   |       | 3.4                      |       | 3.6                         |       |
| Net property, plant and equipment                                                                                             |       | 5.9                      |       | 6.1                         |       |
| Goodwill                                                                                                                      |       | 8.6                      |       | 8.6                         |       |
| Intangible assets, net                                                                                                        |       | 6.7                      |       | 7.3                         |       |
| Other assets                                                                                                                  |       | 5.6                      |       | 6.0                         |       |
|                                                                                                                          |       | $                        | 92.4       |                        | $          | 98.1 |   |
|                                                                                                                          |       |                     |       |                        |       |
| **LIABILITIES,  AND STOCKHOLDERS’ EQUITY**                                                                               |       |                     |       |                        |       |
| Current liabilities:                                                                                                          |       |                     |       |                        |       |
| Accounts payable                                                                                                              |       | $                        | 11.5       |                        | $          | 12.3 |   |
| Accrued compensation and employee benefits.                                                                                   |       | 3.0                      |       | 2.6                         |       |
| Other accrued liabilities                                                                                                     |       | 4.8                      |       | 4.0                         |       |
| Deferred income on shipments to  distributors                                                                                 |       | 6.0                      |       | 6.0                         |       |
| Total current liabilities                                                                                                     |       | 25.3                     |       | 24.9                        |       |
|                                                                                                                          |       |                     |       |                        |       |
| Deferred income taxes                                                                                                         |       | 2.7                      |       | 2.7                         |       |
| Other non-current tax liabilities                                                                                             |       | 6.6                      |       | 6.6                         |       |
| Total liabilities                                                                                                             |       | 34.5                     |       | 34.2                        |       |
|                                                                                                                          |       |                     |       |                        |       |
| Stockholders’ equity:                                                                                                    |       |                     |       |                        |       |
| Common stock                                                                                                                  |       | 0.2                      |       | 0.2                         |       |
| Deferred stock compensation                                                                                                   |       | (0.4                     | )          | (0.7                        | )          |
| Additional paid-in capital                                                                                                    |       | 122.1                    |       | 121.9                       |       |
| Treasury stock                                                                                                                |       | (7.1                     | )          | (7.1                        | )          |
| Accumulated deficit                                                                                                           |       | (57.0                    | )          | (50.4                       | )          |
| Total stockholders’ equity                                                                                               |       | 57.8                     |       | 63.9                        |       |
| Total liabilities and stockholders’ equity                                                                               |       | $                        | 92.4       |                        | $          | 98.1 |   |

 

See accompanying notes to condensed unauditedconsolidated financial statements.

 

5

----

 

**ZiLOG, INC.**

**UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(inmillions)**

 
| ** **                                                                                                        | ** ** | **Three Months Ended**  | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                                        | ** ** | **March 31, 2005** | ** ** | **March 31, 2004** | ** ** |
| ** **                                                                                                        |       |                    |       |   |   |
| **Cash Flows from Operating Activities:**                                                                         |       |                    |       |   |   |
| Net income (loss)                                                                                                 |       | $                       | (6.6       | ) | $ | — |   |
| Adjustments to reconcile net income (loss)  to net cash used by operating activities:                             |       |                    |       |   |   |
| Amortization of fresh start intangible  assets                                                                    |       | 0.6                     |       | 1.1 |   |
| Deferred income tax, assets and liabilities                                                                       |       | —                  |       | (0.7 | ) |
| Depreciation and other amortization                                                                               |       | 0.6                     |       | 1.2 |   |
| Stock-based compensation                                                                                          |       | 0.3                     |       | 0.4 |   |
| Changes in operating assets and  liabilities:                                                                     |       |                    |       |   |   |
| Accounts receivable, net                                                                                          |       | (2.5                    | )          | (3.4 | ) |
| Inventories                                                                                                       |       | 1.5                     |       | (2.2 | ) |
| Prepaid expenses and other current and  non-current assets                                                        |       | 1.6                     |       | 1.3 |   |
| Accounts payable                                                                                                  |       | (0.8                    | )          | 1.6 |   |
| Accrued compensation and employee benefits                                                                        |       | 0.4                     |       | — |   |
| Other accrued liabilities, deferred income  on shipments to distributors, income taxes and accrued special charge |       | 0.8                     |       | (1.5 | ) |
| Net cash used by operating activities                                                                             |       | (4.1                    | )          | (2.2 | ) |
|                                                                                                              |       |                    |       |   |   |
| **Cash Flows From Investing Activities:**                                                                         |       |                    |       |   |   |
| Proceeds from the sale of MOD II assets                                                                           |       | 0.2                     |       | — |   |
| Capital expenditures                                                                                              |       | (0.4                    | )          | (0.7 | ) |
| Cash used by investing activities                                                                                 |       | (0.2                    | )          | (0.7 | ) |
|                                                                                                              |       |                    |       |   |   |
| **Cash Flows From Financing Activities:**                                                                         |       |                    |       |   |   |
| Proceeds from public stock offering, net of  offering expenses                                                    |       | —                  |       | 21.6 |   |
| Repayments of short-term debt                                                                                     |       | —                  |       | (0.6 | ) |
| Proceeds from the issuance of common stock  under employee purchase plans                                         |       | 0.2                     |       | — |   |
| Payments for stock redemptions                                                                                    |       | —                  |       | (0.1 | ) |
| Cash provided by financing activities                                                                             |       | 0.2                     |       | 20.9 |   |
|                                                                                                              |       |                    |       |   |   |
| Increase (decrease) in cash and cash  equivalents                                                                 |       | (4.1                    | )          | 18.0 |   |
| Cash and cash equivalents at beginning of  period                                                                 |       | 37.7                    |       | 22.0 |   |
| Cash and cash equivalents at end of period                                                                        |       | $                       | 33.6       |   | $ | 40.0 |   |
|                                                                                                              |       |                    |       |   |   |
| **Supplemental disclosure of cash flow  information:**                                                            |       |                    |       |   |   |
| Interest paid during period                                                                                       |       | $                       | 0.0        |   | $ | 0.1 |   |
| Income taxes paid during period                                                                                   |       | $                       | 0.1        |   | $ | 0.2 |   |

 

See accompanying notes to condensed unauditedconsolidated financial statements.

 

6

----

 

**ZILOG, INC.**

 

**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1.        BASIS OF PRESENTATION**

 

Theaccompanying 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-K with theSecurities and Exchange Commission File Number 001-13748 for the fiscal yearended December 31, 2004, filed on March 31, 2005.

 

EffectiveDecember 29, 2005, ZiLOG changed its fiscal year end from December 31to March 31. ZiLOG’s interim results are based on fiscal quarters ofapproximately thirteen weeks in duration ending on the closest Saturday to eachcalendar quarter end, with the exception of the last quarter, which will end onMarch 31 beginning in fiscal 2006.  In accordance with the fiscalcalendar in place at that time, the fiscal 2005 year ended on March 27,2005.  The additional four days have been included in the Company’s firstquarter for fiscal 2006. As a requirement of this fiscal year end change, theCompany is reporting unaudited results for the period January 1, 2005through March 27, 2005 as a separate (“stub”) transition period with theresults for the corresponding period of 2004 for comparative purposes. For financial reporting purposes and convenience of reference, interim fiscalperiods are labeled as ending on calendar month-end.  The operatingresults for any interim period are not necessarily indicative of results forany subsequent period or the full fiscal year. The condensed consolidatedbalance sheet at December 31, 2004 has been derived from audited financialstatements at that date, but does not include all of the information andfootnotes required by generally accepted accounting principles for completefinancial statements.

 

**NOTE 2.        SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

***Revenue Recogniton.*** Revenue from product sales to OriginalEquipment Manufacturers (“OEM”) customers is recognized when evidence of anagreement exists, customers or their agents receive the product and titletransfers, and collection of amounts due is reasonably assured. Appropriateallowances for returns, discounts and warranty costs are recorded concurrentwith revenue recognition.

 

TheCompany also licenses technology for certain of its products and receivespayment in the form of royalties. Typically, licensees provide shipment androyalty information when the payment is remitted, usually 60 days subsequent tothe end of the quarter shipments are made. As such, the Company records theseroyalty revenues as micrologic net sales when the cash is received from thelicensees.

 

Revenueon shipments to distributors who have rights of return and price protection onunsold merchandise held by them, is deferred until products are resold by thedistributors to end users. Although revenue is deferred until resale, title ofproducts sold to distributors transfers upon shipment. Accordingly, shipmentsto distributors are reflected in the consolidated balance sheets as accountsreceivable and a reduction of inventories at the time of shipment. Deferredrevenue and the corresponding cost of sales on shipments to distributors arereflected in the consolidated balance sheet on a net basis as “Deferred incomeon shipments to distributors.”

 

***Assets Held for Sale. ***The remaining assets of MOD II, consisting primarily of land andbuildings with a carrying value of $3.4 million at March 31, 2005, havebeen classified as assets held for sale on the Company’s accompanying condensedconsolidated balance sheet.

 

7

----

 

***Goodwill and Intangible Assets.*** Effective January 1, 2002, ZiLOG adopted the provisions of FASBStatement of Financial Accounting Standards No. 142, “Goodwill and OtherIntangible Assets” (“SFAS 142”).  UnderSFAS 142, goodwill and intangible assets with indefinite lives are notamortized, but are reviewed annually or more frequently if impairmentindicators arise.  In the quarter ended September 30,2005, the Company reviewed its goodwill and intangible assets and determinedthat there was no impairment indicated.

 

Separableintangible assets that are deemed to have defined lives are being amortizedutilizing the pattern-of-use method over their estimated useful lives of sixyears for current technology and ten years for brand name.

 

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

 

| ** **                                | ** ** | **Current  Technology** | ** ** | **Brand  Name** | ** ** | **Total** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|-----------------|------------|-----------|------------|
| Gross carrying amount, recorded May, 2002 |       | $                       | 17.0       |            | $          | 9.2       |       | $ | 26.2 |   |
| Accumulated amortization                  |       | 15.6                    |       | 3.9             |       | 19.5      |       |
| Book value at March 31, 2005         |       | $                       | 1.4        |            | $          | 5.3       |       | $ | 6.7 |   |

 

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

 
| **Year**               | ** ** | **Current  Technology** | ** ** | **Brand  Name** | ** ** | **Total  Amortization** | ** ** |
|------------------------|------------|-------------------------|------------|-----------------|------------|-------------------------|------------|
| April- March 2006 |       | $                       | 0.9        |            | $          | 1.0                     |       | $ | 1.9 |   |
| 2007                   |       | 0.3                     |       | 0.9             |       | 1.2                     |       |
| 2008                   |       | 0.1                     |       | 0.9             |       | 1.0                     |       |
| 2009                   |       | 0.1                     |       | 0.7             |       | 0.8                     |       |
| 2010                   |       | —                  |       | 0.7             |       | 0.7                     |       |
| Thereafter             |       | —                  |       | 1.1             |       | 1.1                     |       |
| Total                  |       | $                       | 1.4        |            | $          | 5.3                     |       | $ | 6.7 |   |

 

***Use of Estimates.*** Thepreparation of the condensed consolidated financial statements in conformitywith accounting principles generally accepted in the United States requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of financial statements and the reported amounts of revenues andexpenses during the reporting period. Significant estimates made in preparingthese financial statements include, but are not limited to, excess and obsoleteinventories, taxation valuation allowances, allowance for doubtful accounts,and sales returns and allowances. Actual results could differ from thoseestimates.

 

***Research and Development Expenses.***The Company records all research anddevelopment expenditures with no future alternative use as period expenses whenincurred.

 

***Fair Value ofFinancial Instruments and Concentration of Credit Risk.**** *The carrying value of the Company’s financial instruments, includingcash and cash equivalents, accounts receivable, accounts payable and currentliabilities, approximates fair value due to their relatively short maturities.Financial instruments that subject the Company to concentrations of credit riskconsist primarily of cash and cash equivalents and accounts receivable. TheCompany maintains its cash and cash equivalents and investments with highquality financial institutions. The Company’s customer base is locatedprimarily in North America, Europe and Asia. The Company performs ongoingcredit evaluations of its customers and generally does not require collateralon accounts receivable. The Company maintains allowances for potential creditlosses. As of March 31,2005, there were three individual customers with net accounts receivable eachcomprising 10% or more of total net accounts receivable amounting toapproximately $1.9 million, $1.9 million, and $1.4 million, respectively.

 

8

----

 

***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 describedabove. 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).

 
| ** **                                                                                                                             | ** ** | **Three Months Ended**   | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                                                                             | ** ** | **March 31,  2005** | ** ** | **March 31,  2004** | ** ** |
|                                                                                                                                   |       |                     |       |   |   |
| Net income (loss) as reported                                                                                                          |       | $                        | (6.6       | ) | $ | — |   |
| Add stock-based employee compensation  expense included in reported net income (loss), net of tax for 2004.                            |       | 0.3                      |       | 0.3 |   |
| Deduct total stock-based employee  compensation expense determined under fair-value-based method for all awards,  net of tax for 2004. |       | (0.7                     | )          | (1.0 | ) |
| Pro forma net loss                                                                                                                     |       | $                        | (7.0       | ) | $ | (0.7 | ) |

 

 

Thefair value of options granted in 2005 and 2004 under the 2004 Omnibus StockIncentive Plans were estimated at the date of grant using the Black-Scholesoption pricing model.  The followingweighted average assumptions were used:

 
| ** **                             | ** ** | **Three Months Ended**   | ** ** |
|----------------------------------------|------------|--------------------------|------------|
| ** **                             | ** ** | **March 31,  2005** | ** ** | **March 31,  2004** | ** ** |
| Annual average risk free interest rate |       | 3.4                      | %          | 3.0 | % |
| Estimated life in years                |       | 5                        |       | 5 |   |
| Dividend yield                         |       | 0.0                      | %          | 0.0 | % |
| Volatility                             |       | 52.2                     | %          | 63.5 | % |

 

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

 
| ** **                             | ** ** | **Three Months Ended**   | ** ** |
|----------------------------------------|------------|--------------------------|------------|
| ** **                             | ** ** | **March 31,  2005** | ** ** | **March 31,  2004** | ** ** |
| Annual average risk free interest rate |       | 3.4                      | %          | — |   |
| Estimated life in years                |       | 0.6                      |       | — |   |
| Dividend yield                         |       | 0.0                      | %          | — |   |
| Volatility                             |       | 52.2                     | %          | — |   |

 

9

----

 

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

 
| ** **                                                                 | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                 | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Weighted-average fair value of options  granted during the period          |       | $                                      | 5.07       |   | $ | 14.28 |   |
| Weighted-average fair value of employee  stock purchases during the period |       | $                                      | 4.70       |   | $ | 5.52 |   |

 

***Adoption of Accounting Standards***.  In January 2003,the Financial Accounting Standards Board issued FASB Interpretation No. 46(“FIN 46”), “Consolidation of Variable Interest Entities.” In December 2003,the FASB issued Interpretation No. 46 (revised December 2003), “Consolidationof Variable 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’sinvestment in ZiLOG MOD III, Inc. (“MOD III”) was determined to be avariable interest entity; however, the Company was not determined to be theprimary beneficiary.  Accordingly, asprescribed by FIN 46R, the Company’s adoption of this pronouncement:

 

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

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

•                  Resultedin no impact to results of operations.

 

Substantially all of the equipment of MOD III wassold on July 16, 2004 and the net cash received after recoupment of costswas 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 AccountingPronouncements. ***In November 2004, the FASB issued SFAS No. 151,“Inventory Costs”. SFAS 151 is an amendment to ARB 43, Chapter 4, “InventoryPricing”. SFAS 151 clarified the accounting for abnormal amounts of idlefacility expense, freight, handling costs and wasted material or spoilage.  The provisions of SFAS 151 become effectiveon a prospective basis for fiscal years beginning after June 15, 2005 withearly application permitted.  The Companyhas not yet determined the impact, if any, of adopting SFAS 151, but it doesnot expect the adoption to have a material impact on its consolidated financialposition, results of operations or cash flows.

 

InDecember 2004, the FASB issued SFAS No. 123R, “Share-Based Payment.”SFAS 123R requires employee stock options and rights to purchase shares understock participation plans to be accounted for under the fair value method, andeliminates the ability to account for these instruments under the intrinsicvalue method prescribed by APB Opinion No. 25, and allowed under theoriginal provisions of SFAS No. 123.  SFAS No. 123R requires the use of anoption pricing model for estimating fair value, which is amortized to expenseover 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.

 

10

----

 

InDecember 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.

 

InDecember 2004, the FASB issued FSP No.109-2, “Accounting and DisclosureGuidance for the Foreign Earnings Repatriation Provision within the AmericanJobs Creations Act of 2004.” The AJCA introduces a limited time 85% dividendsreceived deduction on the repatriation of certain foreign earnings to a U.S.taxpayer (repatriation provision), provided certain criteria are met.  FPS109-2 provides accounting and disclosureguidance for the repatriation provision. Although FSP 109-2 is effective immediately, the Company does not expectto be able to complete its evaluation of the repatriation provision until afterCongress or the Treasury Department provides additional clarifying language onkey elements of the provision.  In January 2005,the Treasury Department began to issue the first of a series of clarifyingguidance documents related to this provision. The Company has not yet determined the impact of adopting FSP 109-2, ifany, on its consolidated financial statements and related disclosures.

 

**NOTE 3.                INVENTORIES**

 

Inventoriesare stated at the lower of cost, determined on a first-in-first-out basis, ormarket.  Provisions, when required, aremade to reduce excess and obsolete inventories to their estimated realizablevalues. It is possible that estimates of realizable value can decline in theshort-term. Inventories, net of provisions, consist of the following (inmillions):

 
| ** **       | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------|------------|--------------------------|------------|-----------------------------|------------|
| Raw materials    |       | $                        | 0.6        |                        | $          | 0.6 |   |
| Work-in-progress |       | 6.6                      |       | 8.3                         |       |
| Finished goods   |       | 3.4                      |       | 3.2                         |       |
|             |       | $                        | 10.6       |                        | $          | 12.1 |   |

 

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

 

Thecomponents of special charges are as follows (in millions):

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

 

11

----

 

Thefollowing table summarizes activity in accrued special charges (in millions)which is included in other accrued liabilities in the condensed consolidatedbalance sheet:

 
| ** **                        | ** ** | **Total** | ** ** | **Severance  and   Termination  Benefits** | ** ** | **MOD II  Closure Costs** | ** ** | **MOD III  Closure Costs** | ** ** |
|-----------------------------------|------------|-----------|------------|--------------------------------------------|------------|---------------------------|------------|----------------------------|------------|
| Balance at December 31, 2004 |       | $         | 1.0        |                                       | $          | 0.3                       |       | $                          | 0.7        |   | $ | — |   |
| Provisions for special charges    |       | 0.5       |       | —                                     |       | 0.4                       |       | 0.1                        |       |
| Cash paid                         |       | (1.0      | )          | (0.3                                       | )          | (0.6                      | )          | (0.1                       | )          |
| Balance at March 31, 2005    |       | $         | 0.5        |                                       | $          | —                    |       | $                          | 0.5        |   | $ | — |   |

 

Restructuringof operations during the three months ended March 31, 2005 includedapproximately $0.4 million of special charges for sustaining costs forpost-closure maintenance of the MOD II facility.  These sustaining costs for MOD II and MOD IIIconsists of utilities, taxes, insurance and other maintenance costs required tomaintain the facilities in a condition required for the sale of the respectiveproperties.  During the period ended March 31,2005, we sold certain assets of MOD II totaling $0.2 million at carrying valueand certain assets of MOD III totaling $0.1 million. The recovery of the MODIIIassets was recorded within special charges as an offset to the maintenancecosts of the facility.

 

Restructuring of operationsduring the three-month period ended March 31, 2004, included severance andtermination benefits of approximately $0.1 million related to the Company’scontinued efforts to align infrastructure costs to business-levelrequirements.  Approximately $0.3 millionof special charges for the period relate to post-closure maintenance costs ofthe MOD III eight-inch wafer fabrication facility in Nampa, Idaho.  These costs consist of utilities, taxes,insurance, and other maintenance costs required to maintain the facility in acondition required for the sale of the property.  Approximately $0.1 million of special chargesduring the three months ended March 31, 2004 relate to third-partyprofessional legal service fees for activities associated with the Company’s May 2002debt and equity restructuring.

 

**NOTE 5.        GEOGRAPHIC AND SEGMENT INFORMATION**

 

***Segment Information.*** The Company operates in one operatingsegment and engages primarily in the design, development, manufacture andmarketing of semiconductor products.  TheCompany sells its products to distributors and original equipment manufacturers(OEMs) in a broad range of market segments, performs on-going creditevaluations of its customers and generally requires no collateral.  The Company’s operations outside the UnitedStates consist of a final test facility in the Philippines, sales and supportcenters and design centers in certain foreign countries.  Domestic operations are responsible for thedesign, development and wafer fabrication of all products, as well as thecoordination of production planning and shipping to meet worldwide customercommitments.  The Philippine testfacility is reimbursed in relation to value added with respect to testoperations and other functions performed, and certain foreign sales officesreceive a commission on export sales within their territory.  Accordingly, for financial statementpurposes, it is not meaningful to segregate sales or operating profits for thetest and foreign sales office operations. ZiLOG has two broad business linescalled micrologic devices and other devices that as aggregated are referred toas the ‘base business’ and exclude foundry services. We effectively exited thefoundry services business when we closed our MOD II 5-inch wafer manufacturingfacility in July, 2004.

 

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

 

12

----

 
| ** **                                 | ** ** | **Three Months Ended**   | ** ** |
|--------------------------------------------|------------|--------------------------|------------|
| ** **                                 | ** ** | **March 31,  2005** | ** ** | **March 31,  2004** | ** ** |
| **Net sales by business line:**            |       |                     |       |   |   |
| Micrologic Devices:                        |       |                     |       |   |   |
| 8-bit Microcontrollers and Microprocessors |       | $                        | 14.8       |   | $ | 19.5 |   |
|                                       |       |                     |       |   |   |
| Other Devices :                            |       |                     |       |   |   |
| Serial Communications Controllers          |       | $                        | 2.8        |   | $ | 4.0 |   |
| Modems                                     |       | 1.6                      |       | 0.6 |   |
| IrDA transceivers                          |       | 0.3                      |       | 1.0 |   |
| Television, PC peripheral and other        |       | 0.7                      |       | 0.7 |   |
| Total Other Devices                        |       | $                        | 5.4        |   | $ | 6.3 |   |
| Base business (excluding Foundry)          |       | $                        | 20.2       |   | $ | 25.8 |   |
| Foundry services                           |       | —                   |       | 0.2 |   |
| Net sales                                  |       | $                        | 20.2       |   | $ | 26.0 |   |

 

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

*** ***
| ** **                  | ** ** | **Three Months Ended**   | ** ** |
|-----------------------------|------------|--------------------------|------------|
| ** **                  | ** ** | **March 31,  2005** | ** ** | **March 31,  2004** | ** ** |
| **Net sales by region:**    |       |                     |       |   |   |
| Americas                    |       | $                        | 9.1        |   | $ | 13.8 |   |
| Asia                        |       | 8.5                      |       | 8.0 |   |
| Europe                      |       | 2.6                      |       | 4.0 |   |
| Base business               |       | $                        | 20.2       |   | $ | 25.8 |   |
| Foundry services (Americas) |       | —                   |       | 0.2 |   |
| Net sales                   |       | $                        | 20.2       |   | $ | 26.0 |   |
|                        |       |                     |       |   |   |
| **Net sales by channel :**  |       |                     |       |   |   |
| OEM                         |       | $                        | 10.1       |   | $ | 13.5 |   |
| Distributor                 |       | 10.1                     |       | 12.3 |   |
| Base Business               |       | $                        | 20.2       |   | $ | 25.8 |   |
| Foundry services (OEM)      |       | —                   |       | $ | 0.2 |   |
| Net sales                   |       | $                        | 20.2       |   | $ | 26.0 |   |

 

***Major customers. ***During the three months ended March 31, 2005 two customersaccounted for greater than 10% of the total net sales. These two customersaccounted for approximately 20% and 12% of net sales, respectively.

 

13

----

 

**NOTE 6.       SHORT-TERM DEBT**

##### ** **

The Company entered into a senior securedfinancing facility (the “Facility”) with a commercial lender, dated May 13,2002, for a three-year $15.0 million senior secured revolving credit facility***. ***Borrowings on the Facility are secured primarily againstcertain North American accounts receivable and bear interest at a rate per annumequal, at the Company’s option, to the commercial lender’s stated prime rate orLIBOR, plus 2.5%.  At March 31,2005, the Company had no borrowings outstanding under the facility. TheFacility expired on May 13, 2005.

 

TheCompany wassubject to certain financial covenants under this Facility including tangibleasset and fixed charge coverage ratio only if the total of the Company’s cash,cash equivalents and availability on the revolver are less than $7.5 million atany month end.  As of March 31, 2005,the Company’s cash, cash equivalents and availability on the revolver weregreater than $7.5 million, and as such, the covenants were not applicableduring the quarter. The Company had $0.1 million of standby letters of creditissued to vendors under the Facility during the quarter ended March 31,2005.

 

**NOTE 7.        CONTINGENCIES (Including Subsequent Updates)**

 

OnAugust 11th, 2005 Microchip Technology Inc. (Microchip) filed a patentinfringement claim against the Company in the U.S. District Court of Arizona(case number CV05-2406-PHX-MHM). Microchip alleges that the Company has beeninfringing and currently infringes its patents numbered 5,847,450, 6,696,316and 6,483,183. Microchip claims that unspecified products of the company,including the Z8 Encore! XP 4K Series of products, infringe these patentsand is seeking preliminary and permanent injunctive relief, unspecified damagesand costs including attorneys’ fees. We filed a response to the claims on September 15,2005 generally denying the claims and challenging the validity of the patents. ** **In January, 2006, theCompany filed a request for the re-examination of these patents with the UnitedStates Patent and Trademarks Office. The U.S. PTO usually takes up to 90 daysto determine and advise as to their decision on undergoing such re-examination.

 

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

 

TheCompany is participating in litigation and responding to claims arising in theordinary course of business.  The Companyintends to defend itself vigorously in these matters.  The Company’s management believes that it isunlikely that the outcome of these matters will have a material adverse effecton the Company’s financial statements, although there can be no assurance inthis regard.

 

Fromtime to time we have agreed to indemnify certain customers for potentialallegations of infringement of intellectual property rights and patents arisingfrom the use of the Company’s products. We have indemnification arrangementsthat limit our net contingent obligation to pay for defense costs, if any, upto a maximum of $500,000.

 

**NOTE 8.        INCOME TAXES**

 

TheCompany’s income tax provision for the three months ended March 31, 2005reflects amortization of deferred tax charges and tax expense in its profitableforeign jurisdictions. The Company’s income tax benefit for the quarter ended March 31,2004 reflected its anticipated effective tax rate for the entire year of 2004.The Company’s three months ended March 31, 2004 tax provision includedtaxable income in the U.S. resulting from items that were expensed for bookpurposes but were nondeductible for tax purposes, as well as amortization ofdeferred tax charges and foreign taxes.

 

**NOTE 9.        NET LOSS PER SHARE**

 

Thefollowing table presents the calculation of basic and diluted net loss pershare of common stock (in millions, except per share data):

 

14

----

 

| ** **                                                                      | ** ** | **Three Months Ended**  | ** ** |
|---------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                      | ** ** | **March 31, 2005** | ** ** | **March 31, 2004** | ** ** |
| Net income (loss)                                                               |       | $                       | (6.6       | ) | $ | — |   |
| Weighted-average shares outstanding                                             |       | 16.3                    |       | 14.9 |   |
| Less: Weighted-average shares subject to  repurchase                            |       | 0.1                     |       | 0.2 |   |
| Weighted-average shares used in computing  basic net income (loss) per share    |       | 16.2                    |       | 14.7 |   |
| Basic net income (loss) per share                                               |       | $                       | (0.41      | ) | $ | — |   |
|                                                                            |       |                    |       |   |   |
| Add: Weighted-average shares subject to  repurchase                             |       | —                  |       | 0.2 |   |
| Weighted-average dilutive options                                               |       | —                  |       | 0.4 |   |
| Weighted-average shares used in computing  dilutive net income (loss) per share |       | 16.2                    |       | 15.3 |   |
| Dilutive net income (loss) per share                                            |       | $                       | (0.41      | ) | $ | — |   |

 

AtMarch 31, 2005, options to purchase approximately 2.0 million shares ofcommon stock at a weighted average exercise price of $7.23 were excluded fromthe determination of diluted net loss per share, as the effect of such shareswere anti-dilutive.  At March 31,2005, there were 16,269,481 common shares issued and outstanding and there were16,543,425 common shares issued and outstanding at March 31, 2004.

 

**NOTE 10. COMPREHENSIVE INCOME**

 

TheCompany had no items of other comprehensive income to report in either of thethree-month periods ended March 31, 2005 or March 31, 2004.

 

**NOTE 11.  STOCKAND STOCK REPURCHASES**

 

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

 

2004Stock Repurchase Program: On July 29, 2004 the Company’s Board ofDirectors approved 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 March 31, 2005, the Company had repurchased 572,100shares for $4.4 million under its 2004 Stock Repurchase Program.

 

TheCompany’s common stock trades on NASDAQ national stock market, with a tickersymbol of ZILG. Purchases under the program may be made, from time-to-time, inthe open market, through block trades or otherwise. Depending upon marketconditions and other factors, these purchases may be commenced or suspended atany time or from time-to-time without prior notice by the Company.  No shares were repurchased during the threemonth period ended March 31, 2005 under either plan.

 

**NOTE 12.   SALESOF MOD III AND MOD II ASSETS**

 

***Sale of MOD III Equipment***

 

OnJuly 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 during the quarter ended September 30,2004 as a credit to special charges.

 

15

----

 

***Sale of MOD II Equipment***

*** ***

Duringthe quarter ended December 31, 2004, the Company sold all of its wafermanufacturing equipment and certain other manufacturing support-related assetsof its MOD II facility in Nampa, Idaho, to STM for an aggregate cashconsideration of $5.9 million net of selling costs and expenses. A net gain of$1.7 million was recorded in connection with these sales.  The remaining assets of MOD II primarilyconsist of land and buildings with a carrying value of $3.4 million which havebeen classified as assets held for sale on the Company’s balance sheet.

 

16

----

 

**ITEM 2.  Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

Ouractual results may differ materially from those anticipated in theseforward-looking statements as a result of various factors including those set forthin the section entitled “Risk Factors” and in other sections of thisTransition Report on Form 10Q.

 

**Overview**

 

Thefollowing is management’s discussion and analysis of financial condition andresults of operations of the Company and its subsidiaries for the three-monthtransition period ended March 31, 2005 as compared to the three monthsended March 31, 2004.  Thisdiscussion and analysis should be read in conjunction with the condensedconsolidated financial statements and notes thereto included elsewhere hereinand the Company’s 2004 annual report on Form 10-K. Management’s discussionand analysis provides information concerning our business environment,consolidated results of operations and liquidity and capital resources.

 

Weprepare and release quarterly unaudited financial statements prepared inaccordance with generally accepted accounting principles in the United Statesor GAAP. We also disclose and discuss Earnings Before Interest, Taxes,Depreciation and Amortization (“EBITDA”) as a measure of liquidity in ourfilings with the Securities and Exchange Commission. We believe the disclosureof such information helps investors more meaningfully evaluate the results ofour liquidity.  However, we recommend thatinvestors carefully review the GAAP financial information included as part ofthis report and read the associated reconciliation.

 

EffectiveDecember 29, 2005, ZiLOG changed its fiscal year end from December 31to March 31. ZiLOG’s interim results are based on fiscal quarters ofapproximately thirteen weeks in duration ending on the closest Saturday to eachcalendar quarter end, with the exception of the last quarter, which will end onMarch 31, beginning in fiscal 2006.  In accordance with the fiscalcalendar in place at that time, the fiscal 2005 year ended on March 27,2005.  The additional four days have been included in the Company’s firstquarter for fiscal 2006. As a requirement of this year end change, the Companyis reporting unaudited results for the period January 1, 2005 through March 27,2005 as a separate (“stub”) transition period with the results for thecorresponding period of 2004 for comparative purposes.  For financialreporting purposes, interim fiscal periods are labeled as ending on calendarmonth-end.  The operating results for any interim period are notnecessarily indicative of results for any subsequent period or the full fiscalyear.

 

**Critical Accounting Estimates**

 

Webelieve our critical accounting estimates are as follows:

 

•                       estimating sales returns andallowances;

 

•                       estimating allowance fordoubtful accounts;

 

•                       estimating write-downs of excessand obsolete inventories; and

 

•                       asset impairments.

 

Onan on-going basis, we evaluate our estimates, including those related to salesreturns, 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.**  Ournet sales to OEM customers consist of gross product sales reduced by expectedfuture sales returns and allowances. To estimate sales returns and price allowances,we analyze historical returns and allowance activity to establish a baselinereserve level. We then evaluate whether there are any underlying productquality or other customer specific issues that require additional specificreserves above the baseline level. Because the reserve for sales returns andallowances is based on our judgments and estimates, our reserves may not be 

 

17

----

 

adequateto cover actual sales returns and other allowances. If our reserves are notadequate, our net sales and accounts receivable could be adversely affected.

 

Ournet sales to distributors that have rights of return and/or price protectionallowances on unsold merchandise held by them are deferred until such productsare resold by the distributors to end users of our devices. At the time that werecognize distributor sales as revenue, we record a reserve for estimated priceadjustments that the distributors will reclaim from us on the merchandise theyresold to end users. These reserves are recorded as a reduction to our netsales and a reduction to our accounts receivable. To estimate this distributorprice adjustment reserve, we analyze our historical price adjustment paymentsand pending price adjustments that have been authorized by us but have not yetbeen claimed by our distributors. Because our distributor allowance reserve isbased upon our judgments and estimates, such reserves may not be adequate tocover actual distributor price allowances. If our reserves are not adequate,our net sales and accounts receivable could be adversely affected.

 

**Allowance for doubtful accounts.**  Wemaintain an allowance for losses we may incur as a result of our customers’inability to make required payments.  Anyincrease in the allowance results in a corresponding increase in our selling,general and administrative expenses.  Inestablishing this allowance, and then evaluating the adequacy of the allowancefor doubtful accounts, we consider the aging of our accounts receivable,historical bad debts, customer concentrations, and customer credit-worthinessand, to a lesser extent, current economic trends and changes in our customerpayment terms.  Historically, we have notexperienced material bad debt write-offs. If the financial condition of one or more of our customers unexpectedlydeteriorated, resulting in their inability to make payments, or if we otherwiseunderestimate the losses we incur as a result of our customers’ inability topay us, we could be required to increase our allowance for doubtful accountswhich could adversely affect our operating results.

 

**Estimating write-downs of excess and obsoleteinventories**.  Each inventory component, other than embeddedflash, is assessed for excess or obsolescence by using an algorithm that weestablished.  This algorithm is based onhistorical trends, demand forecasts and inventory age.  We review the result of this algorithm andgenerally record appropriate reserves for all work-in-process inventories morethan six months old and finished goods inventory quantities in excess of ourcurrent backlog and historical shipment rates. Since embedded flash inventories reflect new and growing product sales,inventories have been historically purchased to support anticipateddemand.  We review these inventory levelsregularly and ensure required reserves are recorded appropriately.  Reserves recorded for excess and obsoleteinventories are reflected as a reduction to inventory values in theaccompanying consolidated balance sheets, and an increase in cost ofsales.  Inventory values are reviewed andare compared to the average selling prices. Where prices are lower than thecost of the product, an appropriate lower of cost or market reserve is recordedagainst the inventory value. If actual market conditions or customer demandpatterns are less favorable than, or inconsistent with our assumptions, we maybe required to take further write-downs of our inventory value, which couldadversely impact our cost of sales and operating results.

 

**Assetimpairments.**  We applythe provisions of Statement of Financial Accounting Standards No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets” and Statement of FinancialAccounting Standards No. 142, “Goodwill and Other Intangible Assets.”  We assess the impairment of long-lived assetswhenever events or changes in circumstances indicate that the carrying valuemay not be recoverable.  Factors weconsider important which could trigger an impairment review include thefollowing:

 

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

•                  significant changes in the strategyfor our overall business; and

•                  significant negative changes inindustry or economic trends.

 

When we determine that the carrying value oflong-lived assets may not be recoverable based upon the existence of one ormore of the above indicators of impairment, and the undiscounted cash flowsestimated to be generated by those assets are less than the asset’s carryingvalue, the carrying value of the assets are reduced to their estimated fairvalue.  The estimated fair value isusually determined based on an estimate of future discounted cash flows.  Asset impairments are recorded as a reductionin the asset value in our consolidated balance sheets and as a special charge tooperating expenses in our consolidated statements of operations.

 

Intangible assets consist of existing technology,brand name as well as excess enterprise value, or goodwill.  The existing technology and brand name arebeing amortized based on a pattern-of-use method in proportion to thediscounted cash flows from such assets. Goodwill is not subject to amortization, and is tested for impairment atleast annually, as required by FAS 142.

 

18

----

 

We evaluate the existing technology and brand name ateach reporting period to determine whether events and circumstances continue tosupport the current carrying value as well as the remaining useful life.  Additionally, goodwill is tested forimpairment at least annually and more often if events and circumstancesindicate that its fair value may be less than its carrying value.  We perform the annual impairment test forgoodwill in the third quarter of each fiscal year, unless the existence oftriggering events indicates that an earlier review should be performed.

 

Adjustmentsto record impairment of long-lived assets or intangible assets could have amaterial adverse impact on our financial condition and results of operations inthe period or periods in which such impairment is identified.

 

Followingthe April 2004 announcement of the closure of our MOD II 5-inch wafermanufacturing facility, we have  recorded charges reflecting the impairment of MOD II long-lived assetsas well as other charges related to the closure.

 

**Reporting Segments**

 

Weconduct our business in one reportable segment to reflect the manner in whichour chief operating decision-maker allocates resources and assesses theperformance of our business.

 

**Results of Operations**

 

Ournet sales by region, by channel, and by business line are summarized for eachperiod indicated, as follows (in millions):

 

19

----

 
| ** **                                 | ** ** | **Three Months Ended**   | ** ** |
|--------------------------------------------|------------|--------------------------|------------|
| ** **                                 | ** ** | **March 31,  2005** | ** ** | **March 31,  2004** | ** ** |
| **Net sales by business line:**            |       |                     |       |   |   |
| Micrologic Devices:                        |       |                     |       |   |   |
| 8-bit Microcontrollers and Microprocessors |       | $                        | 14.8       |   | $ | 19.5 |   |
|                                       |       |                     |       |   |   |
| Other Devices :                            |       |                     |       |   |   |
| Serial Communications Controllers          |       | $                        | 2.8        |   | $ | 4.0 |   |
| Modems                                     |       | 1.6                      |       | 0.6 |   |
| IrDA transceivers                          |       | 0.3                      |       | 1.0 |   |
| Television, PC peripheral and other        |       | 0.7                      |       | 0.7 |   |
| Subtotal                                   |       | $                        | 5.4        |   | $ | 6.3 |   |
| Base business (excluding Foundry)          |       | $                        | 20.2       |   | $ | 25.8 |   |
| Foundry services                           |       | $                        | —     |   | $ | 0.2 |   |
| Net Sales                                  |       | $                        | 20.2       |   | $ | 26.0 |   |
|                                       |       |                     |       |   |   |
| **Net sales by region:**                   |       |                     |       |   |   |
| Americas                                   |       | $                        | 9.1        |   | $ | 13.8 |   |
| Asia                                       |       | 8.5                      |       | 8.0 |   |
| Europe                                     |       | 2.6                      |       | 4.0 |   |
| Base business                              |       | $                        | 20.2       |   | $ | 25.8 |   |
| Foundry services (Americas)                |       | —                   |       | 0.2 |   |
| Net Sales                                  |       | $                        | 20.2       |   | $ | 26.0 |   |
|                                       |       |                     |       |   |   |
| **Net Sales by channel :**                 |       |                     |       |   |   |
| OEM                                        |       | $                        | 10.1       |   | $ | 13.5 |   |
| Distributor                                |       | 10.1                     |       | 12.3 |   |
| Base Business                              |       | $                        | 20.2       |   | $ | 25.8 |   |
| Foundry services (OEM)                     |       | $                        | —     |   | $ | 0.2 |   |
| Net Sales                                  |       | $                        | 20.2       |   | $ | 26.0 |   |

 

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

 
| ** **                                | ** ** | **As of:**               | ** ** |
|-------------------------------------------|------------|--------------------------|------------|
| ** **                                | ** ** | **March 31,  2005** | ** ** | **March 31,  2004** | ** ** |
| Days sales outstanding                    |       | 56                       |       | 57 |   |
| Net sales to inventory ratio (annualized) |       | 7.6                      |       | 8.9 |   |
| Weeks of inventory at distributors        |       | 13                       |       | 12 |   |
| Current ratio                             |       | 2.5                      |       | 2.6 |   |

 

20

----

 

Wecalculate each of these key metrics based on annualized results of operationsdata and balance sheet data as of the end of the period indicated. Each ofthese key metrics is described below:

 

Dayssales outstanding, DSO, is a common metric used to analyze how quickly ourcustomers pay us. This metric is influenced largely by the timing of ourcustomer billings, collections, and individual payment terms. At March 31,2005, our DSO was 56 days as compared to DSO of 57 days for the quarter ended March 31,2004. This reflects the non-linearity of our shipments in the quarter ended March 31stof each year.  Typically, shipments arelower in January, reflecting the slower consumer market and tend to increase inFebruary and especially March.  Thistrend drives an increase in billings in the later part of the quarter andusually results in an increase in accounts receivable.

 

Netsales to inventory ratio is a metric we use to analyze how quickly ourinvestment in inventories is recovered by our sales. This metric may not becomparable to those other companies use to analyze inventory. Our net sales toinventory ratio decreased in the quarter ended March 31, 2005 compared tothe quarter ended March 31, 2004 reflecting higher levels of embeddedflash inventory to support our new products and an increase in other inventorymanufactured as buffer inventory to support the closure of MOD II. Our netsales to inventory ratio in the quarter ended March 31, 2005 increasedwhen compared to the quarter ended December 31, 2004 as we consumed theseinventories.

 

Weeksof inventory at distributors measures how quickly our distributors sell theinventories that we sell to them.  We donot recognize revenue on shipments to distributors until our distributorsresell our products. Although our distributors in various regions of the worldmaintain different inventory stocking levels, overall we maintain 11 to 13weeks of inventories at our distributors. These inventories are in line withour expectations.

 

Currentratio represents current assets divided by current liabilities and is commonlyused to assess a company’s liquidity. The Company uses this ratio to makespending determinations on discretionary items. Our current ratio as of March 31, 2005 declined compared to March 31,2004 primarily due to cash utilized by operating activities.

 

**Three Months Ended March 31, 2005 Compared toThree Months Ended March 31, 2004**

 

**Net Sales.** Net sales were $20.2 million forthe three months ended March 31, 2005, as compared to net sales of $26.0million for the same period of 2004.

 

Net sales of our Micrologic devices decreased to $14.8 million for thethree months ended March 31, 2005 compared to $19.5 million for the threemonths ended March 31, 2004. Our new embedded flash sales increased to$1.1 million for the three months ended March 31, 2005 as compared to $0.3million for the three months ended March 31, 2004. The increases in ourflash sales were offset by declines in our non-flash micrologic business of28%.  The decline in the non-flashmicrologic products reflects lower sales in our IR remote-control business, reflectinglower demand in the Satellite TV market, and reduced sales of our Z8 products,reflecting slower sales in the consumer and security markets and generallyslower economic conditions.

 

Net sales of our other devices, which excludes Foundry sales, for thethree months ended March 31, 2005, declined $0.9 million or 14% to $5.4million compared to $6.3 million for the same period of 2004.   The decrease in net sales of other devicesduring the three months ended March 31, 2005 compared to the three monthsended March 31, 2004 reflects a decrease in sales of our SerialCommunications Controllers and IRDA devices primarily to the communicationsmarket offset by an increase in sales of our modem devices.

 

Wehad no sales related to foundry services, for the three months ended March 31,2005, compared to $0.2 million, for the same period of 2004 as we effectivelyexited this business when we closed our MOD II 5-inch wafer manufacturingfacility in July, 2004 and transferred production to our foundry supplier X-fab.This is the final stage of our migration to a fully fab-less manufacturingmodel.

 

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

 

21

----

 

waferfab and under utilization of our test operations as we lowered our productionvolumes and reduced our inventory levels.

 

**Research and Development Expenses.** Research and development expenses were $5.2 million for the three monthsended March 31, 2005, reflecting a 2% increase from the $5.1 million inresearch and development expenses reported for the three months ended March 31,2004.  Research and development spendingreflects continued investments in new products, including our latest line ofFlash-based Microcontrollers, the Z8Encore!XPTM, IR remote control and generalpurpose Microcontrollers.  We are alsoinvesting heavily to add peripheral features to our Z8Encore! and eZ80Acclaim!product lines as well as new devices and software features for our Crimzon lineof consumer solution products.

 

**Selling, General and Administrative Expenses.** Selling, general and administrative expenses increased to $7.4 million forthe three months ended March 31, 2005 from $6.8 million for the threemonths ended March 31, 2004.  Theincrease in our selling, general and administrative spending reflects theimpact of additional expenses of approximately $1.0 million associated withSarbanes-Oxley compliance activities offset by reductions in spending includinglower commissions on lower sales, lower payroll costs reflecting lowerheadcount, and lower program costs.

 

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

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

 

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

 

| ** **                             | ** ** | **Total** | ** ** | **Severance  and   Termination  Benefits** | ** ** | **MOD II  Closure Costs** | ** ** | **MOD III  Closure Costs** | ** ** |
|----------------------------------------|------------|-----------|------------|--------------------------------------------|------------|---------------------------|------------|----------------------------|------------|
| Balance at December 31, 2004      |       | $         | 1.0        |                                       | $          | 0.3                       |       | $                          | 0.7        |   | $ | — |   |
| Provisions for special charges         |       | 0.5       |       | —                                     |       | 0.4                       |       | 0.1                        |       |
| Cash paid before MOD III reimbursement |       | (1.0      | )          | (0.3                                       | )          | (0.6                      | )          | (0.1                       | )          |
| Balance at March 31, 2005         |       | $         | 0.5        |                                       | $          | —                    |       | $                          | 0.5        |   | $ | — |   |

 

Duringthe three months ended March 31, 2005, special charges totaled $0.4million, comprised of $0.4 million associated with sustaining costs of our MODII wafer fab.  During the three months endedMarch 31, 2005, we sold certain assets of MOD II totaling $0.2 millionwhich were recorded through special charges and certain assets of MOD IIItotaling $0.1 million, the recovery of which was recorded as an offset to themaintenance costs of the facility.

 

***Stock-Based Compensation.***** **During the three months ended March 31, 2005 and March 31,2004, we recognized $0.3 million and $0.4 million of stock-based compensation,respectively,  in connection with theaward of restricted stock and stock options to certain executives, employeesand consultants.  These non-cash chargesare primarily included in our selling, general and administrativeexpenses.  Compensation expense foremployee stock awards are 

 

22

----

 

measuredon the award date and are recognized as these restrictions lapse.  Charges for stock awards to consultants ismeasured as the awards vest and are recognized over the periods that therestrictions lapse.  Based on theemployee stock and option awards we made, we anticipate that we will recognizestock compensation charges of $0.5 million, $0.1 million and $0.1 million forthe fiscal years ending March 31, 2006 through 2008, respectively.

 

***Goodwill and Intangible Assets***.  EffectiveJanuary 1, 2002, ZiLOG adopted the provisions of FASB Statement ofFinancial Accounting Standards No. 142, “Goodwill and Other IntangibleAssets” (“FAS 142”).  Under FAS 142,goodwill and intangible assets with indefinite lives are not amortized, but arereviewed annually or more frequently if impairment indicators arise.  In the three months ended September 30,2005, the Company reviewed its intangible assets and determined that there wasno impairment indicated at that time.

 

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

 

Asummary of the amounts recorded in the condensed consolidated balance sheet areas follows (in millions):

 

| ** **                                | ** ** | **Current  Technology** | ** ** | **Brand Name** | ** ** | **Total** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|----------------|------------|-----------|------------|
| Gross carrying amount, recorded May, 2002 |       | $                       | 17.0       |           | $          | 9.2       |       | $ | 26.2 |   |
| Accumulated amortization                  |       | 15.6                    |       | 3.9            |       | 19.5      |       |
| Book value at March 31, 2005         |       | $                       | 1.4        |           | $          | 5.3       |       | $ | 6.7 |   |

 

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

 
| **Year**               | ** ** | **Current  Technology** | ** ** | **Brand  Name** | ** ** | **Total  Amortization** | ** ** |
|------------------------|------------|-------------------------|------------|-----------------|------------|-------------------------|------------|
| April- March 2006 |       | $                       | 1.1        |            | $          | 1.1                     |       | $ | 2.2 |   |
| 2007                   |       | 0.1                     |       | 0.8             |       | 0.9                     |       |
| 2008                   |       | 0.1                     |       | 0.8             |       | 0.9                     |       |
| 2009                   |       | 0.1                     |       | 0.8             |       | 0.9                     |       |
| 2010                   |       | —                  |       | 0.8             |       | 0.8                     |       |
| Thereafter             |       | —                  |       | 1.0             |       | 1.0                     |       |
| Total                  |       | $                       | 1.4        |            | $          | 5.3                     |       | $ | 6.7 |   |

 

**Income Taxes**

 

Ourincome tax provision for thethree months ended March 31, 2005 reflectsamortization of deferred tax charges and tax expense in its profitable foreignjurisdictions. Our income tax benefit for the quarter ended March 31, 2004reflected our anticipated effective tax rate for the entire year of 2004. Ourtax provision for the three months ended March 31, 2004 included taxableincome in the U.S. resulting from items that were expensed for book purposesbut were nondeductible for tax purposes, as well as amortization of deferredtax charges and foreign taxes.

 

**Liquidity and Capital Resources**

 

InMay 2002, we entered into a three-year $15.0 million senior securedrevolving credit facility with a commercial lender under which borrowings bearinterest at a rate per annum equal, at our option, to the commercial lender’sstated prime rate or LIBOR, plus 2.5%. We have elected the LIBOR interest rate option, which, as of March 31,2005, was 5.5%.  As of March 31,2005, we had no outstanding borrowings and standby letters of credit of  $0.1 million. Our ability to borrow under the facility is based on a monthly borrowingbase calculation that is determined as a percentage of eligible accountsreceivable.  We are subject to certainfinancial covenants under the facility, including tangible net 

 

23

----

 

assetbalance and fixed charge coverage ratios only if the total of our cash, cashequivalents and availability on the facility are less than $7.5 million at anymonth end.  This facility expired on May 13,2005.

 

AtMarch 31, 2005, we had cash and cash equivalents of $33.6 million,compared to $37.7 million at December 31, 2004.  Cash used by operating activities was $4.1million for the three months ended March 31, 2005, compared to $2.2million of cash used by operating activities for the three months ended March 31,2004.

 

***Cash Flows From OperatingActivities.***  During the three months ended March 31,2005, cash used by operating activities of $4.1 million reflects the netoperating loss of $6.6 million, an increase in accounts receivable of  $2.5 million and a decrease in accountspayable of $0.8 million, offset by a decrease in inventory of $1.5 million, adecrease in prepaid expenses of  $1.6million, increases in accrued compensation and benefits of $0.4 million anincrease in other accrued liabilities of $0.8 million, and non cash charges of$1.5 million.  Non cash charges includedepreciation of $0.6 million, amortization of intangible assets of $0.6 millionand stock based compensation expense of $0.3 million.

 

Duringthe three months ended March 31, 2004, cash used by operating activitiesof $2.2 million primarily reflects increases in accounts receivable andinventories of $3.4 million and $2.2 million, respectively, and a $1.5 milliondecrease in other accrued liabilities, deferred income on shipments todistributors and accrued special charges. These uses of cash were offset partially by net non-cash charges of $2.0million, a $1.6 million increase in accounts payable and a $1.3 milliondecrease in prepaid expenses and other assets. Non-cash charges include adecrease of deferred income taxes of $0.7 million, $1.1 million foramortization of intangible assets, $1.2 million in depreciation andamortization charges and stock-based compensation expense of $0.4 million.

 

***Cash Flows From InvestingActivities.***  Cash used by investing activities was $0.2million and $0.7 million for the three months ended March 31, 2005 and2004, respectively. Cash used for investing activities in both of these periodsreflects capital expenditures for building improvements, software andequipment.  Cash used by investingactivities during thethree months ended March 31, 2005, also includes thecash received from the sale of MOD II assets.

 

***Cash Flows From FinancingActivities.***  Cash provided from financing activities were$0.2 million and $20.9 million for the three months ended March 31 2005and 2004, respectively.

 

Cashprovided by financing activities for the three months ended March 31, 2005of $0.2 million, reflects proceeds from issuance of common stock under employeepurchase plans.

 

Cashprovided by financing activities for the three months ended March 31, 2004of $20.9 million primarily reflects the net proceeds of $21.6 million from theCompany’s public offering of 2.0 million shares of common stock at a price of$12.50 per share, net of offering expenses. The stock offering proceeds were offset by repayments of $0.6 million ofborrowings under our revolving line of credit and $0.1 million for therepurchase of restricted common stock from a former employee.

 

***Non-GAAP EBITDA Measure.***  TheEBITDA amounts presented below reflect a non-GAAP measure of ourliquidity.  EBITDA reflects our netincome adjusted for non-cash items, interest and income taxes.  Our management uses separate “adjusted EBITDA”calculations for purposes of determining certain employees’ incentive compensationand, subject to meeting specified adjusted EBITDA amounts, for accelerating thevesting of EBITDA-linked stock options. Adjusted EBITDA, as we define it,excludes interest, income taxes, effects of changes in accounting principlesand non-cash charges such as depreciation, amortization, in-process researchand development, and stock-based compensation expense.  It also excludes cash and non-cash chargesassociated with reorganization items and special charges, which representoperational restructuring charges, including asset write-offs, employeetermination costs, and lease termination costs. EBITDA is presented on the basis management uses EBITDA as a measure ofcash earnings for budgeting and financial performance measurement.

 

Thedifferences between the EBITDA figures 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 our May, 2002, debt restructuring;

•                  Leasetermination costs;

 

24

----

 

•      Termination and exit charges, and

•      MOD II and MOD III closure costs and relatedasset impairment charges.

 

OurEBITDA, reconciled to cash provided (used) by operations (the most directlycomparable measure of liquidity under generally accepted accounting principles)for each period presented, is as follows (in millions):

 
| ** **                                                               | ** ** | **Three  Months Ended**  | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                               | ** ** | **March 31,  2005** | ** ** | **March 31,  2004** | ** ** |
| Reconciliation of net income (loss) to  EBITDA:                          |       |                     |       |   |   |
| Net income (loss)                                                        |       | $                        | (6.6       | ) | $ | — |   |
| Depreciation and amortization                                            |       | 1.2                      |       | 2.3 |   |
| Interest (income) expense, net                                           |       | (0.1                     | )          | — |   |
| Income tax provision (benefit)                                           |       | 0.8                      |       | (0.2 | ) |
| EBITDA                                                                   |       | $                        | (4.7       | ) | $ | 2.1 |   |
|                                                                     |       |                     |       |   |   |
| Reconciliation of EBITDA to net cash by  operating activities cash flow: |       |                     |       |   |   |
| EBITDA                                                                   |       | $                        | (4.7       | ) | $ | 2.1 |   |
| Benefit (provision) for income taxes                                     |       | (0.8                     | )          | 0.2 |   |
| Deferred income tax assets and liabilities                               |       | —                   |       | (0.7 | ) |
| Interest income (expense), net                                           |       | 0.1                      |       | — |   |
| Stock-based compensation                                                 |       | 0.3                      |       | 0.4 |   |
| Changes in operating assets and liabilities                              |       | 1.0                      |       | (4.2 | ) |
| Net cash used by operating activities                                    |       | $                        | (4.1       | ) | $ | (2.2 | ) |

 

**Contractual Obligations.**  Welease certain of our facilities and equipment under non-cancelable operatingleases, which expire in 2005 through 2009. These facility lease agreementsgenerally provide for base rental rates which increase at various times duringthe terms of the leases and also provide for renewal options at fair marketrental value. We are also responsible for common area maintenance charges oncertain office leases.

 

Wegenerally make purchases under cancelable purchase orders and do not enter intolong-term supply agreements. Certain of our wafer foundry, assembly, materialssuppliers, software vendors and support tool manufacturers requirenon-cancelable purchase orders since they often provide products and servicestailored to our specifications. Summarized in the table below are minimumfuture commitments under operating leases and non-cancelable purchaseobligations as of December 31, 2004 (in millions):

 
| ** **                  | ** ** | ** ** | ** ** | **Payment  due by period** | ** ** |
|-----------------------------|------------|------------|------------|----------------------------|------------|
| ** **                  | ** ** | **Total**  | ** ** | **Within   1 year**        | ** ** | **1-3  years** | ** ** | **3-5  years** | ** ** | **Greater  than   5 years** | ** ** |
|                        |       |       |       |                       |       |   |   |   |   |   |   |
| Operating lease obligations |       | $          | 6.6        |                       | $          | 2.2 |   | $ | 3.1 |   | $ | 1.3 |   | — |   |
|                        |       |       |       |                       |       |   |   |   |   |   |   |
| Purchase obligations        |       | 6.9        |       | 6.0                        |       | 0.9 |   | — |   | — |   |
|                        |       |       |       |                       |       |   |   |   |   |   |   |
| Total                       |       | $          | 13.5       |                       | $          | 8.2 |   | $ | 4.0 |   | $ | 1.3 |   | — |   |

 

Fromtime to time we have agreed to indemnify certain customers for potentialallegations of infringement of intellectual property rights and patents arisingfrom the use of the Company’s products. We have indemnification arrangementsthat limit our net contingent obligation to pay for defense costs, if any, upto a maximum of $500,000.

 

25

----

 

**Off Balance Sheet Arrangements**

 

Otherthan lease commitments and software licenses incurred in the normal course ofbusiness, we do not have any off balance sheet financing arrangements orliabilities, guarantee contracts, retained or contingent interest intransferred assets, or any obligation arising out of a material variableinterest unconsolidated entity.  We donot have any majority owned subsidiaries that are not included in theconsolidated financial statements. Additionally, we do not have any interest in, or relationship with, anyspecial purpose entity.

 

**Seasonality**

 

Salestypically increase in the quarter ending June 30th and peak in the quarterending September 30th driven by increased holiday demand from ourcustomers in the home entertainment and consumer products markets.  Our revenues are generally lower in the quartersending March 31st and December 31st compared to the rest of the year.  We believe that this historical seasonaltrend could be impacted by general economic conditions and reduction in salesof our legacy products.  Additionally,general world-wide economic, political and regional instabilities may impactour results of operations in any given period.

 

***Recent Accounting Pronouncements.***

 

*** ***In November 2004, the FASB issued SFAS No. 151, “InventoryCosts”. SFAS 151 is an amendment to ARB 43, Chapter 4, “Inventory Pricing”.SFAS 151 clarified the accounting for abnormal amounts of idle facilityexpense, freight, handling costs and wasted material or spoilage.  The provisions of SFAS 151 become effectiveon a prospective basis for fiscal years beginning after June 15, 2005 withearly application permitted.  The Companyhas not yet determined the impact, if any, of adopting SFAS 151, but it doesnot expect the adoption to have a material impact on its consolidated financialposition, results of operations or cash flows.

 

InDecember 2004, the FASB issued SFAS No. 123R, “Share-Based Payment.”SFAS 123R requires employee stock options and rights to purchase shares understock participation plans to be accounted for under the fair value method, andeliminates the ability to account for these instruments under the intrinsicvalue method prescribed by APB Opinion No. 25, and allowed under theoriginal provisions of SFAS No. 123.  SFAS No. 123R requires the use of anoption pricing model for estimating fair value, which is amortized to expenseover 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.

 

InDecember 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

 

InDecember 2004, the FASB issued FSP No.109-2, “Accounting and DisclosureGuidance for the Foreign Earnings Repatriation Provision within the AmericanJobs Creations Act of 2004.” The AJCA introduces a limited time 85% dividendsreceived deduction on the repatriation of certain foreign earnings to a U.S.taxpayer (repatriation provision), provided certain criteria are met.  FPS109-2 provides accounting and disclosureguidance for the repatriation provision. Although FSP 109-2 is effective immediately, the Company does not expectto be able to complete its evaluation of the repatriation provision until afterCongress or the Treasury Department provides additional clarifying language onkey elements of the provision.  In January 2005,the Treasury Department began to issue the first of a series of clarifyingguidance documents related to this provision. The Company has not yet determined the impact of adopting FSP 109-2, ifany, on its consolidated financial statements and related disclosures.

 

26

----

 

**RISK FACTORS**

 

**Risks Related to Our Business and Industry**

 

*The following risk factors should be consideredcarefully in addition to the other information in this Transition Report on 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 in netsales, and, if we fail to implement our new product strategy, we may continueto experience declines in sales and gross margins.***

 

Ineach of the past three years our net sales have declined significantly and ourfuture financial results are anticipated to be subject to substantialfluctuations. Our total net sales were $95.6 million for the year ended December 31,2004, and $103.6 million in 2003. In addition, our net sales for the threemonths ended September 30, 2005 were $20.5 million, compared to net salesof $22.8 million, for the three months ended September 30, 2004. Weanticipate that sales of our legacy products wil continue to decline over time.Our future financial performance and success are largely dependent on ourability to implement our new product strategy, which consists partly ofrefocusing our business on the next generation of micrologic products builtaround our core 8-bit micrologic architecture, beginning with the Z8 Encore!and eZ80 Acclaim! flash products.  In November 2002we launched our new 8-bit Z8 Encore! micrologic product, in February 2003we launched our new eZ80 Acclaim! micrologic product and in March 2004 ourenhanced Z8 Encore! XP flash product family. These products typically have along lead time from design to production, which can range from twelve months tothirty-six months. These new products now represent approximately 10% of ournet sales and we currently expect the contribution of these products tocontinue to grow.  If we are unable todevelop new products in a manner that timely meets changing market requirements,or if we are not able to achieve significant sales of our new 8-bit micrologicproducts for any reason, our product strategy may fail and our net sales andoperating results may continue to decline or not grow as currentlyexpected.  In addition, as we introducenew products, including our flash and IR products, we experience additionalstart up costs and unfavorable manufacturing prices due to low volume. Inaddition, we do not expect margins on our flash products to be as strong asthose on our legacy products for the foreseeable future. Consequently, theintroduction of new products could have a negative impact on our gross margineven if sales from such new products offset declining revenues of our legacyproducts.

 

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

 

Werely on independent third-party foundry manufacturers including X-FAB, TSMC,and UMC to fabricate wafers for all of our product needs.  Industry-wide shortages in foundry capacitycould harm our financial results.  If weare unable to obtain the requisite foundry capacity to manufacture ourproducts, or if we have to pay higher thananticipated 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.

 

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

 

•              limited warranties on wafers or productssupplied to us;

 

•              increased exposure to potentialmisappropriation of our technology;

 

27

----

 

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

 

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

 

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

 

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

 

OnAugust 11th, 2005 Microchip Technology Inc. (Microchip) filed a patentinfringement claim against the Company in the U.S. District Court of Arizona(case number CV05-2406-PHX-MHM). Microchip alleges that the Company has beeninfringing and currently infringes its patents numbered 5,847,450, 6,696,316and 6,483,183. Microchip claims that unspecified products of the company,including the Z8 Encore! XP 4K Series of products, infringe these patentsand is seeking preliminary and permanent injunctive relief, unspecified damagesand costs including attorneys’’ fees. We filed a response to the claims on September 15,2005 generally denying the claims and challenging the validity of the patents. InJanuary, 2006, the Company filed a request for the re-examination of thesepatents with the United States Patent and Trademarks Office. The U.S. PTOusually takes up to 90 days to determine and advise as to their decision onundergoing such re-examination.

 

Wedo not believe it is feasible to predict or determine the outcome or resolutionof this litigation at this time. We believe we have meritorious defenses andwill defend ourselves against these claims vigorously. We may incur substantialexpenses in our defense against these claims. In the event of a determinationadverse to us, we may incur substantial monetary liability, and be required tochange our business practices. Either of these could have a material adverseeffect on our financial position, results of operations or cash flow.

 

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

 

Weuse outside contract assemblers in Indonesia, Thailand and the Philippines forpackaging our products.  These countrieshave been subject to political instability and terrorist activities. Thepackaging of semiconductors is a complex process requiring, among other things,a high degree of technical skill and advanced equipment.  If we are unable to obtain additionalassembly capacity on sufficiently favorable terms, our ability to maintain orgrow our net sales could be impaired. Shortages in contract assembly capacity could cause shortages in ourproducts and could also result in the loss of customers as a result ofdelays.  Because we rely on these thirdparties, we also have less control over our costs, delivery schedules andquality of our products and our technology is at greater risk ofmisappropriation.

 

***Our success depends on our abilityto introduce new products on a timely basis.***

 

Ouroperating results depend on our ability to introduce and sell new products on atimely basis that can compete

 

28

----

 

effectivelybased on price and performance and that address customer requirements. Rapidlychanging technologies and industry standards, along with frequent new productintroductions, characterize the industries that are currently the primaryend-users of semiconductors. As these industries evolve and our customers andpotential customers introduce new products, our success will depend on ourability to adapt to such changes in a timely and cost-effective manner by designing,developing, manufacturing, marketing and providing customer support for newproducts and technologies. In the past, we have brought products to market onan untimely basis or canceled the introduction of previously planned products,such as our Cartezian line of 32-bit microprocessors. Our ability to introduceand sell new products successfully depends on several factors, including:

 

•              development of support tools and technicaldocumentation that make complex products easy for engineers to understand anduse;

 

•              proper new product selection;

 

•              timely completion and introduction of newproduct designs;

 

•              support from our foundry service providers;

 

•              complexity of the new products to be designedand manufactured; and

 

•              market acceptance of our products and ourcustomers’ products.

 

Theemphasis of our new product development is on the next generation of productsbuilt on our 8-bit micrologic architecture. If market demand for these productsdoes not develop as we anticipate, our product development strategy could fail.Because our products are complex, we may not meet the design and introductionschedules for any new products or any additions or modifications to ourexisting products, and these products may not achieve market acceptance. Inaddition, we may not be able to sell these products at prices that arefavorable to us.

 

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

 

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

 

•              our ability to design and manufacture newproducts that implement new technologies, including our eZ80 Acclaim! and Z8Encore! product families;

 

•              our ability to protect our products byeffectively utilizing intellectual property laws;

 

•              our product quality, reliability, ease of useand price;

 

29

----

 

•              the diversity of our product line and featuresets within our products;

 

•              our efficiency of production;

 

•              our ability to obtain adequate supplies ofraw materials and other supplies at acceptable prices;

 

•              the pace at which customers incorporate ourdevices into their products; and

 

•              the success of our competitors’ products andgeneral economic conditions.

 

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

 

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

 

•              our ability to introduce and sell newproducts and technologies on a timely basis, such as our Z8 Encore! and eZ80Acclaim! device families and extensions of these product families;

 

•              any shortage of wafer or assemblymanufacturing capacity at our third-party vendors;

 

•              competitive developments, including pricingpressures;

 

•              technological change and productobsolescence;

 

•              changes in product mix or fluctuations inmanufacturing yields;

 

•              variability of our customers’ product lifecycles;

 

•              the level of orders that we receive and canship in a quarter and customer order patterns;

 

•              seasonality;

 

•              inventory write-downs or asset impairments;

 

•              restructuring charges;

 

30

----

 

•              increases in the cost or scarcity of rawmaterials; and

 

•              gain or 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.***

 

Ournet sales in any given quarter depend upon a combination of orders received inthat quarter for shipment in that quarter and shipments from backlog. Ourbacklog at the beginning of each quarter does not include all sales needed toachieve expected revenues for that quarter. Consequently, we are dependent onobtaining orders to be shipped in the same quarter that the order is receivedfor a significant portion of net sales in that quarter. Moreover, customers mayreschedule shipments, and production difficulties could delay shipments.Accordingly, we have limited visibility into future product shipments, and ourresults of operations may be subject to significant variability from quarter toquarter.

 

***We operate in the highly cyclicalsemiconductor industry, and have experienced a downturn in the business cycle,which has adversely affected our revenues and cash generation.***

 

Thesemiconductor industry is highly cyclical and has experienced significanteconomic downturns, often in connection with, or in anticipation of, maturingproduct cycles (for semiconductors and for the end-user products in which theyare used) and declines in general economic conditions. These downturns havebeen characterized by diminished product demand, erosion of average sellingprices, production over-capacity and high inventory levels. For example,beginning in the quarter ended December 31, 2000 we experienced athree-year downturn in our business cycleand are currently experiencing another downturn. We believe that, inlight of these events, some of our customers curtailed and may in the futuredelay or further curtail spending on technology, which could negatively affectour quarterly results or financial condition in the future.  Similar economic downturn in thesemiconductor industry could increase pressure on us to reduce our prices,which could impair our revenues, gross margins and operating cash flow. Fromtime to time, the semiconductor industry also has experienced periods ofincreased demand and production capacity constraints. We have in the pastexperienced substantial period-to-period declines in operating results, andwill likely in the future experience substantial period-to-period fluctuationsin operating results that are attributable to semiconductor industry conditionsor events occurring in the general economy.

 

***Average selling prices in the semiconductorindustry typically decline over time, which directly affects our revenue andmargins.***

 

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

 

***A significant amount of our revenuescomes from relatively few of our customers and distributors, and any decreaseof revenues from these customers and distributors, or the loss of their business,could significantly harm***

 

31

----

 

***our financial results.***

 

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

 

Historicallywe have been, and we expect to continue to be, dependent on a relatively smallnumber of distributors for a significant portion of our revenues. We depend onthird-party distributors to market and sell our products, and these third-partydistributors accounted for approximately 57% of our net sales for the threemonths ending September 30,  2005, and54% of our net sales for the nine months ending September 30, 2005,. 50%of our net sales for2004 and approximately 47% of our net sales for 2003. Inaddition, our five largest distributors accounted for approximately 45% of ournet sales for the three months ending September 30,  2005, 43% of our net sales for the nine monthsending 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 few majorcustomers for a substantial portion of our sales.***

 

Ourten largest customers, excluding our distributors, accounted for approximately31% and   35% of our net sales for the three month andnine month period ending September 30, 2005, respectively, 37% of our netsales for 2004, and approximately 38% of our net sales for 2003.  For the three months ended September 30,2005, we had one distribution customer that accounted for approximately 25% ofour net sales and OEM customer that accounted for approximately 7% of our netsales.  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 patternson short notice, particularlybecause substantially all of our sales are made on a purchase order or salesorder acknowledgment basis, which permits our customers to cancel, change ordelay product purchase commitments upon 30 days notice for standard productsand 60 days notice for custom products without paying a cancellation or reschedulingcharge. Customers may still cancel or reschedule within these timeperiods, however they routinely incur a cancellation or rescheduling charge.This cancellation risk is increased because our customers can purchase somesimilar products from our competitors. The loss of one or more major customersor any reduction, delay or cancellation of orders by any of these customers orour failure to market successfully to new customers could result in asignificant reduction in net sales during one or more periods, excess inventoryor write-downs of inventory.

 

***Our international operations subjectus to risks inherent in doing business in foreign countries that could impairour results of operations.***

 

Approximately58% of our net sales for the nine-month period ended September 30, 2005,approximately 48% of our net sales for 2004, and approximately 42% of our netsales for 2003, calculated consistent with revenue recognition of distributionrevenue on a deferred (re-sale) basis were made to foreign countries. Thesesales to foreign customers will continue to represent a significant portion ofour net sales in the future. We maintain significant operations or rely on anumber of contract manufacturers in the Philippines, Indonesia, Taiwan,Thailand, India and other locations in Asia.

 

32

----

 

Wecannot assure you that we will be successful in overcoming the risks thatrelate to or arise from operating in international markets. Risks inherent indoing business on an international level include:

 

•              economic and political instability;

 

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

 

•              transportation delays;

 

•              power supply shortages and shutdowns;

 

•              difficulties in staffing and managing foreignoperations and other labor problems;

 

•              existence of language barriers and culturaldistinctions;

 

•              acts of God, including floods, typhoons andearthquakes;

 

•              taxation of our earnings and the earnings ofour personnel; and

 

•              other uncertainties relating to theadministration of, or changes in, or new interpretation of, the laws,regulations and policies of the jurisdictions in which we conduct our business.

 

Inaddition, our activities outside the United States are subject to risks associatedwith fluctuating currency values and exchange rates, hard currency shortagesand controls on currency exchange. While our sales are primarily denominated inU.S. dollars, worldwide semiconductor pricing is influenced by currency ratefluctuations, and such fluctuations could harm our operating resultsmaterially.

 

Therisks inherent in our international operations have been increased by thethreat of terrorist attacks.  Theseattacks, coupled with an international military response, have created an uncertaineconomic environment, and we cannot predict the impact of these politicalthreats or any related military action, on our customers or our business.

 

***We have had a history of losses, andwe may not be profitable in the future.***

 

Wehave had a history of losses for each of the years in the five-year periodended December 31, 2004, excluding the one-time gain on extinguishment ofdebt and fresh-start adjustments in 2002. We were not profitable in thenine-month period ended September 30,2005. We may not be profitablein the future.

 

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

 

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

 

33

----

 

***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.***

 

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

 

Additionally,our pending and future patent applications should not be relied upon as theymay not issue as patents, and even if they do issue, such future patents maynot be of sufficient scope or strength to provide meaningful economic orcompetitive value.

 

Litigationmay be necessary to enforce our intellectual property rights, to protect ourtrade secrets or to determine the validity and scope of our proprietary rightsor the proprietary rights of others. Any such litigation could require us toincur substantial costs and divert significant valuable resources, includingthe efforts of our technical and management personnel, which may harm ourbusiness materially.

 

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

 

Inaddition to the Microchip lawsuit described elsewhere, from time to time wehave received, and may in the future receive, communications from other thirdparties asserting that a product offered by us, or an aspect of our business,infringes a patent held by the other third party and/or requires a licensethereto. With respect to those other third party communications that arecurrently pending, we believe, after having consulted with counsel, that either(i) we have meritorious defenses, (ii) based on license termspreviously offered to us or typically available in the industry, we can obtainany necessary licenses on commercially reasonable terms, or (iii) we canmodify our products to avoid such rights, but if this is not the case, we maybe sued and assessed damages for past infringement. Indeed, licenses may not beavailable on commercially reasonable terms, or at all. In addition, we havecertain indemnification obligations to customers with respect to theinfringement of third party intellectual property rights by our devices.

 

Wehave received in the past a letter from an electronic equipment manufacturerthat makes products that are competitive to certain of our key products,asserting that the sale of certain of our key products may be infringingcertain patents owned by them. After having consulted with counsel, we believethat we have meritorious defenses to the assertions set forth in the letter.However, should it become necessary to engage in litigation to defend againstsuch assertions, such litigation could be expensive and time consuming. Therecan be no assurance that the ultimate resolution of this matter would not havea material adverse affect on our business.

 

Intellectualproperty lawsuits are subject to inherent uncertainties due to the complexityof the technical issues involved, and we may not be successful in defendingourselves against intellectual property claims. The cost of defending againstpatent infringement or other intellectual property litigation, in terms ofmanagement time and attention, legal fees and product delays, could be substantial,whatever the outcome. If any patent or other intellectual property claimsagainst us are successful, we may be prohibited from using the technologiessubject to these claims, and if we are unable to obtain a license on acceptableterms, license a substitute technology, or design new technology

 

34

----

 

toavoid infringement, we could be prohibited from using or selling the infringingproducts or technologies and be required to pay substantial damages. Such aresult could have a material adverse effect on our business.

 

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

 

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

 

•              replacements or recalls could imposesubstantial costs on us;

 

•              rumors, false or otherwise, may be circulatedby the press and other media, which could cause a decrease in sales of ourproducts; and

 

•              customers or end users may file suits or assertother legal claims against us alleging damages caused by defective products orerrors in products. If we do not successfully defend such suits, we could berequired to pay substantial damages. Even if we prevail in suits filed bycustomers or end users, we may be required to expend significant funds indefense.

 

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

 

Asa result of technological changes, from time to time our customers change thedesign of their products so as not to include our products, which may have anegative impact on our net sales. For example, in 1999 and 2000, a number ofour customers changed the designs of computer mouse pointing devices that theymanufactured, and as a result, these devices no longer contain our products.Because we do not have long-term supply contracts with most of our customers,changes in the designs of their products can have sudden and significantimpacts on our sales. For example, net sales of our computer mouse pointingdevices and other computer peripheral products decreased substantially fromapproximately $15.4 million in 2000 to approximately $4.9 million in 2001,approximately $2.4 million in 2002, and approximately $0.7 million for 2003 andapproximately $0.1 million for 2004. These reduced sales due to design changeshave harmed us in the past, and additional design changes could result in lowerrevenues in the future.

 

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

 

Wehave implemented significant cost cutting measures in the past, includingduring 2005. These cost cutting efforts have included:

 

•              restructuring our manufacturing operations,which has included closing and subsequently outsourcing all of our waferfabrication and assembly operations and consolidating probe and final testoperations at our Philippines site;

 

•              refocusing our strategic priorities;

 

•              reallocating personnel and responsibilitiesto better utilize human resources;

 

**•**              reducing our workforce; and

 

•              instituting temporary office and facilityshutdowns.

 

Costcutting measures may not increase our efficiency or lead to profitability.  In the past we have reduced our spending onresearch and development.  Reducingresearch and development spending could harm our ability to

 

35

----

 

introducenew products in the future. If our revenue or operating results significantlydecline in the future, we may be required to institute further cost reductionmeasures.

 

Fromtime to time, we evaluate our strategic alternatives with respect to ourfacilities and we may take actions, such as the sales of the remaining assetsof MOD II and our MOD III subsidiary, which may result in the occurrence ofaccounting charges. Some or all of these charges may be non-cash. Such chargeswould have a negative impact on our GAAP profitability and may have a negativeimpact on our cash balance

 

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

 

Undercertain of these laws and regulations, current or previous owners or operatorsof property may be liable for clean-up costs and other damages without regardto whether they knew of, or caused, the contamination. The presence of, orfailure to remediate, contamination could adversely affect the value of, andthe ability to transfer or encumber, our property. In addition, we may berequired to incur significant expense in connection with governmentalinvestigations of environmental or employee health and safety matters.

 

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

 

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

 

•              insufficient experience with technologies andmarkets in which the acquired business is involved, which may be necessary tosuccessfully operate and integrate the business;

 

•              problems integrating the acquired operations,personnel, technologies or products with the existing business and products;

 

•              diversion of management time and attentionfrom our core business to the acquired business;

 

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

 

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

 

•*             *subsequent impairment of the acquiredassets, including intangible assets.

 

Inaddition, acquisitions could require investment of significant financialresources and may require us to obtain additional equity financing, which maydilute our stockholders’ equity, or to incur additional indebtedness.

 

***Acts of war or terrorism could harm ourbusiness.***

 

Thelong-term effects of potential terrorist attacks on the world economy and ourbusiness are unknown, but could be material to our business. Terrorist acts oracts of war, whether in the United States or abroad, also could cause damage ordisruption to our business, our suppliers, our freight carriers, or ourcustomers, or could create political or economic

 

36

----

 

instability,any of which could have a material adverse effect on our business.

 

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

 

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

 

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

 

Inthe course of our assessment of the effectiveness of our internal controlfinancial reporting as of December 31, 2004, which assessment wasconducted during the quarters ended December 31, 2004 and March 31,2005 in connection with the preparation of 2004 audited financial statementsand our annual report on Form 10-K for 2004, we identified two materialweaknesses in our internal control over financial reporting which are morefully described under Item, Controls and Procedures in our Form 10-K forthe year ended December 31, 2004.

 

Inaddition, in the course of our ongoing 2005 evaluation of the effectiveness ofthe design and operation of our disclosure controls and procedures, weidentified a failure to record and thereby disclose in our 2004 Form 10-Kcertain grants of options to purchase: (1)160,000 shares of our common stock atan exercise price of $12.44 and; (2)45,884 shares of our common stock at anexercise price of $5.20.  These grantswere issued to our Chief Executive Officer in the quarter ended June 30,2004 as more fully described under Item 4, Controls and Procedures, of our Form 10-Qfor the period ended June 30, 2005. A footnote to the beneficial ownership table explaining the beneficialownership of certain stock options held by our CEO was also incorrect.  This reporting deficiency and the abovematerial weaknesses in our internal control over financial reporting disclosedpreviously in our 2004 Form 10-K, as well as any other weaknesses ordeficiencies that may exist or hereafter arise or be identified, could harm ourbusiness and operating results, and could result in adverse publicity and aloss in investor confidence in the accuracy and completeness of our 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 a relatively small accounting staffing level anduse supplemental resources such as contractors and consultants to provideadditional accounting support.  The lossof accounting personnel, contractors and consultants, including our chieffinancial officer, could adversely impact the effectiveness of our controlenvironment and our internal controls, including our internal controls overfinancial reporting.  Additionally, we continueto migrate certain accounting functions from the U.S. to our Philippinesoperations to streamline activities, lower our costs and better support theexpanding Asian region.  Failure toproperly hire, retain, train, and supervise the work of our accounting staff,including those in the Philippines, could adversely impact our controlenvironment and our internal controls, including internal controls overfinancial reporting.

 

Althoughwe believe that we have remediated these weaknesses and deficiencies and ourdisclosure control failure, we cannot assure you that this remediation has beensuccessful or that additional deficiencies or weaknesses in our controls andprocedures will not be identified.  Inaddition, we cannot assure you that our independent registered publicaccounting firm will agree with our assessment that our material weaknesseshave been remediated.

 

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

 

OnDecember 29, 2005, the Company’s Board of Directors unanimously adoptedresolutions to change its fiscal year end from December 31 to March 31.The Company revised its fiscal year so that its audit work can be performedduring non-peak periods with its independent accountants which the Companybelieves will result in cost savings over the long-term. The Company has alsoidentified deficiencies in its information technology controls, including theneed to better segregate duties as it relates to the use of its OracleInformation Systems modules and to improve its General Computing Controlscompliance and documentation. The Company has not determined whether thesedeficiencies in its internal controls over financial reporting would constitutematerial weaknesses, as defined in Public Company

 

37

----

 

AccountingOversight Board Auditing Standard No. 2, as of December 31, 2005. Thechange in fiscal year will provide the Company with additional time to review,improve and remediate activities and operations around these controls althoughno assurance can be made that such deficiencies will be successfully remediatedby March 31, 2006.

 

InDecember, 2005 the Securities and Exchange Commission adopted a change in itsaccelerated filer rules such that a company with a market capitalization,that is the number of shares outstanding multiplied by its trading value pershare, of less than $50 million may be considered a non-accelerated filer andas such is exempt from the management confirmation and independent auditorattestation requirements under the Sarbanes-Oxley 404.. At September 30,2005, the Company was below this measure and as such will not be an acceleratedfiler for fiscal 2007 and will not include the management certification andindependent auditor attestation over internal controls over financial reportingin its Form 10-K for the year ending March 31, 2006.

 

***Recently enacted and proposedchanges in securities laws and regulations may increase our costs.***

 

TheSarbanes-Oxley Act of 2002 that became law in July 2002 required changesin some of our corporate governance practices. The Act also requires the SEC to promulgate new rules on a varietyof subjects. These new rules and regulations have increased our legal andfinancial compliance costs, and made some activities more difficult, timeconsuming and/or more costly.  We alsoexpect that these new rules and regulations may make it more costly toobtain director and officer liability insurance coverage, and we may berequired to accept reduced coverage or incur substantially higher costs toobtain coverage.  These new rules andregulations could also make it more difficult for us to attract and retainqualified members of our board of directors, particularly to serve on our auditcommittee, and qualified executive officers.

 

***Changes in accounting principlesgenerally accepted in the United States may adversely affect our reportedfinancial results or otherwise harm our business.***

 

Weprepare our financial statements in conformity with accounting principlesgenerally accepted in the United States. These accounting principles aresubject to interpretation by the Financial Accounting Standards Board, theAmerican Institute of Certified Public Accountants, the Securities and ExchangeCommission and various bodies formed to interpret and create appropriateaccounting policies. A change in these policies or interpretations could have asignificant effect on our reported financial results, and could affect thereporting of transactions completed before the announcement of a change. Forexample, while current accounting rules allow us to exclude some expenseof stock options from our financial statements, effective fiscal year 2006, theCompany will be required to include the expenses of these options and the 15%discount employees receive on purchase under the employee stock purchase planin the income statement in accordance with FAS 123R. Technology companiesgenerally, and our company, specifically, rely heavily on stock options as amajor component of our employee compensation packages.  Because we will soon be required to expenseoptions, we may be less likely to achieve profitability or we may have todecrease or eliminate options grants. Decreasing or eliminating option grantson our employee stock option program may negatively impact our ability toattract and retain qualified employees. The impact may adversely effect our reported financial results.

 

***Changes in our business conditionscould result in impairment of our goodwill.***

 

Inaccordance with SFAS No.142*Accounting forGoodwill and Other Intangible Assets* the Company must perform atleast an annual testing of the Company’s stated value of its net assetsincluding goodwill and other intangible assets in relation to the implied fairmarket value of the Company.  If theCompany’s market capitalization or fair market value declines, we may be requiredto record financial adjustments to the stated values of our goodwill and otherintangible assets resulting in a material adverse effect on our financialcondition and results of operations.

 

***Our NorthAmerican distributor could emphasize competing products, and we may lose someof our customers as a result.***

 

38

----

 

InOctober 2002, we engaged Future Electronics as our exclusive full-servicedistributor in North America. Additionally, Future Electronics provides distributor support to us inEurope and Asia on a non-exclusive basis. For the nine months ended September 30, 2005 and 2004, Futurepurchased approximately $13 million and $15 million , respectively,contributing approximately 22% and 20% to our net sales, respectively.  Future Electronics distributes products ofour competition that may directly compete with our product offerings. If FutureElectronics chooses to promote those products over our products, our operatingresults could be harmed significantly. In addition, if Future Electronics wereto terminate our distribution agreement, we could experience a period ofsignificant interruption of our business while we obtained other distributionchannels.

 

***Provisions in our organizationaldocuments and Delaware law could discourage acquisition proposals or delay achange in control that would be beneficial to our stockholders.***

 

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

 

•              providing for a classified board of directorswith staggered terms;

 

•              limiting the persons who may call specialmeetings of stockholders; and

 

•              prohibiting stockholders from taking actionby written consent.

 

Inaddition, provisions of Delaware law may discourage, delay or prevent someonefrom acquiring or merging with us.

 

***Our directors, named executive officersand our two largest stockholders, who beneficially own approximately 32% of ourcommon stock in the aggregate, may have interests that conflict with theinterests of our other stockholders.***

 

Our directors and named executive officers,together with two large stockholders, UBS Willow Management, L.L.C., fundsmanaged by Capital Research and Management Company beneficially ownedapproximately 32% of our outstanding common stock, in the aggregate, as of September 30,2005.  As a result of theirownership and positions, our directors and named executive officers, togetherwith UBS Willow Management and Capital Research and Management Company,collectively are able to significantly influence all matters requiringstockholder approval, including the election of directors and approval ofsignificant corporate transactions. Such concentration of ownership may alsohave the effect of delaying or preventing a change in control. If the ownershipof our common stock continues to be highly concentrated, it may prevent you andother stockholders from influencing significant corporate decisions. Theinvestment objectives of these stockholders may differ from those of our otherstockholders, including our future public stockholders.

 

39

----

 

**Item 3.  Quantitativeand 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 and borrowings under ourrevolving credit facility.  We do not usederivative financial investments in our investment portfolio.  Our primary investment objectives are topreserve capital and maintain liquidity. These objectives are met by investing in high-quality credit issuancesand limiting the amount of credit exposure to any one company.  Our policy is to mitigate default risk byinvesting in only the highest quality securities and monitoring the creditratings of such investments.  As of March 31,2005, our cash equivalents were invested in bank time deposits and money marketfunds.  We have no significant cash flowexposure due to rate changes for our cash equivalents as these instruments havevery short maturities.

 

Thetable below presents principal amounts and related interest rates for our cashequivalents as of March 31, 2005 (dollars in millions):

 

| ** **            | ** ** | **Carrying Value** | ** ** | **Fair Value** | ** ** |
|-----------------------|------------|--------------------|------------|----------------|------------|
| Cash Equivalents:     |       |               |       |           |       |
| Fixed rate            |       | $                  | 29.9       |           | $          | 29.9 |   |
| Average interest rate |       | 2.13               | %          | —         |       |
|                       |            |                    |            |                |            |  |  |

 

**Foreign Currency Exchange Risk.**    Wetransact business in various foreign countries, but the vast majority of ourconsolidated net sales and purchases are denominated in U.S. dollars.Currently, we do not employ a foreign currency hedging program to mitigate ourforeign currency exchange risk as foreign currency transactions and we believethe risks to date have not been significant. We maintain local currency bankaccounts in our international offices to facilitate payment of local operatingcosts.

 

**Item 4. Controls and Procedures**

 

# **Evaluation of Controls and Procedures**

# ** **

Asof March 31, 2005, the Company’s management carried out an evaluation,under the supervision and with the participation of the Company’s ChiefExecutive Officer, James Thorburn, and the Company’s Chief Financial Officer,Perry J. Grace, of the effectiveness of the design and operation of the company’sdisclosure controls and procedures. Based upon that evaluation, Mr. Thorburn and Mr. Graceconcluded that the Company’s disclosure controls and procedures are effectivein causing material information to be collected, communicated and analyzed bymanagement of the Company on a timely basis and to ensure that the quality andtimeliness of the Company’s public disclosures complies with its SEC disclosureobligations.

 

**Disclosure Controls and Procedures**

 

 The Company maintains disclosure controls andprocedures designed to ensure that the information the Company must disclose inits filings with the Securities and Exchange Commission is recorded, processed,summarized and reported on a timely basis. As reported in Item 9A of our Annual Report on Form 10-K for theyear ended December 31, 2004 (the “2004 Annual Report”), we determinedthat two material weaknesses identified in our internal control over financialreporting exposed deficiencies in our disclosure controls and procedures, andwe concluded that our disclosure controls and procedures (as such term isdefined in Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”)) were ineffective at December 31,2004.  We have since implemented theremedial measures described in the 2004 Annual Report to correct thosedeficiencies.  The Company’s management,under the supervision and with the participation of the Company’s ChiefExecutive Officer and Chief Financial Officer, has reviewed and evaluated theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures as of the end of the period covered by this report (the “EvaluationDate”).  Based on such evaluation, theCompany’s Chief Executive Officer and Chief Financial Officer have concludedthat the remedial measures implemented to correct the deficiencies in ourdisclosure controls and procedures have been effective to correct thosedeficiencies and that, as of the Evaluation Date, the Company’s

 

40

----

 

disclosurecontrols and procedures are effective in causing material information to becollected, communicated and analyzed by management of the Company on a timelybasis and to ensure that the quality and timeliness of the Company’s publicdisclosures complies with its SEC disclosure obligations.

 

**Changes in Internal Controls Over Financial Reporting**

 

**Changes made during the transition period ending March 31,2005:**

 

Ourmanagement is responsible for establishing and maintaining adequate internalcontrol over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f).  In Item 9A of the 2004 Annual Report we notedthe following material weaknesses in our controls over financial reporting:

 

1)             During the course of executing the Company’s2004 year-end financial reporting process, management determined that theCompany’s policies and procedures did not provide for adequate managementoversight and review of the determination of estimated reserves for distributorprice adjustments. As a result of this deficiency in internal control, amaterial understatement of management’s reserve computation was identified.This material understatement of management’s reserve computation was correctedprior to issuance of the Company’s 2004 consolidated financial statements.

 

2)             Also, in executing the Company’s 2004year-end financial reporting process, management determined that the Company’spolicies and procedures associated with the preparation and review of schedulesand reconciliations supporting the Consolidated Statement of Cash Flows werenot effective. These internal control deficiencies resulted in theoverstatement of cash flows from operating activities and the understatement ofcash flows from investing activities in a corresponding amount. These materialmisstatements in the Consolidated Statements of Cash Flows were corrected priorto issuance of the Company’s 2004 consolidated financial statements.

 

Toaddress the material weaknesses identified in Management’s Report on InternalControl over Financial Reporting, management undertook the remediation actionsrelated to the policies and procedures over the determination of the reservefor distributor price adjustments and the preparation of the Company’sconsolidated financial statements. Specifically, management has remediated thedesign and operating effectiveness of the Company’s internal control overrecording distributor price adjustment reserves by:

 

1)             increasing the management-level review of thedetailed support for the reserves; and

 

2)             reducing the cycle-time for processingoutstanding distributor price adjustments by adding additional staffingresources to this function.

 

Remediationof internal controls in the area of preparing the Company’s consolidatedfinancial statements, including the consolidated statement of cash flows, hasincluded additional staff training and increased levels of supervision andreview to improve the effectiveness of the compilation of the statement of cashflows.

 

**Changes made during the most recent fiscal quarter:**

 

Asdisclosed in the Company’s 8-K filed on December 29, 2005, the Companyidentified deficiencies in its information technology controls, including theneed to better segregate duties as it relates to the Company’s Oracle modulesand to improve access compliance. The Company has not determined whether thesedeficiencies in its internal controls over financial reporting would constitutematerial weaknesses, as defined in Public Company Accounting Oversight BoardAuditing Standard No. 2, as of December 31, 2005. Recently, theCompany engaged independent consultants to assist in the review of the Company’sinternal controls surrounding its information systems including a review withrecommendations for change and the implementation of such changes to; 1)eliminate identified conflicts associated with Segregation of Duties in the useof its information systems, and 2) improve the documentation and compliancesurrounding its General Computer Controls.

 

41

----

 

Otherthan these corrective measures, there have not been any changes in the Company’sinternal control over financial reporting (as such term is defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) during the most recent fiscal quarterthat have materially affected, or are reasonably likely to materially affect,the Company’s internal control over financial reporting.

 

42

----

 

### **PART II**

### ** **

**OTHERINFORMATION**

 

**Item 1.  LegalProceedings**

 

OnAugust 11th, 2005 Microchip Technology Inc. (Microchip) filed a patentinfringement claim against the Company in the U.S. District Court of Arizona(case number CV05-2406-PHX-MHM). Microchip alleges that the Company has beeninfringing and currently infringes its patents numbered 5,847,450, 6,696,316and 6,483,183. Microchip claims that unspecified products of the company,including the Z8 Encore! XP 4K Series of products, infringe these patentsand is seeking preliminary and permanent injunctive relief, unspecified damagesand costs including attorneys’ fees. We filed a response to the claims on September 15,2005 generally denying the claims and challenging the validity of the patents.A hearing has been scheduled for November 17th, 2005. In January, 2006,the Company filed a request for the re-examination of these patents with theUnited States Patent and Trademarks Office. The U.S. PTO usually takes up to 90days to determine and advise as to their decision on undergoing suchre-examination.

 

Wedo not believe it is feasible to predict or determine the outcome or resolutionof this litigation at this time. We believe we have meritorious defenses andwill defend ourselves against these claims vigorously. We may incur substantialexpenses in our defense against these claims. In the event of a determinationadverse to us, we may incur substantial monetary liability, and be required tochange our business practices. Either of these could have a material adverseeffect on our financial position, results of operations or cash flow.

 

**Item 2.  UnregisteredSales of Equity Securities and Use of Proceeds**

 

OnJuly 29, 2004, ZiLOG announced that its board of directors has authorizeda stock repurchase program pursuant to which ZiLOG may repurchase up to$5,000,000 in market value of its outstanding shares of common stock. ZiLOG’scommon stock trades on the NASDAQ National Market and purchases under theprogram are made, from time-to-time, in the open market, through block tradesor otherwise. Depending upon market conditions and other factors, thesepurchases may be commenced or suspended at any time or from time-to-timewithout prior notice.  As of December 31,2005, Zilog had repurchased a total of 572,100 shares at a cost of $4.4 million**.**

 

**Item 3.  Defaults UponSenior Securities**

 

None.

 

**Item 4.  Submission ofMatters to a Vote of Security Holders**

 

None.

 

**Item 5.  OtherInformation**

 

None.

 

43

----

 

**Item6.  Exhibits**

 

a)             Exhibits are filed or incorporated herein byreference as indicated below:

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                            |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                       |
| 2.1 (a)             |       | Joint Reorganization Plan,  as confirmed by order of the U.S. Bankruptcy Court for the Northern District  of California, dated April 30, 2002.                                                                        |
|                |       |                                                                                                                                                                                                                       |
| 3.1 (b)             |       | Amended and Restated  Certificate of Incorporation of ZiLOG, Inc., as amended and corrected.                                                                                                                          |
|                |       |                                                                                                                                                                                                                       |
| 3.2 (c)             |       | Amended and Restated  Bylaws of ZiLOG, Inc.                                                                                                                                                                           |
|                |       |                                                                                                                                                                                                                       |
| 4.1 (d)             |       | Form of Restricted  Stock Purchase Agreement.                                                                                                                                                                         |
|                |       |                                                                                                                                                                                                                       |
| 4.2 (d)             |       | Form of Non-Qualified  EBITDA-Linked Option Grant Agreement.                                                                                                                                                          |
|                |       |                                                                                                                                                                                                                       |
| 4.3 (d)             |       | Form of Non-Qualified  Non-EBITDA-Linked Option Grant Agreement.                                                                                                                                                      |
|                |       |                                                                                                                                                                                                                       |
| 4.4 (e)             |       | Form of 2004  Non-Qualified Option Grant Agreement, Date of Grant.                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                       |
| 4.5 (e)             |       | Form of 2004  Non-Qualified Option Grant Agreement, Date of Hire.                                                                                                                                                     |
|                |       |                                                                                                                                                                                                                       |
| 4.6 (e)             |       | Form of 2004  Non-Qualified Option Grant Agreement, Fully Vest Date of Grant.                                                                                                                                         |
|                |       |                                                                                                                                                                                                                       |
| 31.1                |       | Certification of Chief  Executive Officer pursuant to Securities Exchange Act Rules 13a-14 and  15-d14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of  2002, dated January 31,2006.        |
|                |       |                                                                                                                                                                                                                       |
| 31.2                |       | Certifications of Chief  Financial Officer pursuant to Securities Exchange Act Rules 13a-14 and  15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of  2002, dated January 31, 2006.      |
|                |       |                                                                                                                                                                                                                       |
| 32                  |       | 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, January 31, 2006 |

 

----

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

 

(b)       Incorporated herein by reference to the itemof the same name filed as an exhibit to the Company’s Annual Report on Form 10-K forthe fiscal year ended December 31, 2003.

 

(c)       Incorporated herein by reference to Exhibit 99.1to the Company’s current report on Form 8-K filed with the Commission on November 17,2005.

 

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

 

(e)       Incorporatedherein by reference to the item of the same name filed as an exhibit to theCompany-’sQuarterly Report on Form 10-Q filed with the commission on November 10, 2004.

 

44

----

 

**ZiLOG, Inc.**

 

**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 
|                              | ZiLOG, Inc.                                |
|-----------------------------------|-------------------------------------------------|
|                              | (Registrant)                                    |
|                              |                                            |
|                              |                                            |
|                              | /s/ Perry J. Grace                              |   |
|                              | Vice President and Chief  Financial Officer     |
|                              | (Duly Authorized Officer)                       |
|                              |                                            |
|                              |                                            |
|                              | /s/ James M. Thorburn                           |   |
|                              | Chairman, Chief Executive  Officer and Director |
|                              | (Duly Authorized Officer)                       |
|                              |                                            |
|                              |                                            |
| Date:  January 31, 2006 |                                            |
|                                   |                                                 |  |  |

 

45

----