**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

**FORM 10-K**

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| **x**                                                | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES** |
|------------------------------------------------------|--------------------------------------------------------------------------------|
| ** **                                           | **EXCHANGE ACT OF 1934**                                                       |
| **For the fiscal year ended December 31, 2005** |
| **OR**                                               |
| **o**                                                | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE**        |
| ** **                                           | **SECURITIES EXCHANGE ACT OF 1934**                                            |

 

**Forthe transition period from                    to                   **

**Commissionfile number 000-31337**

**WJ COMMUNICATIONS, INC.**

(Exact name of registrant asspecified in its charter)

| **DELAWARE**                                     |   | **94-1402710**       |
|--------------------------------------------------|--------|----------------------|
| (State or other  jurisdiction of                 |   | (I.R.S. Employer     |
| incorporation or  organization)                  |   | Identification  No.) |
| **401 River Oaks Parkway, San Jose, California** |   | **95134**            |
| (Address of  principal executive offices)        |   | (Zip Code)           |

 

**(408) 577-6200**

(Registrant’s telephonenumber, including area code)

Securities registeredpursuant to Section 12(b) of the Act:   NONE

Securities registeredpursuant to Section 12(g) of the Act:   COMMON STOCK $0.01 PARVALUE (Title of class)

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes o   No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes o   No x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x   No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K(§229.405 of this chapter) is not contained herein, and will not be contained,to the best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of the Form 10-Kor any amendment to the Form 10-K. o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

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

 

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

As of July 3, 2005,the last business day of the registrant’s most recently completed second fiscalquarter, the aggregate market value of voting stock held by non-affiliates ofthe registrant was approximately $49,874,346 (based upon the $1.80 closingprice of the common stock as reported by the NASDAQ National Market on July 1,2005). Shares of the registrant’s common stock held by each officer anddirector and each person known to the registrant to own 10% or more of theoutstanding voting power of the registrant have been excluded in that suchpersons may be deemed to be affiliates. This determination of affiliate statusis not a determination for other purposes.

As of March 28, 2006there were 65,689,880 shares outstanding of the registrant’s common stock,$0.01 par value.

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DOCUMENTS INCORPORATED BYREFERENCE:   None

 

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SPECIAL NOTICE REGARDING FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K, theshareholders’ annual report, press releases and certain information providedperiodically in writing or orally by the Company’s officers, directors oragents contain certain forward-looking statements within the meaning of thefederal securities laws that also involve substantial uncertainties and risks.These forward-looking statements are not historical facts but rather are basedon current expectations, estimates and projections about our industry, ourbeliefs and our assumptions. Words such as “may,” “anticipates,” “expects,” “intends,”“plans,” “believes,” “seeks” and “estimates” and variations of these words andsimilar expressions, are intended to identify forward-looking statements. Thesestatements are not guarantees of future performance and are subject to risks,uncertainties and other factors, some of which are beyond our control, aredifficult to predict and could cause actual results to differ materially fromthose expressed, implied or forecasted in the forward-looking statements. Inaddition, the forward-looking events discussed in this annual report might notoccur. These risks and uncertainties include, among others, those described inthe section of this report entitled “Risk Factors.”  Readers should also carefully review the riskfactors described in the other documents that we file from time to time withthe Securities and Exchange Commission. We assume no obligation to update orrevise the forward-looking statements or risks and uncertainties to reflectevents or circumstances after the date of this report or to reflect theoccurrence of unanticipated events.

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**WJ COMMUNICATIONS, INC.FORM 10-K ANNUAL REPORTFOR THE FISCAL YEAR ENDED DECEMBER 31, 2005TABLE OF CONTENTS**

|                   | ** ** |                                                                                                                    | ** ** | **Page** | ** ** |
|-------------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| **PART I**   |       |                                                                                                               |       |     |       |
| Item 1.           |       | Business                                                                                                           |       |     | 4          |   |   |
| Item  1a.         |       | Risk  Factors                                                                                                      |       |     | 17         |   |   |
| Item 1b.          |       | Unresolved Staff Comments                                                                                          |       |     | 34         |   |   |
| Item 2.           |       | Properties                                                                                                         |       |     | 34         |   |   |
| Item  3.          |       | Legal  Proceedings                                                                                                 |       |     | 34         |   |   |
| Item 4.           |       | Submission of Matters to a Vote of Security Holders                                                                |       |     | 34         |   |   |
| **PART II**  |       |                                                                                                               |       |     |       |
| Item 5.           |       | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |       |     | 35         |   |   |
| Item 6.           |       | Selected Consolidated Financial Data                                                                               |       |     | 38         |   |   |
| Item 7.           |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                   |       |     | 41         |   |   |
| Item 7a.          |       | Quantitative and Qualitative Disclosure About Market  Risks                                                        |       |     | 64         |   |   |
| Item 8.           |       | Consolidated Financial Statements and Supplementary  Data                                                          |       |     | 65         |   |   |
| Item 9.           |       | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure                         |       |     | 113        |   |   |
| Item 9a.          |       | Controls and Procedures                                                                                            |       |     | 113        |   |   |
| Item  9b.         |       | Other  Information                                                                                                 |       |     | 114        |   |   |
| **PART III** |       |                                                                                                               |       |     |       |
| Item 10.          |       | Directors and Executive Officers of the Registrant                                                                 |       |     | 114        |   |   |
| Item  11.         |       | Executive  Compensation                                                                                            |       |     | 118        |   |   |
| Item 12.          |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                    |       |     | 125        |   |   |
| Item 13.          |       | Certain Relationships and Related Transactions                                                                     |       |     | 127        |   |   |
| Item 14.          |       | Principal Accountant Fees and Services                                                                             |       |     | 128        |   |   |
| **PART IV**  |       |                                                                                                               |       |     |       |
| Item 15.          |       | Exhibits and Financial Statement Schedules                                                                         |       |     | 129        |   |   |
|              |       | Signatures                                                                                                         |       |     | 133        |   |   |

 

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**PART I**

**Item 1. BUSINESS**

**Overview**

We are a radio frequency (“RF”) semiconductor companyproviding RF product solutions worldwide to communications equipment companiesand service providers. We design, develop and manufacture innovative, high performanceproducts for both current and next generation wireless and wireline networks,and RF identification (“RFID”) systems. Our RF product solutions are comprisedof advanced, highly functional RF semiconductors, components and integratedassemblies which address the radio frequency challenges of these varioussystems. We currently generate the majority of our revenue from our productsutilized in wireless and wireline networks. Our revenue from our products usedin RF identification systems represents a less significant portion of ourcurrent revenue however we believe they represent areas of future growthopportunity. The RF challenge is to create product designs that function withinthe unique parameters of different wireless system architectures. Our solutionis comprised of design expertise, advanced device technology andmanufacturability. Our commercial communications products are used bytelecommunication and broadband cable equipment manufacturers supporting and facilitatingmobile communications, enhanced voice services, data and image transport. Ourobjective is to be the leading supplier of innovative RF semiconductorsproducts.

We have continued to augment our existing technologybase and design capabilities with two recent acquisitions. On January 28,2005 we completed our acquisition of Telenexus, Inc. (“Telenexus”). Webelieve the addition of Telenexus’ RFID products and technology will allow usto continue to enhance our RFID reader offerings to further capitalize onmarket opportunity. On June 18, 2004, we completed our acquisition of thewireless infrastructure business and associated assets from EiC Corporation, aCalifornia corporation and EiC Enterprises Limited (together “EiC”). We believethat the addition of EiC’s technical expertise further enhances WJ’s strategyof offering customers what we believe to be industry leading products for thewireless infrastructure market.

WJ Communications, Inc. (formerly Watkins-JohnsonCompany, “we,” “us,” “our” or the “Company”) was founded in 1957 in Palo Alto,California, and for many years we focused on RF microwave devices for defenseelectronics and space communications systems. Beginning in the 1990s, we beganapplying our RF design, semiconductor technology and integration capabilitiesto address the growing opportunities for commercial communications products. Webelieve that our history of designing high quality, reliable products and ourlong-standing relationships with industry-leading customers is animportant competitive advantage. We were originally incorporated in Californiaand reincorporated in Delaware in August 2000.

Our principal executiveoffices are located at 401 River Oaks Parkway, San Jose, California 95134, andour telephone number at that location is (408) 577-6200. OurInternet address is *www.wj.com.*Ourannual reports on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K, amendments to those reports and otherSecurities and Exchange Commission, or SEC, filings are available free ofcharge through our website as soon as reasonably practicable after such reportsare electronically filed with, or furnished to, the SEC. The informationcontained on our website is not intended to be part of this report. Our commonstock is listed on the Nasdaq National Market and traded under the symbol “WJCI”.

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**Industry Background**

Industry overview

We believe severalimportant trends provide long-term growth opportunities for RF technology inmarkets such as wireless communications, RFID and broadband cable. Markettrends that drive the growth in demand for high-performance RF productsinclude:

·       Growthin the number of wireless subscribers and an increase in consumer demand foradvanced data services. The worldwide wireless communications industry hasgrown considerably in recent years and continues to grow, with the number ofsubscribers expected to grow from 1.3 billion in 2003 to 1.7 billion in 2007according to IDC, representing a 7% compound annual growth rate. At the sametime, mobile subscribers are increasingly demanding data services in additionto traditional voice telephony services. To meet this demand, network operatorsare building new and upgrading existing mobile networks to offer greaternetwork capacity and speed to deliver voice and data services. These nextgeneration wireless networks require new equipment based on more advanced RFtechnology.

·       Potentialbroad deployment of RFID technology. RFID offers the potential for substantialproductivity gains and operational cost savings because it enables real-timeknowledge of greater amounts of unique product data than can be delivered byconventional technology, such as product type, date of manufacture, serialnumber and expiration date. The technology has been successfully used inseveral applications to date, such as Exxon Mobil’s SpeedpassTM, and severalrecent announcements indicate a growing desire of companies to implement RFIDtechnology, including Wal Mart’s public announcement that it’s 100 topsuppliers must be RFID compliant in 2005 and a Department of Defense statementthat its suppliers must use RFID tags by early 2005. According to VentureDevelopment Corporation, the RFID market is forecasted to grow from $965million in 2002 to $2.7 billion in 2007, representing a 23% compound annualgrowth rate. We are targeting the ultra high frequency (“UHF”) reader segmentof that market.

·       Demand for high performancebroadband cable network services. In recent years, many cable network operatorshave begun to upgrade their network infrastructure to support high-speed dataservices, a broad selection of digital television channels and voice telephonyservices. To support these enhanced services, cable network operators areupgrading their network infrastructure with equipment that utilizes highfrequency RF technologies.

*NetworkInfrastructure*

Consumers and businesses are continually seekingimproved connectivity, mobility, functionality, reliability and bandwidth fromvoice and data networks. Increased deployment and use of wireless communicationssystems and the rise of cable and wireless Internet applications has alsoplaced additional demands on network infrastructure.

Wireless communications and broadband cable serviceproviders continue to make investments in network infrastructure to expandcapacity and offer a broader range of services to support the changing needs ofend users while reducing their operating costs. In addition, wireless networkoperators and service providers have announced their plans for deployment ofnext generation wireless services and networks, referred to in the industry as2.5G and 3G networks. These networks will offer subscribers increased speeds,additional application capabilities, and broader compatible coverage acrossgeographies. To meet these objectives,network operators are building new and upgrading existing mobile networks tooffer greater network capacity and speed to deliver voice and data services.These next generation wireless networks require new equipment based on moreadvanced RF semiconductor technology. In broadband cable networks, operators have begun to upgrade their networkinfrastructure to support high-speed data services, 

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abroad selection of digital television channels, video-on-demand and voicetelephony services. To support these enhanced services, cable network operatorsare upgrading their network infrastructure with equipment that utilizes highfrequency RF technologies.

Original equipment manufacturers (“OEMs”) must developsystems to meet the requirements of communications service providers. Inmeeting these requirements, OEMs face significant market and productperformance pressures including cost reduction, higher performance, greaterreliability and shorter time to market. OEMs are adopting new approaches indesigning systems to deliver the performance and feature improvements thatservice providers require. In a typical communications system, the principalfunctional blocks are the RF subsystem, which receives, amplifies and transmitssignals, the signal processor, which encodes and decodes digitized signals, andthe antenna. Since the RF subsystem receives the signal, interfaces with thesignal processor, and amplifies and transmits the signal, a system’sperformance and signal quality are significantly affected by the RF subsystem.Some OEMs do not have the internal resources to address every aspect of asystem’s RF performance. To lower their production costs and shorten productdevelopment cycles, OEMs are seeking innovative RF components from third-partysuppliers. We believe that there is a substantial market opportunity for athird-party supplier of high performance RF components who can meet the needsfor flexibility, performance and value required by OEMs.

RF components aregenerally technically sensitive devices that demand circuit design expertiseand sophisticated process technology. A process technology is a method ofmanufacturing semiconductor devices and circuits using a given wafer material.Many RF component suppliers have made significant investments in their ownwafer fabrication facilities (“fabs”) which are typically based on a singleprocess technology. As a result, RF component suppliers with wafer fabsgenerally focus most of their attention on developing products using their ownprocess technology even if another process may be more appropriate for a givenapplication. To adopt one of these other process technologies, these componentsuppliers would have to migrate their current facility to the othertechnologies, make significant capital investments in new wafer fabricationequipment or would have to develop relationships with merchant wafer fabs.Because all of these steps are expensive and time consuming, most RF componentsuppliers resist changing process technologies. As a result, it is difficult fora single RF component supplier to supply a broad range of products that meetall the requirement of the major OEMs, thus allowing multiple supplierstargeting different segments of the markets.

*Radio FrequencyIdentification (RFID)*

Radio frequency identification, or RFID, is a genericterm for technologies that use radio waves to automatically identify individualitems. In general, the system consists of an RFID tag, which contains theidentification of the item tagged, and an RFID reader, which sends out a radiowave signal to read the information contained on the tag. The RFID tag is madeup of a microchip with an antenna, and it can be either passive or active. PassiveRFID tags contain no internal power source such as a battery. To read a passiveRFID tag, the reader sends out electromagnetic waves. Passive RFID tags drawpower from these electromagnetic waves and use it to power the microchip’scircuits. The microchip modulates the waves that the tag reflects back to thereader and the reader converts the returned waves into digital data. Thedigital data is then passed on to a host computer that can make use of thedata. Active RFID tags operate more or less in the same manner except that thetags have a battery; this internal power supply in the tag allows for activeresponse to the reader as well as active data manipulation on the tag.

Profitable and effective commercial RFID systems havebeen in operation for over a decade. The current market is driven bytraditional applications such as security/access control, automobileimmobilization, toll collection, and transportation. Many other applicationsare in the early adoption phase, including pallet tracking, point of salecommerce, baggage handling. There are notable obstacles to overcome before significantgrowth can be seen, including but not limited to, acceptable industry and 

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application standards,cost, end user education, frequency regulations, power restrictions, theweakness of indirect channel support and the highly fragmented competitive environment.

In addition to a high number of trial applications,there have also been many real implementations across several industries. Forexample, numerous libraries, labs, hospitals, warehouses, retailers, commerciallaundries, and automobile manufacturers implemented RFID for applications suchas item, material and asset management. This penetration into verticalindustries occurs as a growing number of systems integrators and softwarecompanies who serve these industries continue to form relationships with RFIDhardware vendors. RFID hardware manufactures are also welcoming serviceproviders who specialize in warehouse management, logistics services, assetmanagement, and industrial automation into their partner programs.

Going forward, the supplychain will begin to drive the RFID market. For example, Wal-Mart Stores Inc.(NYSE: WMT), Gillette Co (NYSE: G) and the United States Department of Defensemandates for their respective suppliers to deliver product RFID tagged at thecase and pallet level have helped spur the industry to move beyondexperimentation to implementation. We believe that the full Realization of theTransportation Recall Enhancement, Accountability, and Documentation Actmandated by the United States Congress in 2000 could also create opportunityfor RFID readers. The next level in the supply chain will be item level taggingleading to the need for a high volume of shelf readers so that real timeinventory tracking and shrinkage reduction can be put into place. In our view,the natural evolution for RFID will be into cell phones and other portabledevices for point of sale applications.

**The RF Challenge**

Radio frequency (“RF”)semiconductor technology presents different engineering challenges thanstandard semiconductor design. In general, digital semiconductors are createdfrom standard semiconductor circuit designs that have predictable performance.This permits an automated design process. Each RF component, however, hasdistinctly different characteristics that influence overall system performancein complex ways. Instead of having stable inputs and outputs, the RF circuitcharacteristics can drift based on process variations, temperature, powersupply and other variables. As a result, performance characteristics are uniquefor each device, and the RF engineer must evaluate and develop new designs on acontinuous basis for each system performance level and air interface standard.In addition to being skilled in semiconductor circuit design, the RF circuitdesigner must have a thorough understanding of signal processing principles,must understand the totality of the system for which the device is intended andmust be able to create designs that function within the unique parameters ofdifferent wireless system architectures.

The knowledge and skillsrequired to design and to manufacture RF semiconductors, components andintegrated modules are unique and can take many years to develop. Manufacturersseek companies with the technical skills and engineering resources to design,manufacture and integrate RF semiconductors and the other advanced productsrequired by current and future generations of wireless and cable communicationsequipment.

**The WJ Communications Solution**

With the ability to design and manufacture RFsemiconductors, components, and integrated RF modules, and interface theseassemblies with other network elements, we enable both current and nextgeneration wireless networks, RFID systems and broadband cable worldwide. Ourcore technology lies within our advanced RF semiconductor designs.

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Our RF expertisecovers a broad range of frequencies used in advanced communications networkstoday. Our capabilities are comprised of the following key elements:

·       *RF Design Expertise.*We have been designing RF and microwaveproducts for more than 45 years and have developed significant RF designexpertise. Our team of 84 highly qualified and talented engineering andtechnical employees is capable of applying this expertise to a variety of RFproducts. These products are optimized to achieve high performance with minimumcost.

·       *Advanced Device Technology.*We have substantial expertise indesigning and manufacturing highly linear semiconductor products that amplifyand transform signals with minimal distortion and interference.

·       *Manufacturability.*Our ability to rapidly convert new technologies and designs intocompleted RF semiconductors, integrated assemblies, and highly functionalcomponents products results from our flexible manufacturing operations and ourmanufacturing engineering expertise.

**Business Strategy**

Our objective is tobe the leading supplier of innovative RF semiconductor products. To meet thisgoal, we intend to:

·       *Leverage Our Technology Leadership and Our Design and IntegrationExpertise to Grow with Growing Markets.*We intend to target multiplegrowth markets such as RFID, power amplifiers and WiMAX and expand ouraddressable market opportunities in wireless communications and broadbandcable. We believe that as data throughput requirements expand in wirelessnetworks the ability to meet the RF requirements becomes increasingly importantand the market for RF products will grow accordingly. We intend to apply our RFdesign expertise to develop additional leading-edge products in each of therapidly growing areas of the communications markets, focusing on the marketsfor RF semiconductors, modules and components. Due to the commonality of RFrequirements in broadband cable and wireless communications networks, we havethe flexibility to allocate our design and engineering resources to any or allof these markets and intend to use this flexibility to take advantage of marketopportunities as they arise.

·       *Maintain and Develop Strong Collaborative Customer Relationships withIndustry Leaders.*We believe our reputation for product quality,technical performance, customer responsiveness, on-time delivery and costcompetitiveness will help us to continue to maintain and develop a loyalcustomer base. We collaborate with many of our customers to design and developnew products for them as they develop new products. We plan to maintain ourcurrent, and develop new, customer relationships with industry leaders withinwireless and cable communications markets.

·       *Acquire andDevelop New Technologies.*We intend to continue to augment ourexisting technology base and design capabilities by acquiring complementarytechnologies, design capabilities, manufacturing processes and productofferings for broadband cable applications. In June 2004 we acquired thewireless infrastructure business of EiC Corporation and EiC Enterprises Limitedand in January 2005 we acquired Telenexus, Inc. which designs,develops, manufactures and markets RFID reader products for a broad range ofindustries and markets. In addition, we intend to continue to focus our researchand development efforts on emerging communications and RF technologies.

**Products and Technology**

We are committed to being a leader and innovator of RFproducts and believe that we are positioned to provide a broad portfolio of RFtechnology products. Our RF products are comprised primarily of semiconductorsincluding amplifiers, mixers, RF integrated circuits, transistors, chipsets andmulti-chip 

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modules (“MCMs”), and RFIDreaders and reader modules. Our MCMs integrate multiple RF semiconductors,process technologies and functions in a single package allowing us tosignificantly reduce cost, power consumption and circuit board space. Ourability to design our semiconductors in multiple process technologies enablesus to address a variety of end-markets and applications.

Thefollowing table summarizes the sales from our significant product lines:

| ** **                                       | ** ** | **Year Ended**         | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|
| ** **                                       | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** |
| Semiconductor and  RFID (RF products)            |       |                        | $          | 31,201 |   |   |   | $ | 29,808 |   |   |   | $ | 20,246 |   |   |
| Wireless Integrated  Assemblies and Fiber Optics |       |                        | 396        |   |   |   | 2,528 |   |   |   | 6,319 |   |   |
| Total                                            |       |                        | $          | 31,597 |   |   |   | $ | 32,336 |   |   |   | $ | 26,565 |   |   |

 

In the second quarter of2003 we sold our Thin-Film product line, included in Semiconductor and RFID, toM/A-COM, a unit of Tyco Electronics. Our Thin-Film product line contributed$855,000 to our semiconductor sales in 2003. The Wireless Integrated Assembliesand Fiber Optic businesses are at end-of-life, and we expect very modestcontribution to sales from Wireless Integrated Assemblies and no contributionfrom Fiber Optic products.

*SemiconductorProducts and Process Technologies*

Our semiconductor products include a broad array ofhigh performance semiconductors that we manufacture for our own use as well asfor sale to others. The primary markets for our semiconductor products are thewireless and broadband cable infrastructure markets.

Our semiconductor products are comprised primarily ofamplifiers, mixers, multi-chip modules and transistors. Amplifiers and transistors increase the level of signalswhile mixers translate a signal from one frequency to another. The strength ofour semiconductor technology lies in our ability to design and in the case ofour gallium arsenide (“GaAs”) semiconductor products, manufacture highly linearproducts. High linearity is one of the most critical performance parameters forbroadband cable and wireless networks and represents a semiconductors’ abilityto amplify and transform signals with minimal distortion and interference.

We have expertise in designing and manufacturing RFcomponents in multiple process technologies. Some of these processes have beenbuilt in our own manufacturing operations and in other cases we have ourproducts manufactured for us by an outside foundry.

The followingmature processes are running in our wafer fabrication facility. These processessupport our current product portfolio in production. These technologies arealso used actively in new product design now and will be for the next four tofive years .

·       Galliumarsenide metal semiconductor field effect transistor (GaAs MESFET)

·       Galliumarsenide heterostructure fieldeffect transistor (GaAs HFET)

·       Indiumgallium phosphide heterojunction bipolar transistor (InGaP HBT)

We also designproducts with state-of-the-art integrated circuit designs by using processesfrom outside foundries. Products have been released to market based ontechnologies from these foundries and more new products are being designed using these foundries. As foundriesupgrade their process technologies, we expect that we will continue our designwork with the latest process.

·       SiliconOn Insulator (SOI)

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·       Integratedcombination of silicon-germanium heterostructure bipolar transistor andcomplementary metal oxide semiconductor (SiGe BiCMOS)

·       Siliconcomplementary metal oxide semiconductor transistor (CMOS),

Finally, there areemerging process technologies that we have identified as being suitable forfuture amplifier products. These emerging technologies are focused aroundadvanced InGaP HBT processes that will allow us to expand into higher poweramplifier products that operate at higher supply voltages. We are in productionbased on the 12 Volt version of the InGaP HBT process. We are qualifying our 28Volt  InGap HBT process for a series ofour new power amplifier products.

*RFID ReaderProducts*

Our radio frequencyidentification (“RFID”) products are primarily UHF RFID readers. During 2003 webegan to utilize our core RF design expertise and RF semiconductor integrationIP to address the market’s need for low cost RFID readers capable of working inreal world environments. In September 2003, we introduced an Auto-IDCenter Class 1 EPC compliant reader operating in the 900MHz ISM bandachieving significant improvement in reader performance with a substantialreduction in cost and form factor. By the end of 2003 we began productiondeliveries of this product and have completed development on a Class 1 EPCcompliant reader operating in the worldwide 2.4GHz band. During 2004, weintroduced our MPR5000 and MPR6000 multi-protocol readers operating in the 900MHz ISM band in the industry standard PCMCIA form factor. In 2005 we completedour acquisition of Telenexus, Inc. (“Telenexus”). We believe the additionof Telenexus’ RFID products and technology will allow us to continue to enhanceour RFID reader offerings to further capitalize on market opportunity. Forexample, during 2005, we developed the Apollo I four-port fixed reader, a SmartReader with a Linux based operating system and a thin-client Class 3reader. Also during 2005, we introduced our MPR7000, a 1.0 Watt PCMCIA Type II RFID Reader Card.

*WirelessCommunications Integrated Assembly Products*

Our wireless integrated assembly products areprimarily used in wireless infrastructure equipment, such as cellular basestations, which provide a combination of voice and data services to mobileusers. These products include base station RF front ends, diagnostic andsupport equipment and repeaters. Base station RF front ends consist of filtersand frequency converters, and are used in virtually every communications systemto translate signals from one frequency to another.

These products havereached the end of their product life cycle and are considered as legacyproducts which will not be a significant factor in our long term business.Aside from potential and infrequent “life time buys,” our focus willpredominantly be repair and maintenance of the existing product base.

**Customers**

Wesell our products principally to our distributor and original equipmentmanufacturers, including their manufacturing subcontractors. We believe that wehave strong relationships with market leaders in all of our target markets. Asample of our revenue-producing customers includes:

| Andrew Corporation             |   | LG Electronics, Inc.      |   | Richardson Electronics Ltd.    |
|--------------------------------|--------|--------------------------------|--------|--------------------------------|
| Celestica                      |   | Lucent Technologies, Inc. |   | Samsung Electronics Co. Ltd.   |
| Ericsson                       |   | Motorola                       |   | Siemens                        |
| Flextronics                    |   | Nokia Networks                 |   | Symbol Technologies, Inc. |
| Global Electronics Corporation |   | Nortel Networks                |   | UNIRF System Co., Ltd.         |
| Huawei Technologies            |   | Powerwave Technologies         |   | Withus Co., Ltd.               |
| Intermec, Inc.            |   | RF Net Co. Ltd.                |   | ZTE Corporation                |

 

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We depend on a limitednumber of key customers for a majority of our sales. In 2005, RichardsonElectronics, our sole worldwide distributorof our complete line of RF semiconductor products, and Celestica eachaccounted for more than 10% of our sales and in aggregate accounted forapproximately 58% of our sales. In 2004, Richardson Electronics and Celesticaeach accounted for more than 10% of our sales and in aggregate accounted forapproximately 63% of our sales. In 2003, Richardson Electronics and Lucent Technologieseach accounted for more than 10% of our sales and in aggregate accounted forapproximately 70% of our sales. We expect that our key customers will continueto account for a substantial portion of our sales in 2006 and in theforeseeable future. These customers and their respective contributions to ournet revenue have varied and will likely continue to vary from period to period.We typically sell products pursuant to purchase orders that customers cangenerally cancel or defer on short notice without incurring a significantpenalty, and currently do not have agreements with any of our key customersthat contain long-term commitments to purchase specified volumes of ourproducts.

**Sales,Marketing and Customer Support**

·       *Direct Sales  *We have a dedicated team of directsales people who are responsible for maintaining relationships with our keycustomers and generating new business with both existing and potentialcustomers. We cultivate strong, direct relationships with our key customersthrough major account teams that are led by our sales professionals and arecomprised of engineers and product managers. These teams are designed toaddress the specific product needs of our key customers.

·       *Distributor  *In June 2002, we entered into asole worldwide distributorship agreement with Richardson Electronics, Ltd., aglobal provider of engineered products, to resell our products through catalog,e-commerce and direct channels. This agreement expanded our previousrelationship and includes provisions for joint marketing and promotionalactivities such as advertising in trade publications and the planning andexecution of technical tours/demonstrations and trade shows, including suchexpenses as rental of space and/or equipment, travel and posters. We directly compensate vendors for the cost ofthese specifically identified goods or services or may reimburse RichardsonElectronics, Ltd. if they incurred the costof such specifically identified goods or services on our behalf the value ofwhich is substantiated by invoicing from vendors. Our cost for these activitiesis recorded in selling and administrative expense as advertising.

·       *Manufacturer Sales Representatives  *Our worldwide network of twenty-fourindependent manufacturer sales representatives is responsible forassisting our direct sales force in calling on potential customers as well asmaintaining relationships with non-major accounts.

·       *Applications Engineering*  Ourproducts are highly technical and our customers frequently consult with us toselect a component for a given application, determine product performance underspecified conditions unique to their system, or test a product for newapplications. To meet the needs of our customers, we provide support in allstages of the sales process, from concept definition and product selection topost-sale support. These services are provided by our applications engineeringorganization, which works closely with our sales organization in all pre- andpost-sale activities. We intend to continue to invest in expanding ourapplications engineering organization to assist our customers.

·       *InternationalSales*  Our sales outside the United States were 44%, 35%and 32% of our total sales in 2005, 2004 and 2003, respectively. We believeAsia is one of the fastest growing technology markets. In 2005 we opened ourShenzhen office in China and we recently added a director of Asia Sales andappointed country managers in China and Korea.

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**Manufacturing**

Our facility in Milpitas, California produces some ofour gallium arsenide semiconductor products. At the same facility, we alsoproduced our thin-film products until our second quarter of 2003. Considerablemanufacturing capacity exists for our gallium arsenide semiconductors. Ourgallium arsenide products are packaged in Singapore, The Philippines, Malaysia,and Taiwan at vendor facilities. We utilize external wafer foundries for ourSiGe and some of the MESFET and InGap HBT semiconductor products. On March 8,2006 we announced we had formed a strategic foundry relationship with GlobalCommunication Semiconductors, Inc. to second-source our GaAs and InGaP HBTwafers.

Our San Jose, California facility produces ourwireless communications and RFID products. We contract with external surfacemount manufacturers for high volume manufacturing, using both turnkey andconsignment material arrangements depending on the characteristics of theassembly. We have used a number of capable surface mount manufacturers. Oncethe surface mount assembly operations are completed, the products are shippedto our facilities for testing and final configuration.

We depend on single or limited source suppliers forthe components and materials used in many of our products, including our SiGeprocessed wafers, 5Volt and 12Volt InGap HBT processed wafers, gallium arsenidewafers, packaging, electronic components and antennas. Although we rely onlimited or sole source suppliers for other components and materials, there aretypically alternative sources of supply available for them. If in the future weface difficulties obtaining these components and materials from any of ourlimited or sole source suppliers, we may face a delay in the shipment ofproducts which are manufactured using these components and materials while weidentify and qualify an alternative source of supply, if available. As a resultof these delays, we may fail to satisfy customer orders and our sales maydecline while we look for a suitable alternative supplier.

We are committed toquality of the management systems governing the manufacture of our products andour systems are ISO 9001 (revision 2000) certified. The InternationalOrganization for Standardization (“ISO”) is a network of the national standardsinstitutes of 148 countries including the United States of America. The ISO9000 family of standards is primarily concerned with “quality management,”meaning the systems the organization utilizes to fulfill:  the customer’s quality requirements, andapplicable regulatory requirements, while aiming to enhance customersatisfaction, and achieve continual improvement of its performance in pursuitof these objectives. The ISO 9001: 2000 is approved as an American NationalStandard by the American Society for Quality. Our systems are regularlyassessed by independent certifying bodies, through routine quality systemaudits, for adherence to ISO 9001 standards.

**Research and Development**

Our future success dependson our ability to develop new designs, technologies and product enhancements.We have assembled a core team of experienced engineers and technologists toaccomplish these objectives. These employees are involved in advancing our coretechnologies, as well as applying these core technologies to our productdevelopment activities in our target markets. We have made, and will continueto make, a substantial investment in research and development activities.Research and development costs, which are expensed when incurred, were $18.1million, $17.2 million and $16.9 million for the years 2005, 2004 and 2003,respectively.

**Intellectual Property**

The protection of our intellectual property iscritical to our success. We rely on patent, copyright, trademark and tradesecret laws, as well as confidentiality procedures and contractual provisions,to protect our proprietary rights. We believe that one of our competitivestrengths is our core competence in engineering, manufacturing andunderstanding our customers and markets, and we take aggressive steps toprotect that knowledge. We have been active in securing patents and enteringinto non-disclosure and 

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confidentiality agreementsto protect our proprietary technologies and know-how resulting from our ongoingresearch and development.

We seek patent protection for our unique developmentsin circuit designs, processes and algorithms. We have 22 United States patentsand 16 foreign patents. We currently have a number of patent applicationspending in the United States Patent and Trademark Office and throughout theworld, including 22 patent applications filed in the United States in 2005. Ourexisting United States patents will expire between June 2007 and October 2022.We have chosen to pursue foreign patent protection only in selected foreigncountries. Our failure to pursue foreign protection in certain countries andthe fact that patent rights may be unavailable or limited in some foreigncountries could make it easier for our competitors to utilize our intellectualproperty. We cannot assure you that any patent will be issued as a result ofour pending applications or any future applications or that, if issued, thesepatents will be sufficient to protect our technology. In addition, we cannotassure you that any existing or future United States or foreign patents willnot be challenged, invalidated or circumvented, or that any patent granted willprovide us with adequate protection or any competitive advantages.

We license various technologies from third partiesthat we have integrated into our products. We have a non-exclusive,non-transferable, perpetual license to use particular thin-film technology andtransferable, non-exclusive, perpetual licenses to use particular galliumarsenide technology, and technology used in the field of commercial, ornon-military, RF communications. Although our business does not depend on anyof the licenses to a material extent, our failure to maintain these licensescould harm our business.

We generally enter into non-disclosure agreements withour vendors, customers and licensees. Our employees are generally required toenter into agreements providing for the maintenance of confidentiality and theassignment of rights to inventions made by them while in our employ. Wegenerally control access to the distribution of documentation and otherinformation concerning our intellectual property. We also have entered into non-disclosureagreements to protect our confidential information delivered to third parties,in connection with possible strategic partnerships and for other purposes.

We have entered into license agreements in connectionwith some of our recent business dispositions with respect to some of ourintellectual property used in these sold businesses. We cannot assure you thatthe other parties to these license agreements will honor the terms of theagreements or aggressively prevent the misappropriation or infringement of ourintellectual property. Further, under these license agreements, some of ourintellectual property may be licensed to one or more of our competitors.

The telecommunicationsindustry is characterized by the vigorous protection and pursuit of intellectualproperty rights. We cannot assure you that actions alleging infringement by usof third-party intellectual property, misappropriation or misuse by us ofthird-party trade secrets or the invalidity of the patents held by us will notbe asserted or prosecuted against us, or that any assertions of infringement,misappropriation or misuse or prosecutions seeking to establish the invalidityof our patents will not harm our competitive position or reputation or resultin significant monetary expenditures.

**Employees**

We believe that oneof our most important assets is our base of well-trained and experiencedemployees. As of December 31, 2005, we had 204 employees, consisting of:

·       18executive and administrative employees;

·       21sales and marketing employees;

·       81manufacturing, facilities and operations employees; and

·       84engineering and technical employees.

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Our employees have anaverage of over seven years tenure with us. Many of our engineering andtechnical staff have been with us for even longer. We believe that many of ourengineers, as a result of their tenure and their defense electronicsbackground, are among the most experienced high frequency engineers in theUnited States. None of our employees is covered by collective bargainingagreements or represented by labor unions, and we have never experienced a workstoppage. We believe our employee relations are good.

**Backlog**

Ourbacklog is comprised of standard purchase orders and annual contracts for thedelivery of products. For our annual contracts, our major customers provide uswith rolling sales forecasts on at least a monthly basis. Theseforecasts are subject to changes, including changes as a result of changes inmarket conditions, and could fluctuate significantly from quarter to quarter.At December 31, 2005, our backlog was $6.7 million, compared to $5.3million at the end of December 31, 2004. We include in our backlog allaccepted product purchase orders for which delivery has been specified within90 days, including orders from distributors. We do not recognize revenue fromsales through our distributors until the distributor has sold our product tothe end customer. Product orders in our backlog are subject to changes indelivery schedules or quantities or to cancellation at the option of thepurchaser without significant penalty. Our backlog may vary significantly fromtime to time depending upon the level of capacity available to satisfy unfilledorders. Accordingly, although useful for scheduling production, we do notbelieve that backlog as of any particular date is necessarily indicative of our2006 results.

**Competition**

The markets for ourproducts are extremely competitive and are characterized by rapid technologicalchange, new product development, product obsolescence and evolving industrystandards. We compete primarily on the basis of product performance and design,reliability, quality, level of integration, delivery, price, customer support,reputation and the availability and breadth of product offerings. In each ofthe markets we serve, we compete primarily with other suppliers of highperformance RF components. We also compete with current and potentialcommunications equipment manufacturers who manufacture RF components internallysuch as Ericsson, Lucent, Motorola and Nortel Networks. We expect increasedcompetition from existing competitors and from a number of companies that mayenter the RF component market, as well as future competition from companiesthat may offer new or emerging technologies. Some of our competitors are largepublic companies that have significantly greater financial, technical,marketing and other resources than us. As a result, these competitors may beable to devote greater resources to the development, promotion, sale andsupport of their products. Furthermore, those of our competitors that havelarge market capitalization or cash reserves may be better positioned than weare to acquire other companies in order to gain new technologies or productsthat may displace our product lines. Many of our competitors operate their ownfabrication facilities and have longer operating histories and presence in keymarkets, greater name recognition, larger customer bases and significantlygreater financial, sales and marketing, manufacturing, distribution, technical andother resources than we do. As a result, these competitors may be able to adaptmore quickly to new or emerging technologies and changes in customerrequirements or to devote greater resources to the promotion and sale of theirproducts. Current and potential competitors have established or may establishfinancial or strategic relationships among themselves or with existing orpotential customers, resellers or other third parties. Accordingly, it ispossible that new competitors or alliances among competitors could emerge andrapidly acquire significant market share. In addition, competitors may developtechnologies that more effectively address our markets with products that offerenhanced features, lower power requirements or lower cost. Increased competitioncould result in pricing pressures, decreased gross margins and loss of marketshare and may materially and adversely affect our business, financial conditionand results of operations.

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**Acquisitions**

We have completed two acquisitions in connection withthe implementation of our business strategy to acquire and develop new andcomplementary technologies.

On January 28, 2005 we completed our acquisitionof Telenexus, Inc. Pursuant to an Agreement and Plan of Merger, dated January 19,2005, by and between us, WJ Newco, LLC (the “WJ Sub”), Telenexus and Richard J.Swanson, Wilfred K. Lau, David Fried, Kurt Christensen and Mark Sutton.Telenexus was merged with and into the WJ Sub effective on January 29,2005. The WJ Sub was the survivor in the merger and is our wholly-ownedsubsidiary. Telenexus designs, develops, manufactures and markets radiofrequency identification reader products for a broad range of industries andmarkets. By virtue of the merger, we purchased through the WJ Sub all of theassets necessary for the conduct of the RFID business of Telenexus, consistingprimarily of, and including, but not limited to RFID modules, basebandprocessing algorithm technology, applications software and realizations ofseveral reader product designs. The consideration we paid on the closing datein connection with the merger consisted of cash in the amount of $3.0 million,which was paid out of our cash reserves on the closing date, and 2,333,333shares of our common stock valued at $8.2 million at the closing date. Includingacquisition costs of $230,000, the aggregate purchase price for the net assetsof Telenexus totaled $11.4 million.

On June 18, 2004, wecompleted our acquisition of the wireless infrastructure business andassociated assets from EiC Corporation, a California corporation and EiCEnterprises Limited (together “EiC”). The aggregate purchase price was $13.3million which included consideration to EiC in the form of payments of cash of $10.0 million and the issuance of737,000 shares of our common stock valued at $2.5 million, as well asacquisition related costs we incurred of $1.2 million and $152,000 of estimatedregistration statement related expenses reduced by a $576,000 benefit from thetermination settlement of the associated supply agreement with EiC recognizedduring our quarter ended December 31, 2004.

**Compliancewith Environmental, Health and Safety Regulations**

We are committed to achieving high standards ofenvironmental quality and product safety, and strive to provide a safe and healthyworkplace for our employees, contractors and the communities in which we dobusiness. We have developed environmental, health and safety policies for ourbusiness, and internal processes focused on minimizing and properly managingany hazardous materials used in our facilities and products.

The manufacture, assembly and testing of our productsrequires the use of hazardous materials that are subject to a broad array ofenvironmental, health and safety laws and regulations. As we continue to useadvanced process technologies, the materials, technologies and productsthemselves become increasingly complex. Our evaluations of new materials foruse in research and development, manufacturing, and assembly and test take intoaccount environmental, health and safety considerations. Many new materialsbeing evaluated for use may be subject to existing or future laws andregulations. Failure to comply with any of the applicable laws or regulationscould result in fines, suspension of production, alteration of fabrication andassembly processes, curtailment of operations or sales, and legal liability.Our failure to properly manage the use, transportation, emission, discharge,storage, recycling or disposal of hazardous materials could subject us tofuture liabilities. Existing or future laws and regulations could require us toprocure pollution abatement or remediation equipment, modify product designs,or incur other expenses. In addition, restrictions on the use of certainmaterials in our facilities or products in the future could have a materialadverse effect on our operations. Compliance with these complex laws andregulations, as well as internal voluntary programs, is integrated into ourmanufacturing and assembly and test processes.

Our former Scotts Valley and Palo Alto sites havesignificant environmental liabilities for which in July 1999 we enteredinto and funded fixed price remediation contracts and obtained cost-overrun and

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unknown pollutionconditions insurance coverage. There can be no assurance that this insurancewill be sufficient to cover all liabilities related to these two sites.

The Scotts Valley site is a federal Superfund site.Chlorinated solvent and other contamination was identified at the site in theearly 1980s, and by the late 1980s we had installed a groundwater extractionand treatment system. In 1991, we entered into a consent decree with the UnitedStates Environmental Protection Agency providing for remediation of the site.In July 1999, we signed a remediation agreement with an environmentalconsulting firm, ARCADIS Geraghty & Miller. Pursuant to thisremediation agreement, we paid $3.0 million in exchange for which ARCADISagreed to perform the work necessary to assure satisfactory completion of ourobligations under the consent decree. The agreement also contains a costoverrun guaranty from ARCADIS up to a total project cost of $15.0 million. Inaddition, the agreement included procurement of a ten-year, claims-madeinsurance policy to cover overruns of up to $10.0 million from RelianceInsurance Company, along with a ten-year, claims made $10-million policyto cover various unknown pollution conditions at the site.

The Palo Alto site is a state Superfund site and iswithin a larger, regional state Superfund site. As with the Scotts Valley site,contamination was discovered in the 1980s, and groundwater extraction andtreatment systems have been operating for several years at both the site andthe regional site. In July 1999, we entered into a remediation agreementwith an environmental consulting firm, SECOR. Pursuant to this remediationagreement, we paid $2.4 million in exchange for which SECOR agreed to performthe work necessary to assure satisfactory completion of our obligations underthe applicable remediation orders. The payment included the premium for a 30-year,claims-made insurance policy to cover cost overruns up to $10.0 million fromAIG, along with a ten-year claims-made $10.0 million insurance policy to covervarious unknown pollution conditions at the site.

With respect to our remaining current or formerproduction facilities, to date either no contamination of significance has beenidentified or reported to us or the regulatory agency involved has grantedclosure with respect to the identified contamination. Nevertheless, we may faceenvironmental liabilities related to these sites in the future which could harmour business.

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**Item 1a. RISK FACTORS**

*You should carefully consider the risks describedbelow before making an investment decision in our securities. These riskfactors are effective as of the date of this Annual Report on Form 10-Kand shall be deemed to be modified or superseded to the extent that a statementcontained in our future filings modifies or replaces such statement. Theforward-looking statements in this Annual Report on Form 10-Kinvolve risks and uncertainties and actual results may differ materially fromthe results we discuss in the forward-looking statements. If any of thefollowing risks actually occur, our business, financial condition or results ofoperations could be materially adversely affected. In that case, the tradingprice of our stock could decline, and you may lose all or part of yourinvestment. The most significant risks and uncertainties known to us that webelieve make an investment in our stock speculative or risky are set forth inthis section. This section does not include those risks and uncertainties thatcould apply to any issuer or any offering.*

***We have a history of losses, we may incur futurelosses, and if we are unable to achieve profitability our business will sufferand our stock price may decline.***

We have not recorded operating income since 1999, ouroperating losses have been increasing and we may not be able to achieve revenueor earnings growth or obtain sufficient revenue to sustain profitability.In  2005 our sales were $31.6 million andwe incurred an operating loss of $22.1 million compared to sales of $32.3million and an operating loss of $17.3 million for 2004. In addition, our salesfor 2003 were $26.6 million and we incurred an operating loss of  $16.7 million. Our accumulated deficit was$174.2 million at December 31, 2005.

We expect thatreduced end-customer demand will, and other factors could, adversely affect ouroperating results in the near term, and we anticipate incurring additionallosses in the future. Other factors that could negatively impact our resultsinclude, but are not limited to:

·       productionovercapacity in the industry, which could reduce the price of our productsadversely affecting our sales and margins;

·       rescheduling,reduction or cancellation of significant customer orders, which could cause us tolose sales that we had anticipated;

·       anyloss of a key customer;

·       theability of our customers to manage their inventories, which if not properlymanaged could cause our customers to reschedule, reduce or cancel significantorders or return our products; and

·       politicaland economic instability, foreign conflicts involving or the impact of regionaland global infectious illnesses (such as outbreaks of SARS and bird flu) in thecountries of our vendors, manufacturers, subcontractors and customers, particularlyin the countries of China, South Korea, Malaysia and The Philippines.

We may incur losses forthe foreseeable future, particularly if our revenues do not increasesubstantially or if our expenses increase faster than our revenues. In order toreturn to profitability, we must achieve substantial revenue growth, and wecurrently face an environment of uncertain demand in the markets our productsaddress.

***We operate in the highly cyclical semiconductorindustry which has experienced significant fluctuations in demand.***

The semiconductor industryis highly cyclical and has historically experienced significant fluctuations indemand for products. The industry has experienced significant downturns, oftenin connection with, or in anticipation of, maturing product cycles and declinesin general economic conditions. These downturns have been characterized bydiminished product demand of end-customers, production overcapacity, high 

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inventorylevels and accelerated erosion of average selling prices. We have experiencedthese conditions in our business in the past and may experience such downturnsin the future. Future downturns in the semiconductor industry could seriouslyimpact our revenues and harm our business, financial condition and results ofoperations.

***We depend on Richardson Electronics, Ltd. fordistribution of our RF semiconductor products and the loss of this relationshipcould materially reduce our sales.***

RichardsonElectronics, Ltd. is the sole worldwide distributor of our complete lineof RF semiconductor products. This sole distributor is our largestsemiconductor customer, and our sales to Richardson Electronics, Ltd. represent49%, 56% and 61%  of our semiconductorsales (45%, 52% and 47% of total sales) in 2005, 2004 and 2003, respectively. In 2005 our revenue fromRichardson Electronics was adversely effected by a change in the application ofour revenue recognition policy to when our distributors have sold the productto the end customer which change in application resulted in a $4.0 millionrevenue deferral in our second quarter of 2005. We cannot assure you that thisexclusive relationship will improve sales of our semiconductor products or thatit is the most effective method of distribution. If Richardson Electronics,Ltd. fails to successfully market and sell our products, our semiconductorsales could materially decline. Our agreement with this distributor does notrequire it to purchase our products and is terminable at any time. If thisdistribution relationship is discontinued, our RF semiconductor sales coulddecline significantly.

***We depend upon a small number of customers thataccount for a high percentage of our sales and the loss of, or a reduction inorders from, a significant customer could result in a reduction of sales.***

We depend on a small number of customers for amajority of our sales. We currently have two customers, Richardson Electronics,Ltd. and Celestica, Inc., which each accounted for more than 10% of oursales and in aggregate accounted for 58% of our sales in 2005. Sales toRichardson Electronics, Ltd. accounted for 45%, 52% and 47% in 2005, 2004 and2003, respectively. Sales to Celestica accounted for 13% of our sales in 2005and 12% and 5% in 2004 and 2003, respectively. Sales to Lucent Technologiesaccounted for 1%, 7% and 23% of our sales in 2005, 2004 and 2003, respectively.

The decrease in our sales to Richardson Electronics,Ltd. during 2005 was related primarily to our change in the application of ourrevenue recognition policy to when our distributors have sold the product tothe end customer which change in application resulted in a $4.0 million revenuedeferral in our second quarter of 2005. The increase in our sales to RichardsonElectronics, Ltd. during 2004 is primarily related to our new productintroductions which have had a greater adoption rate amongst our smallercustomers, particularly those in countries outside the United States of America.Both market segments are serviced through the distributor. The increase in oursales to Richardson Electronics, Ltd. during 2003 is primarily related to ourentering into a sole worldwide distributorship arrangement with them during mid-2002.The increase in our sales to Celestica during 2005, 2004 and 2003 is related toan increasing business practice of original equipment manufacturers tooutsource a greater percentage of their manufacturing. The decrease in oursales to Lucent Technologies represents the decrease in the sales of ourwireless integrated assembly products as these products have reached the end oftheir product life cycle as well as Lucent Technologies outsourcing a greaterpercentage of their manufacturing.

In addition, most of oursales result from purchase orders or from contracts that can be cancelled onshort-term notice. Moreover, it is possible that our customers may developtheir own products internally or purchase products from our competitors. Also,events that impact our customers, for example wireless carrier consolidation,can adversely affect our sales. We expect that our key customers will continueto account for a substantial portion of our revenue in 2006. The loss of, or areduction in orders from, a significant customer for any reason could cause oursales to decrease.

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***The new markets we are targeting may not grow asforecasted,  and we may not be asuccessful participant in those markets.***

Our growth strategy is based in part on our success inpenetrating new radio frequency identification (“RFID”) markets. These marketscurrently are not a material source of revenue for us, and we cannot assure youthat our new products will succeed. In addition to the risks generallyassociated with new product development and introduction, these products aresubject to the particular risks described below.

The growth of the RFIDmarket will depend on, among other things, the ability of suppliers to meetsize, portability, cost and power consumption objectives, the ability ofindustry participants to agree on appropriate technology standards and thewillingness of end users to invest in the required equipment and informationsystems. Even if the market does grow as forecasted, our ability tosuccessfully participate in the RFID market will depend upon, among otherthings, our timely development and marketing of appropriate products,attracting the most advantageous industry partnerships, securing any necessaryadditional intellectual property and forming customer relationships. Therefore,we may not be a successful participant in these markets.

***We may not be able to successfully integrate thosebusinesses we have acquired or may acquire in the future, which could harm ourbusiness, financial condition and results of operations.***

We acquired thewireless infrastructure business and associated assets of EiC and we acquiredTelenexus, Inc. which designs develops manufactures and markets radiofrequency identification reader products. We believe these acquisitionscomplement and expand our product portfolio, and we may continue to acquirebusinesses in the future as part of our growth strategy. Integrating completedacquisitions into our existing operations involves numerous risks including thefollowing:

·       diversionof management’s attention;

·       potentialloss of key personnel;

·       abilityof the acquired business to maintain its pre-acquisition revenues and growthrates;

·       abilityof the acquired business to be financially successful or provide desiredresults; and

·       abilityto develop and introduce new products.

We may not be able tosuccessfully integrate our acquisitions which could harm our business,financial condition and results of operations.

***Third party intellectual property claims could harmour business.***

We occasionally receivecommunications from third parties alleging infringement of patent and otherintellectual property rights. While we are not subject to any current claimsthat we believe could be material, there can be no assurance that materialclaims will not arise in the future. While all of our revenue is derived fromproducts containing our proprietary intellectual property, approximately 9% and5% of our revenue for 2005 and 2004, respectively, is derived from newlydeveloped technologies which could have a higher risk of infringement claims.We intend to vigorously protect our proprietary intellectual property rightswith respect to all of our products. However, we cannot assure you that claimscan be amicably disposed of, and it is possible that litigation could ensue.Litigation could result in substantial costs to us and diversion of ourresources. If we fail to obtain a necessary license or if we do not prevail inpatent or other intellectual property litigation, we could be required todiscontinue selling the affected products, to seek to develop non-infringingtechnologies, which may not be feasible, and to pay monetary damages, any of whichcould harm our business.

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***Our quarterly operating results may fluctuatesignificantly. As a result, we may fail to meet the expectations of securitiesanalysts and investors, which could cause our stock price to decline.***

Our quarterly revenues andoperating results have fluctuated significantly in the past and are expected tovary from quarter to quarter due to a number of the factors described in this “RiskFactors” section and in our public filings, many of which are not within ourcontrol. If our operating results do not meet our publicly stated guidance orthe expectations of securities analysts or investors, our stock price maydecline. For example, in early 2003 and as recently as during our third quarterended September 26, 2004, we publicly announced revised loweredexpectations of financial results for certain periods. Subsequent to suchannouncements, the trading price of our common stock declined significantly.

***As we continue to develop new products utilizingexisting and  new process technologies,we will likely increase our utilization of third parties for the manufacture ofour products.***

As we continue to develop new products utilizingexisting and new process technologies, we will obtain an increasing portion ofour wafer requirements from outside wafer fabrication facilities, known asfoundries. There are significant risks associated with our reliance on third-partyfoundries, including:

·       thelack of ensured wafer supply, potential wafer shortages and higher waferprices;

·       limitedcontrol over product delivery schedules, quality assurance and control,manufacturing yields and production costs; and

·       the unavailability of, ordelays in obtaining, access to key fabrication process technologies.

The foundries we use may experience financial difficultiesor suffer damage or destruction to their facilities. If these events or anyother disruption of wafer fabrication capacity occur, we may not have a secondmanufacturing source immediately available. We may therefore experiencedifficulties or delays in securing an adequate supply of our products, whichcould impair our ability to meet our customers’ needs and have a materialadverse effect on our operating results. In the event of these types of delays,we cannot assure you that the required alternate capacity, particularly waferproduction capacity, would be available on a timely basis or at all. Even ifalternate wafer production capacity is available, we may not be able to obtainit on favorable terms, which could result in a loss of customers. We may beunable to obtain sufficient manufacturing capacity to meet demand, either atour own facilities or through foundry or similar arrangements with others.

In addition, the highly complex and technologicallydemanding nature of semiconductor manufacturing has caused foundries toexperience from time to time lower than anticipated manufacturing yields,particularly in connection with the introduction of new products and theinstallation and start-up of new process technologies. Lower than anticipated manufacturingyields may affect our ability to fulfill our customers’ demands for ourproducts on a timely and cost-effective basis.

We cannot be certain thatwe will be able to maintain our good relationships with our existing foundries.In addition, we cannot be certain that we will be able to form relationshipswith other foundries as favorable as our current ones. Moreover, transferringfrom our internal fabrication facility or our existing foundries to anotherfoundry, could require a significant amount of time and loss of revenue, and wecannot assure you that we could make a smooth and timely transition. When wechoose to use a new foundry, it typically takes several months to complete thequalification process before we can begin shipping products from the newfoundry. If foundries are unable or unwilling to continue to supply us withthese semiconductor products in required time frames and volumes or atcommercially acceptable costs, our business may be harmed.

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***If we are unable to develop and introduce newsemiconductors successfully,  and in acost-effective and timely manner or to achieve market acceptance of our newsemiconductors, our operating results would be adversely affected.***

The future successof our semiconductor business depends on our ability to develop newsemiconductor products for existing and new markets, introduce these productsin a cost-effective and timely manner and convince leading equipmentmanufacturers to select these products for design into their own new products.Our quarterly results in the past have been, and are expected in the future tocontinue to be, dependent on the introduction of new products and the timelycompletion and delivery of those products to customers. The development of newsemiconductor devices is highly complex, and from time to time we haveexperienced delays in completing the development and introduction of newproducts and lower than anticipated manufacturing yields in the earlyproduction of such products. Our ability to develop and deliver new semiconductorproducts successfully will depend on various factors, including our ability to:

·       accuratelypredict market requirements and evolving industry standards;

·       accuratelydefine new products;

·       timelycomplete and introduce new product designs;

·       timelyqualify and obtain industry interoperability certification of our products andthe products of our customers into which our products will be incorporated;

·       obtainsufficient foundry capacity;

·       achievehigh manufacturing yields;

·       shiftour products to smaller geometry process technologies to achieve lower cost andhigher levels of design integration; and

·       gainmarket acceptance of our products and our customers’ products.

If we are not able to develop and introduce newproducts successfully and in a cost-effective and timely manner, our business,financial condition and results of operations would be materially and adverselyaffected.

Our new semiconductorproducts generally are incorporated into our customers’ products at the designstage. We often incur significant expenditures for the development of a newproduct without any assurance that an equipment manufacturer will select ourproduct for design into its own product. The value of our semiconductorslargely depends on the commercial success of our customers’ products and theextent to which those products accommodate components manufactured by ourcompetitors. We cannot assure you that we will continue to achieve design winsor that equipment that incorporates our products will be commercially successful.

***The amount and timing of revenue from newly designedsemiconductors is often uncertain.***

We announce from time to time new semiconductorproducts and design wins for new and existing semiconductors. Achieving adesign win with a customer does not create a binding commitment from thatcustomer to purchase our products. Rather, a design win is solely an expressionof interest by potential customers to purchase our products and is notsupported by binding commitments of any nature. Accordingly, a customer maychoose at any time to discontinue using our products in their designs orproduct development efforts. Even if our products are chosen to be incorporatedinto our customer’s products, we still may not realize significant revenuesfrom that customer if their products are not commercially successful. A designwin may not generate revenue if the customer’s product is rejected by 

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their end market.Typically, most new products or design wins have very little impact onnear-term revenue. It may take well over a year before a new product or designwin generates revenue.

Once a manufacturer ofcommunications equipment has designed a supplier’s semiconductor into itsproducts, the manufacturer may be reluctant to change its source ofsemiconductors due to the significant costs associated with qualifying a newsupplier and potentially redesigning its product. Accordingly, our failure toachieve design wins with equipment manufacturers, which have chosen acompetitor’s semiconductor, could create barriers to future sales opportunitieswith these manufacturers.

***Our semiconductor products typically have lengthysales cycles,  and we may ultimately beunable to recover our investment in new products.***

After we have developed and delivered a semiconductorproduct to a customer, the customer will usually test and evaluate our productprior to designing its own equipment to incorporate our product. Our customermay need three to six months or longer to test, evaluate and adopt oursemiconductors and an additional three to nine months or more to begin volumeproduction of equipment that incorporates our semiconductors. Moreover, inlight of the ongoing economic slow down in the telecommunications sector, itmay take significantly longer than three to nine months before customerscommence volume production of equipment incorporating some of oursemiconductors. Due to this lengthy sales cycle, we may experience significantdelays from the time we increase our expenses for research and development,sales and marketing efforts and make investments in inventory until the timethat we generate revenue from these products. It is possible that we may nevergenerate any revenue from these products after incurring such expenditures.Even if a customer selects our semiconductors to incorporate into itsequipment, we have no assurances that the customer will ultimately market andsell its equipment or that such efforts by our customer will be successful. Thedelays inherent in our lengthy sales cycle increase the risk that a customerwill decide to cancel or change its product plans. Such a cancellation orchange in plans by a customer could cause us to lose sales that we hadanticipated. In addition, our business, financial condition and results ofoperations could be materially and adversely affected if a significant customercurtails, reduces or delays orders during our sales cycle or chooses not torelease equipment that contains our products.

The resources devoted toproduct research and development and sales and marketing may not generatematerial revenue for us, and from time to time, we may need to write off excessand obsolete inventory. If we incur significant marketing and inventoryexpenses in the future that we are not able to recover, and we are not able tocompensate for those expenses, our operating results could be adverselyaffected. In addition, if we sell our products at reduced prices inanticipation of cost reductions and we still have higher cost products ininventory, our operating results would be harmed.

***If we are unable to respond to the rapid technologicalchanges taking place in our industry, our existing products could becomeobsolete and we could face difficulties making future sales.***

The markets in which we compete are characterized byrapidly changing technologies, evolving industry standards and frequentimprovements in products and services. If the technologies supported by ourproducts become obsolete or fail to gain widespread acceptance, as a result ofa change in industry standards or otherwise, we could face difficulties makingfuture sales.

We must continue to makesignificant investments in research and development to seek to develop productenhancements, new designs and technologies on a cost effective basis. If we areunable to develop and/or gain access to and introduce new products orenhancements in a timely and cost effective manner in response to changingmarket conditions or customer requirements, or if our new products do notachieve market acceptance, our sales could decline. Additionally, initial lowermargins are typically experienced with new products under development.

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***Our existing and potential customers operate in anintensely competitive environment,  andour success will depend on the success of our customers.***

The companies in ourtarget markets face an extremely competitive environment. Some of the productswe design and sell are customized to work with specific customers’ systems. Ifthe companies with whom we establish business relations are not successful inbuilding their systems, promoting their products, including new revenue-generatingservices, receiving requisite approvals and accomplishing the many otherrequirements for the success of their businesses, our growth will be limited.Furthermore, our customers may have difficulty obtaining parts from othersuppliers causing these customers to cancel or delay orders for our products.In addition, we have limited ability to foresee the competitive success of ourcustomers and to plan accordingly.

***If the wireless communications and broadband cablemarkets fail to grow, or they decline, our sales may not grow or may decline.***

Our future growthdepends on the success of the wireless communications and broadband cablemarkets. The rate at which these markets will grow is difficult to predict.These markets may fail to grow or decline for many reasons, including:

·       insufficientconsumer demand for wireless products or broadband cable or services;

·       theinability of the various communications service providers to access adequatecapital to build their networks;

·       inefficiencyand poor performance of wireless communications or broadband cable servicescompared to other forms of broadband access; and

·       realor perceived security or health risks associated with wireless communications.

If the markets for ourproducts in wireless communications or broadband cable decline, fail to grow,or grow more slowly than we anticipate, the use of our products may be reducedand our sales could suffer.

***If we or our outsourced manufacturers fail toaccurately forecast component and material requirements, we could incuradditional costs or experience product delays.***

We use rolling forecastsbased on anticipated product orders to determine our component requirements. Itis very important that we accurately predict both the demand for our productsand the lead times required to obtain the necessary products and/or componentsand materials. Lead times for components and materials that we, or ouroutsourced manufacturers, order can vary significantly and depend on factorssuch as specific supplier requirements, the size of the order, contract termsand current market demand for the components. To the extent that we rely onoutsourced manufacturers, many of these factors will be outside of our directmanagerial control. For substantial increases in production levels, ouroutsourced manufacturers and some suppliers may need six months or more leadtime. As a result, we may be required to make financial commitments in the formof purchase commitments. We lack visibility into the finished goods inventoriesof our customers and the end-users. This lack of visibility impacts our abilityto accurately forecast our requirements. If we overestimate our component,material and outsourced manufactured requirements, we may have excessinventory, which would increase our costs. An additional risk for potential excessinventory results from our volume purchase commitments with certain materialsuppliers, which can only be reduced in certain circumstances. Additionally, ifwe underestimate our component, material, and outsourced manufacturedrequirements, we may have inadequate inventory, which could interrupt and delaydelivery of our products to our customers. Any of these occurrences wouldnegatively impact our sales and profitability. We have incurred, and may in thefuture incur, charges related to excess and obsolete inventory. These chargesamounted to $975,000, $670,000 and $251,000 in 2005, 2004 and 2003,respectively. While these charges may be partially offset by subsequent salesof 

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previouslywritten-down inventory, there can be no assurance that any such sales will besignificant. As we broaden our product lines we must outsource themanufacturing of or purchase a wider variety of components. In addition, newproduct lines contain a greater degree of uncertainty due to a lack ofvisibility of customer acceptance and potential competition. Both of thesefactors will contribute a higher level of inventory risk in our near future.

***We depend on, and will likely increase our use of,outsourced manufacturers and single or limited source suppliers which makes ussusceptible to shortages or price fluctuations that could adversely affect ouroperating results.***

We currently purchaseseveral key components and materials used in our products from single orlimited source suppliers. These products amounted to 15%, 5% and 5% of ourrevenue in 2005, 2004 and 2003, respectively. Although we do not currently haveany suppliers that are material to our business, in the event one of our solesource suppliers or outsourced manufacturers are unable to deliver us productsor unwilling to sell us components or materials, it could harm our business. Itcould take us as long as six to 12 months to replace our single or limitedsource suppliers and there can be no assurance that we would be successful.Additionally, we or our outsourced manufacturers may fail to obtain requiredproducts and components in a timely manner in the future. We may alsoexperience difficulty identifying alternative sources of supply for thecomponents used in our products or products we obtain through outsourcing. Wewould experience delays if we were required to test and evaluate products ofpotential alternative suppliers or products we obtain through outsourcing.Furthermore, financial or other difficulties faced by our outsourcedmanufacturers, or suppliers or significant changes in demand for the componentsor materials they use in the products and/or supply to us could limit theavailability of those products, components or materials to us. Thus far we havenot experienced any material delays related to such suppliers, but we cannotassure you that this will continue to be the situation. To the extent that ourdependence on outsourcing continues to increase in the future, ourcorresponding risks will be greater.

***We rely on the significant experience and specializedexpertise of our senior management in our industry and must retain and attractqualified engineers and other highly skilled personnel in a highly competitivejob environment to maintain and grow our business.***

Our performance is substantially dependent on thecontinued services and on the performance of our senior management and ourhighly qualified team of engineers, who have many years of experience andspecialized expertise in our business. We have recently undergone changes inour senior management. Our performance also depends on our ability to retainand motivate our other executive officers and key employees. The loss of theservices of any of our executive officers or of a number of our engineers couldharm our ability to maintain and build our business. We have no “key man” lifeinsurance policies.

Our future success alsodepends on our ability to identify, attract, hire, train, retain and motivatehighly skilled technical, managerial, sales, marketing and customer servicepersonnel. If we fail to attract, integrate and retain the necessary personnel,our ability to maintain and build our business could suffer significantly.Additionally, California State law can create unique difficulties for aCalifornia based company attempting to enforce covenants not to compete withemployees, which could be a factor in our future ability to retain keymanagement and employees in a competitive environment.

***Our business is subject to the risks of productreturns, product liability and product defects.***

Products as complex as ours frequently containundetected errors or defects, especially when first introduced or when newversions are released. The occurrence of errors could result in product returnsfrom and reduced product shipments to our customers. In addition, any failureby our products to properly perform could result in claims against us by ourcustomers. Such failure also could result in the loss of or delay in marketacceptance of our products or harm our reputation. Due to the recentintroduction of some of our products, we have limited experience with theproblems that could arise with these products. If 

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problems occur or becomesignificant, it could result in a reduction in our revenues and increased costsrelated to inventory write-offs, warranty claims and other expenses which couldhave a material and adverse affect on our financial condition.

Our purchase agreementswith our customers typically contain provisions designed to limit our exposureto potential product liability claims. However, the limitation of liabilityprovision contained in these agreements may not be effective as a result offederal, state or local laws or ordinances or unfavorable judicial decisions inthe United States or other countries. Although we maintain $22.0 million of insuranceto protect against claims associated with the use of our products, ourinsurance coverage may not adequately cover all claims asserted against us. Inaddition, even ultimately unsuccessful claims could result in costlylitigation, divert our management’s time and resources and damage our customerrelationships.

***We use a number of specialized technologies, some ofwhich are patented, to design, develop and manufacture our products.Infringement of our intellectual property rights could hurt our competitiveposition, harm our reputation and negatively impact our future profitability.***

We regard the protection of our copyrights, patents,service marks, trademarks, trade dress and trade secrets as critical to ourfuture success and rely on a combination of copyright, patent, trademark andtrade secret law, as well as on confidentiality procedures and contractualprovisions, to protect our proprietary rights. We seek patent protection forour unique developments in circuit designs, processes and algorithms. Adequateprotection of our intellectual property rights may not be available in everycountry where our products and services are made available. We intend, as ageneral policy, to enter into confidentiality and invention assignmentagreements with all of our employees and contractors, as well as intonondisclosure agreements with parties with which we conduct business, to limitaccess to and disclosure of our proprietary information; however, we have notdone so on a uniform basis. As a result, we may not have adequate remedies topreserve our trade secrets or prevent third parties from using our technologywithout authorization. We cannot assure you that all future employees,contractors and business partners will agree to these contracts, or that, even ifagreed to, these contractual arrangements or the other steps we have taken toprotect our intellectual property will prove sufficient to preventmisappropriation of our technology or to deter independent third-partydevelopment of similar technologies. If we are unable to execute theseagreements or take other steps to prevent misappropriation of our technology orto deter independent development of similar technologies, our competitive andfinancial position and reputation could suffer, and we could be forced to makesignificant expenditures.

We regularly file patent applications with the U.S.Patent and Trademark Office and in selected foreign countries coveringparticular aspects of our technology and intend to prosecute such applicationsto the fullest extent of the law. Based upon our assessment of our current andfuture technology, we may decide to file additional patent applications in thefuture, and may decide to abandon current patent applications. We cannot assureyou that any patent application we have filed or will file will result in anissued patent, or, if patents are issued to us, that such patents will provideus with any competitive advantages and will not be challenged by third partiesor invalidated by the U.S. Patent and Trademark Office or foreign patentoffice. Any failure to protect our existing patents or to secure new patentsmay limit our ability to protect the intellectual property rights that suchpatents or patent applications were intended to cover. Furthermore, the patentsof others may impair our ability to do business.

We have several registeredtrademarks and service marks, in the United States and abroad, and are in theprocess of registering others in the United States. Nevertheless, we cannotassure you that the U.S. Patent and Trademark Office will grant us theseregistrations. Should we decide to apply to register additional trademarks orservice marks in foreign countries, there is no guarantee that we will be ableto secure such registrations. The inability to register or decision not toregister in certain foreign countries 

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andadequately protect our trademarks and service marks could harm our competitiveposition, harm our reputation and negatively impact our future profitability.

***We must gain access to improved process technologies.***

For our semiconductorproducts, our future success will depend upon our ability to continue to gainaccess to new and/or improved process technologies in order to adapt toemerging industry standards or competitive market conditions. In the future, wemay be required to transition one or more of our products to processtechnologies with smaller geometries, other materials or higher speed in orderto reduce costs and/or improve product performance. We may not be able to gainaccess to new process technologies in a timely or affordable manner. Inaddition, products based on these technologies may not achieve marketacceptance.

***Due to our relationships with foreign vendors,manufacturers, customers and subcontractors, we are subject to internationaloperational, financial and political risks.***

We expect tocontinue to rely on vendors, manufacturers and subcontractors located in China,Malaysia, Singapore, South Korea, Taiwan and The Philippines. Additionally, weutilize vendors located in such countries in our semiconductor business tosource gallium arsenide (“GaAs”) wafers as raw material in our semiconductorfabrication, to fabricate certain products, to assemble certain products and topackage the majority of our semiconductor die in plastic or ceramic.Accordingly, we will be subject to risks and challenges such as:

·       compliancewith a wide variety of foreign laws and regulations:

·       changesin laws and regulations relating to the import or export of semiconductorproducts;

·       legaluncertainties regarding taxes, tariffs, quotas, export controls, exportlicenses and other trade barriers;

·       politicaland economic instability, foreign conflicts involving or the impact of regionaland global infectious illnesses (such as outbreaks of SARS and bird flu) in thecountries of these vendors, manufacturers and subcontractors causing delays inour ability to obtain our product;

·       reducedprotection for intellectual property rights in some countries; and

·       fluctuationsin freight rates and transportation disruptions.

Political and economicinstability and changes in governmental regulations in these areas as well asthe United States could affect the ability of our overseas vendors to supplymaterials or services. Any interruption or delay in the supply of our requiredcomponents, products, materials or services, or our inability to obtain thesecomponents, materials, products or services from alternate sources atacceptable prices and within a reasonable amount of time, could impair ourability to meet scheduled product deliveries to our customers and could causecustomers to cancel orders.

***There are inherent risks associated with sales to ourforeign customers.***

We sell a significantportion of our product to customers outside of the United States. Sales to customersoutside of the United States accounted for approximately 44%, 35% and 32% ofour sales in 2005, 2004 and 2003, respectively. We expect that sales tocustomers outside of the United States will continue to account for asignificant portion of our sales. Although all of our foreign sales aredenominated in U.S. dollars, such sales are subject to certain risks,including, among others, changes in regulatory requirements, the imposition oftariffs and other trade barriers, the existence of political, legal andeconomic instability in foreign markets, language and cultural barriers,seasonal reductions in business 

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activities,our ability to receive timely payment and collect our accounts receivable,currency fluctuations, and potentially adverse tax consequences, which couldadversely affect our business and financial results.

***We face intense competition, and, if we do not competeeffectively in our markets, we will lose sales and have lower margins.***

The semiconductorindustry is intensely competitive in each of the markets we serve and ischaracterized by:

·       rapidlychanging technology;

·       swiftproduct obsolescence;

·       manufacturingyield problems;

·       priceerosion; and

·       limitedsupplies of components and materials.

Our end markets arerapidly evolving and intensely competitive, and we expect competition tointensify further in the future. Many of our current and potential competitorshave substantially greater technical, financial, marketing, distribution andother resources than we have. Price competition is intense and the marketprices and margins of products frequently decline after competitors beginmaking similar products. A number of our competitors may have greater namerecognition and market acceptance of their products and technologies. Furthermore,our competitors, or the competitors of our customers, may develop newtechnologies, enhancements of existing products or new products that offersuperior price or performance features. These new products or technologiescould render obsolete our products or the systems of our customers into whichour products are integrated. If we fail to successfully compete in our markets,our business and operating results would be materially and adversely affected.

***Our growth depends in part on future acquisitions andinvestments in new businesses, products or technologies that involve numerousrisks, including the use of cash and diversion of management’s attention.***

As part of our growthplans, we may make acquisitions of and investments in new businesses, productsand technologies or we may acquire operations that expand our manufacturingcapabilities. If we identify an acquisition candidate, we may not be able tosuccessfully negotiate or finance the acquisition. Even if we are successful,we may not be able to integrate the acquired businesses, products ortechnologies into our existing business and products. As a result of the rapidpace of technological change, we may misgauge the long-term potential of theacquired business or technology or the acquisition may not be complementary toour existing business. Furthermore, potential acquisitions and investments,whether or not consummated, may divert our management’s attention and requireconsiderable cash outlays at the expense of our existing operations. Inaddition, to complete future acquisitions, we may issue equity securities,incur debt, assume contingent liabilities or have amortization expenses andwrite-downs of acquired assets, which could affect our profitability.

***Changes in the regulatory and market dynamicsenvironment of the communications industry may reduce the demand for ourproducts.***

The deregulation of thetelecommunications industry has resulted in an increased number of serviceproviders. Such increase, coupled with the expanding use of the Internet anddata networking by businesses and consumers, has resulted in the rapid growthof the communications industry. This has led and will likely continue to leadto intense competition, short product life cycles, and, to some extent,regulatory uncertainty in and outside the United States. The course of thedevelopment of the communications industry is difficult to predict. Forexample, the delays in governmental approval 

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processesthat our customers are subject to, such as the issuance of site permits and theauction of frequency spectrum, have in the past caused, and may in the futurecause, the cancellation, postponement or rescheduling of the installation ofcommunications systems by our customers. A reduction in network infrastructureexpenditures could negatively affect the sale of our products. Moreover, in theshort term, deregulation may result in a delay or a reduction in theprocurement cycle because of the general uncertainty involved with thetransition period of businesses.

***If we fail to maintain an effective system of internalcontrols, we may not be able to accurately report our financial results orprevent fraud which could subject us to regulatory sanctions, harm our businessand operating results and cause the trading price of our stock to decline.***

Effective internalcontrols required under Section 404 of the Sarbanes-Oxley Act of 2002 arenecessary for us to provide reliable financial reports and effectively preventfraud. If we cannot provide reliable financial reports or prevent fraud, ourbusiness, reputation and operating results could be harmed. We have in the pastdiscovered, and may in the future discover, areas of our internal controls thatneed improvement. For example, a “material weakness” was identified in ourquarter ended December 31, 2005, which means that there was “a significantdeficiency, or a combination of significant deficiencies, that results in morethan a remote likelihood that a material misstatement of the annual or interimfinancial statements will not be prevented or detected.” The material weaknesswas in the operating effectiveness of the controls over the determination ofexcess and obsolete inventory and the related valuation adjustments resultingin an audit adjustment to reduce inventory and increase cost of goods sold. Theerror occurred in our fourth quarter of 2005 and was corrected in the sameperiod. This material weakness arose from our failure to consider all currentbusiness conditions in determining the salability of our current inventory. Wecannot be certain that the measures we have taken or intend to take will ensurethat we implement and maintain adequate controls over our financial processesand reporting in the future. Any failure to implement required new or improvedcontrols, or difficulties encountered in their implementation, could subject usto regulatory sanctions, harm our business and operating results or cause us tofail to meet our reporting obligations. Inferior internal controls could alsoharm our reputation and cause investors to lose confidence in our reportedfinancial information, which could have a negative impact on the trading priceof our stock.

***Our future profitability could suffer from known orunknown liabilities that we retained when we sold parts of our company.***

In the recent past,we completed the divestiture of all but our current business. In thetransactions in which we sold our other businesses, we generally retainedliability arising from events occurring prior to the sale. Some of theseliabilities were or have since become known to us, such as the environmentalcondition of the production facilities we sold. We may have underestimated thescope of these liabilities, and we may become aware of additional liabilitiesassociated with the following in the future:

·       ownershipof the intellectual property we have sold;

·       thepotential infringement by our sold businesses of the intellectual property ofothers;

·       theregulatory compliance of our sold defense business;

·       exportcontrol compliance with respect to our defense products purchased by the UnitedStates and foreign governments; and

·       productdefect claims with respect to products manufactured by our sold businessesbefore they were sold.

If these and any otherunknown liabilities and obligations exceed our expectations and establishedreserves, our future profitability could suffer and our capital needs couldincrease.

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***If we fail to comply with environmental regulations wecould be subject to substantial fines, we could be required to suspendproduction, alter manufacturing processes or cease operations.***

Two of our former production facilities at ScottsValley and Palo Alto have significant environmental liabilities for which wehave entered into and funded fixed price remediation agreements and obtainedcost-overrun and unknown pollution insurance coverage.

The Scotts Valley site is a federal Superfund site.Chlorinated solvent and other contamination was identified at the site in theearly 1980s, and by the late 1980s we had installed a groundwater extractionand treatment system. In 1991, we entered into a consent decree with the UnitedStates Environmental Protection Agency providing for remediation of the site.In July 1999, we signed a remediation agreement with an environmentalconsulting firm, ARCADIS Geraghty & Miller. Pursuant to thisremediation agreement, we paid $3.0 million in exchange for which ARCADISagreed to perform the work necessary to assure satisfactory completion of ourobligations under the consent decree. The agreement also contains a costoverrun guaranty from ARCADIS up to a total project cost of $15.0 million.In addition, the agreement included procurement of a ten-year, claims-madeinsurance policy to cover overruns of up to $10.0 million from AmericanInternational Specialty, along with a ten-year, claims made $10.0 millionpolicy to cover various unknown pollution conditions at the site.

The Palo Alto site is a state Superfund site and iswithin a larger, regional state Superfund site. As with the Scotts Valley site,contamination was discovered in the 1980s, and groundwater extraction andtreatment systems have been operating for several years at both the site andthe regional site. In July 1999, we entered into a remediation agreementwith an environmental consulting firm, SECOR. Pursuant to this remediationagreement, we paid $2.4 million in exchange for which SECOR agreed to performthe work necessary to assure satisfactory completion of our obligations underthe applicable remediation orders. The payment included the premium for a 30-year,claims-made insurance policy to cover cost overruns up to $10.0 millionfrom AIG, along with a ten-year claims-made $10.0 million insurance policyto cover various unknown pollution conditions at the site.

We cannot assure you thatthis insurance will be sufficient to cover all liabilities related to these twosites. In addition, we are subject to a variety of federal, state and localgovernmental regulations relating to the storage, discharge, handling,emission, generation, manufacture and disposal of toxic or other hazardoussubstances used to manufacture our products. In the past, we have been subject toperiodic environmental reviews and audits, which have resulted in minor fines.If we fail to comply with these regulations, substantial fines could be imposedon us, and we could be required to suspend production, alter manufacturingprocesses or cease operations any of which could have a material negativeeffect on our sales, income and business operations.

***If RF emissions pose a health risk, the demand for ourproducts may decline.***

Recent news reports haveasserted that some radio frequency emissions from wireless handsets may belinked to various health concerns, including cancer, and may interfere withvarious electronic medical devices, including hearing aids and pacemakers. Ifit were determined or perceived that RF emissions from wireless communicationsequipment create a health risk, the market for our wireless customers’ productsand, consequently, the demand for our products could decline significantly.

***We may need to raise additional capital in the futurethrough the issuance of additional equity or convertible debt securities or byborrowing money, and additional funds may not be available on terms acceptableto us.***

We believe that the cash, cash equivalents andinvestments on hand, the cash we expect to generate from operations andborrowings under our line of credit will be sufficient to meet our liquidityand capital spending requirements for at least the next twelve months. However,it is possible that we may need to raise additional funds to fund ouractivities during and/or beyond that time. We could raise these funds by 

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selling more stock to thepublic or to selected investors, or by borrowing money. In addition, eventhough we may not need additional funds, we may still elect to sell additionalequity securities or obtain credit facilities for other reasons. We may not beable to obtain additional funds on favorable terms, or at all. If adequatefunds are not available, we may be required to curtail our operationssignificantly or to obtain funds through arrangements with strategic partners orothers that may require us to relinquish rights to certain technologies orpotential markets. If we raise additional funds by issuing additional equity orconvertible debt securities, the ownership percentages of existing stockholderswould be reduced. In addition, the equity or debt securities that we issue mayhave rights, preferences or privileges senior to those of the holders of ourcommon stock.

It is possible thatour future capital requirements may vary materially from those now planned. Theamount of capital that we will need in the future will depend on many factors,including:

·       whetherwe operate on a positive cash flow basis;

·       themarket acceptance of our products;

·       thelevels of promotion and advertising that will be required to launch our productsand achieve and maintain a competitive position in the marketplace;

·       volumeprice discounts;

·       ourbusiness, product, capital expenditure and research and development plans andproduct and technology roadmaps;

·       thelevels of inventory and accounts receivable that we maintain;

·       capitalimprovements to new and existing facilities;

·       technologicaladvances;

·       ourcompetitors’ response to our products; and

·       ourrelationships with suppliers and customers.

In addition, we mayrequire additional capital to accommodate planned growth, hiring,infrastructure and facility needs or to consummate acquisitions of otherbusinesses, products or technologies.

***Our facilities are concentrated in an area susceptibleto earthquakes.***

Our facilities areconcentrated in an area where there is a risk of significant earthquakeactivity. Substantially all of the production equipment that currently accountsfor our sales, as well as planned additional production equipment, is or willbe located in a known earthquake zone. We cannot predict the extent of thedamage that our facilities and equipment would suffer in the event of anearthquake or how such damage would affect our business. We do not maintainearthquake insurance.

**Risks Related to Our Stock**

***Sales of substantial amounts of our common stock byour largest stockholder in connection with shares we have issued in recentacquisitions and others could adversely affect the market price of our commonstock.***

We are required to register for resale up to25,492,044 shares of common stock for resale by Fox Paine Capital Fund, L.P.,FPC Investors, LP, WJ Coinvestment Fund I, LLC, WJ Coinvestment Fund III, LLCand WJ Coinvestment Fund IV, LLC******(together the**“FPEntities”) pursuant to an agreement providing for registration rights. The FoxPaine Entities are collectively our largest stockholder. As of December 31,2005, the Fox Paine Entities beneficially owned 39.2% of our common stock whichrepresents approximately 25.5 million of our 65.0 million outstanding shares ofcommon stock. To date, we 

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have issued an aggregateof 2,442,882 shares of our common stock in connection with our recent EiC andTelenexus acquisitions of which there are an aggregate of 627,451 shares beingheld in escrow which will be released if there are no indemnification claims. Wemay be required to pay further compensation in the EiC acquisition of up to$14.0 million in cash (10%) and shares (90%) if specific revenue and grossmargin targets are achieved by March 31, 2005 and March 31, 2006, andin the Telenexus acquisition, up to $2.5 million in cash and 833,333 shares ifcertain revenue targets are achieved by July 28, 2006. If the targets areattained and we elect to pay in shares of common stock, the number ofadditional shares issued in connection with these transactions could besignificant depending on the average closing price of our stock on Nasdaqduring the 10 day period prior to the end of the earnout period. If, forexample, the average closing price is $3.50 per share and the full targets aremet in 2006, we would be obligated to issue 2,633,333 shares unless weotherwise elect to pay in cash. With respect to the EiC transaction, we havecalculated that the revenue and the gross margin targets were not met for thenine month period ending March 31, 2005, which was provided to EiC on May 31,2005. EiC subsequently notified us that it disagrees with our conclusions thatthe revenue and gross margin targets were not met for the nine month periodending March 31, 2005. While we believe EiC’s assertions are without meritand we have notified EiC of such, there can be no assurance as to the eventualoutcome of this matter. Our stock is not heavily traded and our stock pricescan fluctuate significantly. As such, sales of substantial amounts of ourcommon stock into the public market by the Fox Paine Entities, or sellingstockholders in connection with the EiC and Telenexus acquisitions or others,or perceptions that significant sales could occur, could adversely affect themarket price of our common stock.

Furthermore, future sales of substantial amounts ofcommon stock by our officers, directors and other stockholders, including anysales under a Rule 10b5-1 sales plan, in the public market orotherwise or the awareness that a large number of shares is available for sale,could adversely affect the market price of our common stock. In addition to theadverse effect a price decline would have on holders of our common stock, thatdecline would impede our ability to raise capital through the issuance of additionalshares of common stock or other equity or convertible debt securities.

In addition to the adverseeffect a price decline would have on holders of our common stock, a pricedecline in our common stock could impede our ability to raise capital throughthe issuance of additional shares of common stock or other equity orconvertible debt securities. A price decline in our common stock below theNasdaq minimum bid requirements due to substantial sales of our common stockcould result in our common stock being delisted from the Nasdaq NationalMarket. Delisting could in turn reduce the liquidity of our common stock andinhibit or preclude our ability to raise capital.

***If our common stock ceases to be listed for trading onthe NASDAQ National Market, it may harm our stock price and make it moredifficult to sell shares.***

Our common stock is listed on the NASDAQ NationalMarket and their marketplace rules for continued listing require, amongother things, that the bid price for our common stock not fall below $1.00 pershare for a period of 30 consecutive trading days. In late October 2005the bid price for our common stock was below $1.00 per share for fiveconsecutive trading days and as recently as April 2003 the bid price forour common stock was been below $1.00 per share for thirty consecutive tradingdays. Although we have been able to regain compliance in the past, because ofthe volatility in our common stock price, there can be no assurance that wewill be able to maintain compliance in the future. If, in the future, ourminimum bid price is again below $1.00 for 30 consecutive trading days, underthe current NASDAQ National Market rules we will have a period of 180 daysto attain compliance by meeting the minimum bid price requirement for 10consecutive days during the compliance period.

If our common stock ceases to be listed for trading onthe NASDAQ National Market, we expect that our common stock would be traded onthe NASD’s Over-the-Counter Bulletin Board (OTC-BB) unless NASDAQ grants anadditional grace period for transfer to the NASDAQ Capital Market (formerlyknown 

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as the NASDAQ SmallCapMarket), which also has a similar $1.00 minimum bid requirement. In addition,our stock could then potentially be subject to the Securities and ExchangeCommission’s “penny stock” rules, which place additional disclosurerequirements on broker-dealers. These additional disclosure requirements mayharm your ability to sell shares if it causes a decline in the ability orwillingness of broker-dealers to sell our common stock. We also expect that thelevel of trading activity of our common stock would decline if it is no longerlisted on the NASDAQ National Market or NASDAQ Capital Market. As such, if ourcommon stock ceases to be listed for trading on the NASDAQ National Market orNASDAQ Capital Market for any reason, it may harm our stock price, increase thevolatility of our stock price and make it more difficult to sell your shares ofour common stock.

On January 10, 2006,we received a letter from the staff of the Listings Qualification Department ofthe Nasdaq Stock Market, Inc. (“Nasdaq”) dated January 10, 2006,notifying the Company that as a result of the Board of Directors vacancycreated by the resignation of Jan Loeber as a director and member of theCompany’s Audit Committee on December 31, 2005, the Company does notcomply with Nasdaq’s Marketplace Rule 4350(d)(2), which requires thecompany to have an audit committee of at least three independent directors asdefined by Nasdaq’s rules. Consistent with Marketplace Rule 4350(d)(4),the Company has a cure period until the earlier of December 31, 2006 orthe Company’s next annual meeting of stockholders to fill the vacancy andregain compliance.

***Our largest stockholder has the ability to take actionthat may adversely affect our business, our stock price and our ability toraise capital.***

As of December 31,2005, Fox Paine & Company, LLC (“Fox Paine”) is the indirect beneficialowner of 39.2% of our outstanding share capital. As a result, Fox Paine has andwill continue to have significant influence over the outcome of mattersrequiring stockholder approval, including:

·       electionof all our directors and the directors of our subsidiaries;

·       amendingour charter or by-laws; and

·       agreeingto or preventing mergers, consolidations or the sale of all or substantiallyall our assets or our subsidiaries’ assets.

Fox Paine’s significant ownership interest could alsodelay, prevent or cause a change in control relating to us which couldadversely affect the market price of our common stock.

Fox Paine’s significant ownership interest could alsosubject us to a class action lawsuit which could result in substantial costsand divert our management’s attention and financial resources from moreproductive uses. Fox Paine, on September 18, 2002, made a proposal toacquire all of the shares held by unaffiliated stockholders, which wassubsequently withdrawn on March 27, 2003. Prior to Fox Paine’s withdrawalof such proposal, four lawsuits, three of which were purported class actionlawsuits, were filed against us and Fox Paine in connection with such proposal.Among other things, these lawsuits sought an injunction against theconsummation of the proposal and an award of unspecified compensatory damages.These lawsuits were voluntarily dismissed after Fox Paine’s withdrawal of suchproposal without any consideration being required to be paid to the plaintiff’sand each party was obligated to bear its own attorney’s fees, costs andexpenses. We can make no assurance, however, that Fox Paine will not at somepoint in the future make another proposal regarding us and, if so, what theterms and outcome of such proposal might be. If Fox Paine were in the future tomake a proposal involving us then, depending on the terms of such proposal, theresulting transaction could result in litigation which could adversely affectour business or our stock price.

In addition, Fox Paine receives management fees fromus which could influence their decisions regarding us. Under our managementagreement with Fox Paine, we are obligated to pay Fox Paine a fee in the amountof 1% of the prior year’s income before interest expense, interest income,income taxes, 

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depreciation andamortization and equity in earnings (losses) of minority investments,calculated without regard to the fee. Due to our losses incurred, we have notbeen required to pay management fees to Fox Paine since 2001.

Fox Paine may in the future make significantinvestments in other communications companies. Some of these companies may beour competitors. Fox Paine and its affiliates are not obligated to advise us ofany investment or business opportunities of which they are aware, and they arenot restricted or prohibited from competing with us.

The sale of a substantialnumber of shares of our common stock by Fox Paine or the perception that suchsale could occur, could negatively affect the market price of our common stockand could also materially impair our future ability to raise capital through anoffering of securities. In addition, the sale of a substantial number of sharesof our common stock by Fox Paine could result in the loss of Fox Paine’sservices to us as well as the services of members of Fox Paine on our board ofdirectors which could adversely effect our business.

***Our stock price is highly volatile.***

The market price ofour common stock has fluctuated substantially in the past and is likely tocontinue to be highly volatile and subject to wide fluctuations. Since ourinitial public offering in August, 2000, through December 31, 2005, ourcommon stock has traded at prices as low as $0.560 and as high as $59.875 pershare. These fluctuations have occurred and may continue to occur in responseto various factors, many of which we cannot control, including:

·       sharessold by the selling stockholders;

·       quarter-to-quartervariations in our operating results;

·       announcementsof technological innovations or new products by our competitors, customers orus;

·       generalconditions in the semiconductor industry and telecommunications and datacommunications equipment markets;

·       changesin earnings estimates or investment recommendations by analysts;

·       changesin investor perceptions; or

·       changesin expectations relating to our products, plans and strategic position or thoseof our competitors or customers.

In addition, the marketprices of securities on the NASDAQ National Market and that of our customersand competitors have been especially volatile. This volatility hassignificantly affected the market prices of securities for reasons frequentlyunrelated to the operating performance of the specific companies. Accordingly,you may not be able to resell your shares of common stock at or above the priceyou paid. In the past, companies that have experienced volatility in the marketprice of their securities have been the subject of securities class actionlitigation. If we were the object of a securities class action litigation, itcould result in substantial losses and divert management’s attention andresources from other matters.

***We do not expect to pay any dividends for theforeseeable future.***

Although we had cash, cashequivalents and short-term investments of approximately $30.2 million at December 31,2005, we do not anticipate that we will pay any dividends to holders of ourcommon stock in the foreseeable future. Accordingly, investors must rely onsales of their common stock after price appreciation, which may never occur, asthe only way to realize any future gains on their investment. Investors seekingcash dividends should not invest in our common stock.

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**Item 1b. UNRESOLVED STAFF COMMENTS**

**Not applicable.**

**Item 2. PROPERTIES**

We have three leased sites:  a building in Milpitas, California with over35,000 square feet, at a base monthly rent of $40,738, two buildings in SanJose, California totaling over 124,000 square feet and leased space inRichardson, Texas for 10,754 square feet, at a base monthly rent of $12,322.The San Jose facility consists of two buildings: a larger building ofapproximately 82,000 square feet and a smaller building of approximately 42,000square feet. Both buildings are leased for ten years. The larger building has abase monthly rent of $192,645 as of December 31, 2005, which increases by4% over each succeeding twelve month period. The smaller building has a basemonthly rent of $110,552 as of December 31, 2005 which will also increaseby 4% over each succeeding twelve month period. The Fremont facility weacquired as a part of the EiC transaction in June 2004 was shut downduring the first quarter of 2005 after we relocated the manufacturing capacityand associated personnel to our facility in Milpitas and completed ourobligations under this sublease agreement.

In September 2001, we decided to abandon thesmaller building at our San Jose facility based on revised anticipated demandfor our products and market conditions and as of December 31, 2005, wehave signed three tenants to cover approximately 76% of such excess leasedspace. In September 2002, we decided to abandon a portion of the largerbuilding at our San Jose facility based on revised anticipated demand for ourproducts and market conditions. This excess space is located on the first floorof our current corporate headquarters and originally housed a portion of ouroptics and integrated assemblies manufacturing operations. We are activelyseeking tenants to occupy the excess leased space.

We believe that ourpresent facilities are in good condition and suitable for our operations. Wealso believe that we have excess capacity, which more than meets ouranticipated requirements for the foreseeable future.

**Item 3. LEGAL PROCEEDINGS**

We currently are involvedin litigation and regulatory proceedings incidental to the conduct of ourbusiness and expect that we will be involved in other litigation and regulatoryproceedings from time to time. While we currently believe that any adverseoutcome of such pending matters will not materially affect our business orfinancial condition, there can be no assurance that this will ultimately be thecase.

**Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

There were no matters submitted to a vote of securityholders in the fourth quarter of 2005.

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**PART II**

**Item5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS ANDISSUER PURCHASES OF EQUITY SECURITIES**

**PriceRange of Common Stock**

Ourcommon stock is listed on the Nasdaq National Market and traded under thesymbol “WJCI”. The following table sets forth, for the periods indicated thehigh and low sales prices as reported on the Nasdaq National Market for WJCommunications, Inc. common stock.

| ** **                                       | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------------------------------------|------------|----------|------------|---------|------------|
| First Quarter  (through March 28, 2004)     |       | 7.500    |       | 3.100   |       |
| Second Quarter  (through June 27, 2004)     |       | 4.540    |       | 2.250   |       |
| Third Quarter  (through September 26, 2004) |       | 3.850    |       | 2.070   |       |
| Fourth Quarter  (through December 31, 2004) |       | 4.300    |       | 1.710   |       |
| First Quarter (through April 3, 2005)       |       | 3.680    |       | 2.180   |       |
| Second Quarter  (through July 3, 2005)      |       | 2.450    |       | 1.680   |       |
| Third Quarter  (through October 2, 2005)    |       | 1.870    |       | 1.180   |       |
| Fourth Quarter (through  December 31, 2005) |       | 1.950    |       | 0.880   |       |

 

As of December 31,2005, there were approximately 267 stockholders of record of our common stockaccording to our transfer agent.

**Issuer Purchases of EquitySecurities**

We did not repurchase anyshares of our common stock in the fourth quarter of 2005.

**DividendPolicy**

We did not pay anydividends in 2005 and 2004. We do not intend to pay cash dividends on ourcommon stock for the foreseeable future. Instead, we intend to retain allearnings for use in the operation and expansion of our business. Our board ofdirectors will make any future determination of the payment of dividends basedupon various factors then existing, including, but not limited to, ourfinancial condition, operating results and current and anticipated cash needs.In addition, covenants in our revolving credit facility limit our ability todeclare and pay cash dividends on our common stock.

**Recent Sales of Unregistered Securities**

Except as previouslyreported in our Form 8-K filed with the Securities and ExchangeCommission on February 3, 2005 in connection with the Telenexusacquisition, we did not sell any of our securities that were not registeredunder the Securities Act during 2005.

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**EquityCompensation Plan Information**

**Equity Compensation Table.****  **The following table sets forth information as of December 31,2005, with respect WJ Communication’s equity compensation plans.

| **Plan Category**                                     | ** ** | ** ** | ** ** | **Number of Shares of  Common Stock to be  Issued Upon Exercise  of Outstanding  Options and Rights** | ** ** | **Weighted-Average  Exercise Price of  Outstanding Options** | ** ** | **Number of Shares of Common   Stock Remaining Available for   Future Issuance Under Equity   Compensation Plans  (Excluding Shares Reflected  in the First Column)** | ** ** |
|------------------------------------------------------------|------------|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity Compensation Plans Approved by Stockholders(1)      |       |       | 8,355,559  | (2)                                                                                                                                                          |       |                                                                        | $          | 1.765                                                                                                                                                                                                                                                                |       |   |   | 4,785,886 | (3) |   |
| Equity  Compensation Plans Not Approved by Stockholders(4) |       |       | 1,011,200  |                                                                                                                                                         |       |                                                                        | $          | 2.779                                                                                                                                                                                                                                                                |       |   |   | 948,456 |   |   |

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(1)          The equity compensation plans approved by stockholders are the 2000 StockIncentive Plan and the amended and restated 2000 Non-Employee Director StockCompensation Plan.

(2)          Of these shares 270,000 options wereoutstanding under the amended and restated 2000 Non-Employee Director StockCompensation Plan and 8,085,559 were outstanding under the 2000 Employee Stock Incentive Plan.

(3)          Of these shares 4,619,542 shares areavailable for issuance under the 2000 Stock Incentive Plan and 166,344 sharesare available for issuance under the amended and restated 2000 Non-EmployeeDirector Plan.

(4)          The equity compensation plan not approved bystockholders is the 2001 EmployeeStock Incentive Plan. Key provisions of the plan are:

·       Theplan was adopted by the board of directors on May 23, 2001 and waseffective on that date. The plan will terminate on May 23, 2011, however,awards outstanding at that time will not be affected or impaired by the plan’stermination;

·       Participationis limited to our employees or affiliates who are not directors or officers ofthe Company or any of its affiliates at the time a particular award is made;

·       Stockoptions granted may include incentive stock options, restricted stock,nonqualified stock options and stock appreciation rights or any combinationthereof;

·       Theplan shall be administered by the Board or any committee that has beendesignated by the board;

·       Theterm of each stock option may in no event be more than 10 years; and

·       Upona change of control transaction as described in the plan, the committee may, inits sole discretion, do one or more of the following;

·        shortenthe period during which stock options are exercisable, provided they remainexercisable for at least 30 days after the date notice of the shortening isgiven to the participants;

·        accelerateany vesting schedule to which a stock option or restricted stock award issubject;

·        arrangeto have the surviving or successor entity or any parent entity thereof assumethe restricted stock awards and the stock options or grant replacement optionswith appropriate adjustments in the exercise prices and adjustments in thenumber and kind of securities issuable upon exercise or adjustments so that thestock options or their replacements represent 

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the right to purchase theshares of stock, securities or other property, including cash, as may beissuable or payable as a result of the change of control transaction withrespect to or in exchange for the number of shares of common stock purchasableand receivable upon exercise of the stock options had such exercise occurred infull prior to the change of control transaction; or

·        cancelstock options or unvested stock awards upon payment to the participants incash, with respect to each stock option or restricted stock award to the extentthen exercisable or vested, including, if applicable, any stock options orrestricted stock awards as to which the vesting schedule has been acceleratedby decision of the compensation committee because of the change of controltransaction, of an amount that is the equivalent of the excess of the fairmarket value of the common stock at the effective time of the change of controltransaction over, in the case of stock options, the exercise price of the stockoption.

 

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**Item 6. SELECTED CONSOLIDATED FINANCIAL DATA**

Thefollowing selected consolidated financial data should be read in conjunctionwith the consolidated financial statements and notes thereto and with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andother financial data included elsewhere in this report. The statements ofoperations data for the years ended December 31, 2005, 2004, and 2003 andthe selected balance sheet data as of December 31, 2005 and 2004 arederived from our audited consolidated financial statements which are includedelsewhere in this annual report on Form 10-K. The statements ofoperations data for the years ended December 31, 2002 and 2001 and theselected consolidated balance sheet data as of December 31, 2003, 2002 and2001 are derived from our audited consolidated financial statements which arenot included in this annual report on Form 10-K. The historicalresults are not necessarily indicative of results to be expected for any futureperiod.

| ** **                                                                                 | ** ** | **Year Ended December 31,**                         | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2005**                                                           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                                 | ** ** | **(in thousands, except per share data)** | ** ** |
| **Consolidated Statements of  Operations Data:**                                           |       |                                                               |       |   |   |   |   |   |   |   |   |
| Sales, net                                                                                 |       | $                                                                  | 31,597     |   | $ | 32,336 |   | $ | 26,565 |   | $ | 40,156 |   | $ | 62,220 |   |
| Cost of goods sold                                                                         |       | 16,906                                                             |       | 15,278 |   | 15,495 |   | 28,892 |   | 58,932 |   |
| Gross profit                                                                               |       | 14,691                                                             |       | 17,058 |   | 11,070 |   | 11,264 |   | 3,288 |   |
| Operating  expenses:                                                                       |       |                                                               |       |   |   |   |   |   |   |   |   |
| Research and development                                                                   |       | 18,070                                                             |       | 17,238 |   | 16,882 |   | 17,882 |   | 17,325 |   |
| Selling and administrative                                                                 |       | 15,295                                                             |       | 12,503 |   | 10,251 |   | 11,167 |   | 14,160 |   |
| Acquired in-process research and development(1)                                            |       | 3,400                                                              |       | 8,500 |   | — |   | — |   | — |   |
| Recapitalization merger(2)                                                                 |       | —                                                             |       | — |   | 680 |   | 509 |   | — |   |
| Restructuring charges (reversals)(3)                                                       |       | —                                                             |       | (3,845 | ) | (54 | ) | 34,233 |   | 9,797 |   |
| Total operating expenses                                                                   |       | 36,765                                                             |       | 34,396 |   | 27,759 |   | 63,791 |   | 41,282 |   |
| Loss from operations                                                                       |       | (22,074                                                            | )          | (17,338 | ) | (16,689 | ) | (52,527 | ) | (37,994 | ) |
| Interest income                                                                            |       | 1,048                                                              |       | 682 |   | 755 |   | 1,218 |   | 3,015 |   |
| Interest expense                                                                           |       | (96                                                                | )          | (104 | ) | (117 | ) | (142 | ) | (238 | ) |
| Other income—net                                                                      |       | 14                                                                 |       | 5 |   | 1,094 |   | 16 |   | 693 |   |
| Gain on dispositions of real property(4)                                                   |       | —                                                             |       | — |   | — |   | — |   | 325 |   |
| Loss before income taxes                                                                   |       | (21,108                                                            | )          | (16,755 | ) | (14,957 | ) | (51,435 | ) | (34,199 | ) |
| Income tax benefit                                                                         |       | 120                                                                |       | 7,674 |   | 647 |   | — |   | 12,528 |   |
| Net loss                                                                                   |       | $                                                                  | (20,988    | ) | $ | (9,081 | ) | $ | (14,310 | ) | $ | (51,435 | ) | $ | (21,671 | ) |
| Basic and diluted net loss per share                                                       |       | $                                                                  | (0.33      | ) | $ | (0.15 | ) | $ | (0.25 | ) | $ | (0.91 | ) | $ | (0.39 | ) |
| Shares used to calculate loss from continuing operations  per share—basic and diluted |       | 64,162                                                             |       | 60,397 |   | 56,835 |   | 56,291 |   | 55,629 |   |

 

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| ** **                                     | ** ** | **December 31,**   | ** ** |
|------------------------------------------------|------------|-------------------------|------------|
| ** **                                     | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                     | ** ** | **(in thousands)** | ** ** |
| **Selected Consolidated Balance  Sheet Data:** |       |                    |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents                     |       | $                       | 14,169     |   | $ | 24,392 |   | $ | 10,900 |   | $ | 43,524 |   | $ | 25,216 |   |
| Short-term investments                         |       | 16,052                  |       | 18,732 |   | 49,232 |   | 21,221 |   | 30,457 |   |
| Working capital                                |       | 28,362                  |       | 46,724 |   | 58,748 |   | 71,431 |   | 84,822 |   |
| Total assets                                   |       | 61,644                  |       | 69,733 |   | 79,820 |   | 95,548 |   | 127,016 |   |
| Total debt                                     |       | —                  |       | — |   | — |   | — |   | — |   |
| Capital leases, net of current portion         |       | —                  |       | — |   | 14 |   | — |   | — |   |
| Total  stockholders’ equity               |       | 31,117                  |       | 41,297 |   | 36,239 |   | 49,618 |   | 99,722 |   |
|                                                |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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1)               During 2005, $3.4million of the purchase price for the acquisition of Telenexus, Inc. wasallocated to acquired in-process research and development expense (“IPRD”).

During 2004, $8.5 million of the purchase price forthe acquisition of the wireless infrastructure business and associated assetsfrom EiC was allocated to IPRD.

For further discussion, see Management’s Discussionand Analysis of  Financial Condition andthe Results of Operations under the caption “Acquired In-process Research andDevelopment Expenses” included elsewhere in this Form 10-K.

2)               Our 2003 and 2002recapitalization merger and other expense is a non-recurring expenditurecomprised of expenses incurred by the special committee to our Board ofDirectors to review a proposal from an affiliate, Fox Paine & CompanyLLC to acquire all of the shares of the Company’s common stock held byunaffiliated stockholders. In 2003, Fox Paine & Company LLC withdrewits proposal.

3)               During the secondquarter of 2004, the Company delayed the closure of its internal waferfabrication facility (“fab”) for a minimum of three months to assess theintegration of the EiC acquisition into its existing operations which resultedin an approximate $430,000 reduction in its lease loss accrual. During thethird quarter of 2004, the Company decided to not close its fab as the Companybelieved at that time that integrating the newly acquired fab from EiC with itspre-existing fab will offer the Company certain benefits over outsourcing thepre-existing fab. As such, the Company reversed the remainder of this leaseloss accrual of $3.6 million. Also during the third quarter of 2004, theCompany revised its lease loss assumptions for its other facilities based onreductions in sublease occupancy rates and current facility costs. As such theCompany accrued $161,000 of additional lease loss. During 2003, we revised our lease loss accrual downward for the fourmonth additional operation of our wafer fab and reduced facility costs at ourother two abandoned facilities. This credit was largely offset by an additionallease loss accrual for reductions in estimated sublease occupancy and marketrates and disposal of our remaining unsold assets held for sale. We alsoreversed a portion of our severance accrual for one employee slated to beterminated but instead retained for another position. Our 2002 restructuringcharge reflects further consolidation and abandonment of leased space andassociated impairment of tenant improvements, severance costs, an assetimpairment charge and the initiation of a program to sell excess manufacturingequipment resulting from the prolonged downturn in the telecommunicationsindustry, especially related to our fiber optics products. The 2002restructuring charge also includes an additional charge for the leased facilitywe abandoned in 2001 based on our downward revised assumptions regardingsublease occupancy rates and market rates due to an overall deteriorating realestate market and difficulties encountered in subleasing the available space.Also during 2002, we recorded a restructuring charge related to our decision inDecember 2002 to completely outsource our internal wafer fabrication. Our2001 restructuring charge reflects ourdecision to abandon a leased facility based on revised anticipated 

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demandfor our products and current market conditions. For further discussion of ourrestructuring charges, see Note 14 to the consolidated financial statementsincluded elsewhere in this Form 10-K.

4)               Our 2001 gain on dispositions of realproperty is related to the release of escrow funds related to our saleof leasehold interests in our Palo Alto site which was partially offset byresidual expenses from the sale of the property.

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**Item7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND THE RESULTSOF OPERATIONS**

*Special NoticeRegarding Forward-Looking Statements. The following discussion and analysiscontains forward-looking statements including financial projections, statementsas to the plans and objectives of management for future operations, andstatements as to our future economic performance, financial condition orresults of operations. These forward-looking statements are not historicalfacts but rather are based on current expectations, estimates, projectionsabout our industry, our beliefs and our assumptions. Words such as “may,” “anticipates,”“expects,” “intends,” “plans,” “believes,” “seeks” and “estimates” andvariations of these words and similar expressions are intended to identifyforward-looking statements. Our actual results may differ materially from thoseprojected in these forward-looking statements as a result of a number offactors, including, but not limited to, those factors described in “RiskFactors” above. Readers of this report are cautioned not to place unduereliance on these forward-looking statements.*

*The following discussion should be read in conjunctionwith our consolidated financial statements and related disclosures includedelsewhere in this annual report on Form 10-K. Except for historicactual results reported, the following discussion may contain predictions,estimates and other forward-looking statements that involve a number of risksand uncertainties. See “Special Notice Regarding Forward-looking Statements”above and “Risk Factors” above for a discussion of certain factors that couldcause future actual results to differ from those described in the followingdiscussion.*

**Overview**

We are a radio frequency (“RF”) semiconductor companyproviding RF product solutions worldwide to communications equipment companiesand service providers. We design, develop and manufacture innovative, highperformance products for both current and next generation wireless and wirelinenetworks, and RF identification systems. Our RF product solutions are comprisedof advanced, highly functional RF semiconductors, components and integratedassemblies which address the radio frequency challenges of these varioussystems. We currently generate the majority of our revenue from our productsutilized in wireless and wireline networks. Our revenue from our products usedin RFID represents a less significant portion of our current revenue however webelieve they represent areas of future growth opportunity. The RF challenge isto create product designs that function within the unique parameters ofdifferent wireless system architectures. Our solution is comprised of designexpertise, advanced device technology and manufacturability. Our commercialcommunications products are used by telecommunication and broadband cableequipment manufacturers supporting and facilitating mobile communications,enhanced voice services, data and image transport. Our objective is to be theleading supplier of innovative RF semiconductors products.

We have continued to augment our existing technologybase and design capabilities with two recent acquisitions. On January 28,2005 we completed our acquisition of Telenexus, Inc. (“Telenexus”). Webelieve the addition of Telenexus’ RFID products and technology will allow usto continue to enhance our RFID reader offerings to further capitalize onmarket opportunity. On June 18, 2004, we completed our acquisition of thewireless infrastructure business and associated assets from EiC Corporation, aCalifornia corporation and EiC Enterprises Limited (together “EiC”). We believethat the addition of EiC’s technical expertise further enhances WJ’s strategyof offering customers what we believe to be industry leading products for thewireless infrastructure market.

WJ Communications, Inc. (formerly Watkins-JohnsonCompany, “we,” “us,” “our” or the “Company”) was founded in 1957 in Palo Alto,California, and for many years we focused on RF microwave devices for defenseelectronics and space communications systems. Beginning in the 1990s, we beganapplying our RF design, semiconductor technology and integration capabilitiesto address the growing opportunities for commercial communications products. Webelieve that our track record of designing high quality, reliable products andour long-standing relationships with industry-leading 

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customers are importantcompetitive advantages. We were originally incorporated in California and reincorporatedin Delaware in August 2000.

Our principal executiveoffices are located at 401 River Oaks Parkway, California 95134, and ourtelephone number at that location is (408) 577-6200. Our Internetaddress is *www.wj.com.*Our annual reports on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K,amendments to those reports and other Securities and Exchange Commission, orSEC, filings are available free of charge through our website as soon asreasonably practicable after such reports are electronically filed with, orfurnished to, the SEC. The information contained on our website is not intendedto be part of this report. Our common stock is listed on the Nasdaq NationalMarket and traded under the symbol “WJCI”.

**Acquisitions**

We have completed two acquisitions in connection withthe implementation of our business strategy to acquire and develop new andcomplementary technologies.

On January 28, 2005 we completed our acquisitionof Telenexus, Inc. (“Telenexus”). Pursuant to an Agreement and Plan ofMerger, dated January 19, 2005, by and between us, WJ Newco, LLC (the “WJSub”), Telenexus and Richard J. Swanson, Wilfred K. Lau, David Fried, KurtChristensen and Mark Sutton (the “Shareholders”). Telenexus was merged with andinto the WJ Sub effective on January 29, 2005. The WJ Sub was the survivorin the merger and is our wholly-owned subsidiary. Telenexus designs, develops,manufactures and markets radio frequency identification (“RFID”) readerproducts for a broad range of industries and markets. By virtue of the merger,we purchased through the WJ Sub all of the assets necessary for the conduct ofthe RFID business of Telenexus, consisting primarily of, and including, but notlimited to RFID modules, baseband processing algorithm technology, applicationssoftware and realizations of several reader product designs. The considerationwe paid on the closing date in connection with the merger consisted of cash inthe amount of $3.0 million, which was paid out of our cash reserves on theclosing date, and 2,333,333 shares of our common stock valued at $8.2 millionat the closing date. Including acquisition costs of $230,000, the aggregatepurchase price for the net assets of Telenexus totaled $11.4 million. Of the closing consideration, cash in theamount of $500,000 and 333,333 shares of our common stock are being held inescrow with respect to any indemnification matter under the merger agreement.The outstanding cash balance of the escrow account less any properly noticedunpaid or contested amounts was to be distributed within two days after October 28,2005. We released the full amount of the cash balance of the escrow account on October 31,2005. The 333,333 shares in the escrow account less any shares for anyproperly noticed unpaid or contested amounts will be distributed within fivedays after July 28, 2006. The fair value of our common stock wasdetermined based on the average closing price per share of our common stockover a 5-day period beginning two trading days before and ending two tradingdays after the amended terms of the acquisition were agreed to and announced (January 31,2005). In addition to the closing consideration, the sellers may be entitled tofurther compensation of up to up to $2.5 million in cash and up to 833,333 sharesof our common stock if we achieve certain revenue targets by July 28, 2006.Any change in the fair value of the net assets of Telenexus or any additionalconsideration to the Shareholders will change the amount of the purchase priceallocable to goodwill. The acquisition was accounted for using the purchasemethod of accounting in accordance with SFAS No. 141, BusinessCombinations (“SFAS No. 141”).

On June 18, 2004, we completed our acquisition ofthe wireless infrastructure business and associated assets from EiCCorporation, a California corporation and EiC Enterprises Limited (together “EiC”).The aggregate purchase price was $13.3 million which included consideration toEiC  in the form of payments of cash of$10.0 million and the issuance of 737,000 shares of our common stock valued at$2.5 million, as well as acquisition related costs we incurred of $1.2 millionand $152,000 of estimated registration statement related expenses reduced by a$576,000 benefit from the termination settlement of the associated supplyagreement with EiC recognized during our quarter ended December 31, 2004.In 

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connection with theacquisition, $1.5 million in cash and 294,118 shares of common stock were heldin escrow as security against certain financial contingencies. On March 30,2005, we made a claim against the escrow account for unpaid invoices issuedunder the supply agreement. We received those funds on May 4, 2005. Theuncontested amount was released to EiC on April 5, 2005 per the escrowagreement and the residual balance of the $1.5 million was released to EiC on May 4,2005. The 294,118 shares in the escrow account less  any shares for any properly noticed unpaid orcontested amounts will be distributed within five days after March 31,2006. On November 23, 2004 we filed a registration statement registeringfor resale by the seller of up to 442,882 shares of our common stock issued inthe acquisition.

In addition to the closing consideration, EiC wasoriginally entitled to further consideration of up to $7.0 million and $7.0million in cash and shares of our common stock if certain revenue and grossmargin targets were achieved by March 31, 2005 and March 31, 2006,respectively. We have determined that the revenue and gross margin targets werenot met for the nine month period ending March 31, 2005. EiC subsequentlynotified us that it disagrees with our conclusion that the revenue and grossmargin targets were not met for the nine month period ending March 31,2005. While we believe EiC’s assertions are without merit and has notified EiCof such, there can be no assurances as to the eventual outcome of this matter.

If we achieve certainrevenue targets by March 31, 2006, we will be obligated to pay EiC the remaining contingent consideration ofup to $7.0 million, ninety percent (90%) in our common stock and ten percent(10%) in cash. The number of shares of our common stock to be delivered is tobe determined by dividing the value in dollars of the portion payable in ourcommon stock by the average closing price of our common stock, as quoted on theNASDAQ National Market, during the ten consecutive trading days ending onetrading day before the end of the period covered by the payment, provided,however, that in the event that the calculation of the average closing priceresults in a price per share for the first payment that would be less than$5.00 or for the second payment that would be less than $6.00, then we, at ouroption, in our sole discretion, may elect to make the payment part or all incash and the balance, if any, in shares of our common stock. If EiC receivessuch consideration, the amounts will be recorded as an increase to goodwill. As of March 20, 2006 we have not yetdetermined if the revenue targets were met for the year ending March 31,2006. We will not be able to make our determination until after we havecompleted our internal control procedures after our quarter end on April 2,2006. The fair value of our common stock was determined based on theaverage closing price per share of our common stock over a 5-day periodbeginning two trading days before and ending two trading days after the amendedterms of the acquisition were agreed to and announced (June 21, 2004). Theacquisition was accounted for using the purchase method of accounting inaccordance with SFAS No. 141, Business Combinations (“SFAS No. 141”).

*Sales*

We sell our products toa broad group of communications original equipment manufacturers (“OEMs”) andtheir suppliers and subcontractors. Our major customers provideforecasted demand on at least a monthly basis, which assists us in managing ourinventory requirements. These forecasts, however, are subject to changes,including changes as a result of market conditions, and could fluctuate fromquarter to quarter.

We depend on a small number of customers for amajority of our sales. Sales to our customers which individually account formore than 10% of our total annual sales were,in aggregate, 58%, 63% and 70% of our sales for the years ended December 31,2005, 2004 and 2003, respectively. For the identity of our customers who contributed greater than 10% of ourtotal sales for each of the preceding three years and the annual amount ofthose sales, see Note 16 to the consolidated financial statementsincluded elsewhere in this Form 10-K. We have diversified ourcustomer base over the last few years and intend to further diversify ourcustomer base and product offering in the future. However, we anticipate thatwe will 

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continue to sell amajority of our products to a relatively small group of customers. In addition,most of our sales result from purchase orders or contracts that can becancelled on short-term notice. Delays in manufacturing or supply procurementor other factors, including general market slow downs, have caused and couldpotentially continue to cause cancellation, reduction or delay in orders by orin shipments to a significant customer. If the markets for our productsdecline, fail to grow, or grow more slowly than we anticipate, the use of ourproducts may be reduced with a significant negative impact on our sales,earnings, inventory valuations and cash flow.

Revenues from product sales are recognized when all ofthe following conditions are met:  theproduct has been shipped and title has passed to the customer, we have the rightto invoice the customer at a fixed price, the collection of the receivable isreasonably assured and there are no significant obligations remaining.Generally, title passes upon shipment of our products. Certain contracts areunder a consignment arrangement under which title to our products does not passuntil the customer utilizes these products in its production processes. As aconsequence, we recognize revenue on these contracts only when the customernotifies us of product consumption.

We may enter intofixed price development contracts with customers. Revenue under developmentagreements is recognized when applicable contractual non-refundable milestoneshave been met, including deliverables, and in any case, does not exceed theamount that would be recognized using the percentage-of-completion accountingmethod based on the actual physical completion of work performed and the ratioof costs incurred to total estimated costs to complete the contract. Losses oncontracts are recognized when determined. Revisions in estimates are reflectedin the period in which the conditions become known.

Generally, the sellingprices of our products tend to decrease over time as a result of increasedvolumes or general competitive pressures and in general we expect that priceswill continue to decline as a result of volume increases or these competitivepressures.

*Cost of Goods Sold*

Our cost of goodssold consists primarily of:

·       directmaterial costs of product components;

·       productionwages, taxes and benefits;

·       costsof assembly and test by third party contract manufacturers;

·       wafercosts from third-party semiconductor foundries;

·       laborcontracted on a temporary basis;

·       suppliesconsumed in the manufacturing process;

·       depreciationand amortization of manufacturing and test equipment and leaseholdimprovements;

·       leaseexpense for our manufacturing facilities;

·       allocatedoccupancy costs;

·       scrappedmaterial used in the production process; and

·       write-downsof excess and obsolete inventory.

We recognize cost of goodssold upon recognition of revenue. We recognize losses on contracts, includingpurchase order commitments, when identified. We have not recognized any suchlosses during 2005, 2004 or 2003.

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*Operating Expenses*

Our operating expenses areclassified into two general categories: research and development, and sellingand administrative. We classify all charges to these two categories based onthe nature of the expenditures. Although each of these two categories includesexpenses that are unique to the category type, there are commonly recurringexpenditures that are typically included in these categories, such as wages,fringe benefit costs, depreciation and allocated overhead.

*Research andDevelopment*

Research and developmentexpense represents wages, supplies and allocated overhead costs to design,develop and improve products and processes. These costs are expensed asincurred. We generate revenues from development contracts with customers thathave enabled us to accelerate our own product development efforts. Suchdevelopment revenues have only partially funded our product developmentactivities, and we generally retain ownership of the products developed underthese arrangements. As a result, we classify all development costs related tothese contracts as research and development expenses.

*Selling andAdministrative*

Selling and administrativeexpense consists primarily of wages, travel and facility costs incurred by andother expenses allocated to our selling and administrative departments. Sellingand administrative expense also includes manufacturer representatives anddistributor sales commissions, trade show and advertising expenses and fees andexpenses of legal, accounting, and other professional consultants.

*RecapitalizationMerger*

In September 2002 weannounced the receipt of a proposal from an affiliate, Fox Paine &Company LLC (“Fox Paine”) to acquire all of the shares of the Company’s commonstock held by unaffiliated stockholders (the “Acquisition Proposal”). On March 27,2003, Fox Paine withdrew its Acquisition Proposal. Our 2003 recapitalizationmerger and other expense is a non-recurring expenditure comprised of expensesincurred by the special committee to our Board of Directors to review the proposal from an affiliate, Fox Paine &Company LLC to acquire all of the shares of our common stock held byunaffiliated stockholders for $1.10 per share in cash. These expensesinclude legal and financial consulting fees as well as compensation to themembers of the special committee.

*Restructuring Charge*

Our 2001 restructuringcharge reflects our decision to abandon a leased facility based on revisedanticipated demand for our products and current market conditions. It iscomprised of future lease payments net of anticipated sublease income, brokercommissions and other facility costs, and an asset impairment charge on tenantimprovements. In determining this estimate, we have made certain assumptionswith regards to our ability to sublease the space and have reflectedoff-setting assumed sublease income in line with our best estimate based on thecurrent market conditions. Our 2002 restructuring charge reflects furtherconsolidation and abandonment of leased space and associated impairment oftenant improvements, severance costs, an asset impairment charge and theinitiation of a program to sell excess manufacturing equipment resulting fromthe prolonged downturn in the telecommunications industry, especially relatedto our fiber optics products. The 2002 restructuring charge also includes anadditional charge for the leased facility we abandoned in 2001 based on ourdownward revised assumptions regarding sublease occupancy rates and marketrates due to an overall deteriorating real estate market and difficultiesencountered in subleasing the available space. Also during 2002, we recorded arestructuring charge related to our decision in December 2002 tocompletely outsource our internal wafer fabrication (“fab”) within one year. Asa result of the planned fab closure, we accrued 

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associatedseverance expenses, accrued the eventual abandonment of additional excess spacefor which we will have a remaining two year commitment and recorded animpairment on our internal wafer fabrication equipment and related leaseholdimprovements. During 2003, we revised our lease loss accrual downward for thefour month additional operation of our wafer fab and reduced facility costs atour other two abandoned facilities. This reversal was largely offset by anadditional lease loss accrual for reductions in estimated sublease occupancyand market rates and disposal of our remaining unsold assets held for sale. Wealso reversed a portion of our severance accrual for one employee slated to beterminated but instead retained for another position. During 2004, we reversedthe lease loss associated with our fab and remaining severance accrual due toour assessment and subsequent decision to not close our fab as we believed atthat time that integrating the newly acquired fab from EiC with ourpre-existing fab will offer the Company certain benefits over outsourcing thepre-existing fab. This reversal was partially offset by a net increase in thelease loss accrual for our other leased facilities based on reductions insublease occupancy rates and a net increase in facility operating costs.

**CriticalAccounting Policies and Estimates**

Our discussion and analysis of our financial conditionand results of operations are based upon our consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States. The preparation of these financial statementsrequires us to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses, and related disclosure ofcontingent assets and liabilities. On a continuous basis, we evaluate all oursignificant estimates including those related to doubtful accounts receivable,inventory valuation, impairment of long-lived assets, income taxes,restructuring including accruals for abandoned lease properties, contingenciesand litigation. We base our estimates on historical experience and on variousother assumptions that are believed to be reasonable under the circumstance,the results of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources.Actual results may differ from these estimates under different assumptions orconditions and such differences could be material.

We believe the followingcritical accounting policies affect our more significant judgments andestimates used in the preparation of our consolidated financial statements. SeeNote 2 to the consolidated financial statements included elsewhere in thisForm 10-K for a detailed discussion of all our significantaccounting policies.

*BusinessCombinations*

We allocate the purchase price of acquired companiesto the tangible and intangible assets acquired and in-process research anddevelopment based on their estimated fair values. Such valuations require managementto make significant estimations and assumptions, especially with respect tointangible assets.

Critical estimates invaluing certain intangible assets include but are not limited to: futureexpected cash flows from acquired developed technologies and patents, expectedcosts to develop the in-process research and development into commerciallyviable products and estimating cash flows from the projects when completed,customer contracts, customer lists, distribution agreements, also the brandawareness and the market position of the acquired products and assumptionsabout the period of time the brand will continue to be used in the combinedcompany’s product portfolio. Management’s estimates of fair value are basedupon assumptions believed to be reasonable, but which are inherently uncertainand unpredictable.

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*Revenue Recognition*

We recognize revenue in accordance with SEC StaffAccounting Bulletin (“SAB”) No. 104, “Revenue Recognition.”  This SAB requires that four basic criteriamust be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) deliveryhas occurred or services rendered; (3) the fee is fixed or determinable;and (4) collectibility is reasonably assured. Determination of criteria (3) and(4) are based on management’s judgments regarding the fixed nature of thefee charged for products delivered and the collectibility of those fees.

Effective for our second quarter ended July 3,2005, we changed the application of our revenue recognition policy regardingour distributors. We had previously recognized revenue upon shipment to ourdistributors less estimated reserves for distributor right of return,authorized price reductions for specific end-customer sales opportunities andprice protection based on known events and historical trends. Effective for oursecond quarter ended July 3, 2005, we recognize revenue from ourdistribution channels when our distributors have sold the product to the endcustomer. Historically, we have received stock rotation requests from ourdistributors that were within the amounts estimated and contractually allowedwith only one exception of an insignificant amount.  However, the request for stock rotation duringour second quarter ended July 3, 2005 was higher than the amountcontractually allowed. Our management, with the concurrence of our AuditCommittee, believes the increasing percentage of new products introduced by usmakes it likely that stock rotation reserves will continue to be difficult toestimate based on historical patterns and contractual provisions. Based on thischange in facts and circumstances and our management’s future expectations, webelieve that we can no longer reasonably estimate the amount of future returnsfrom our distributors as of July 3, 2005. Accordingly, recognition ofrevenue and associated cost of sales on shipments to distributors is deferreduntil the resale to the end customer. This change in application resulted in a$4.1 million revenue deferral in our second quarter of 2005. Although revenueis deferred until resale, title of products sold to distributors transfers uponshipment. Accordingly, shipments to distributors are reflected in theconsolidated balance sheets as accounts receivable and a reduction ofinventories at the time of shipment. Deferred revenue and the correspondingcost of sales on shipments to distributors are reflected in the consolidatedbalance sheet on a net basis as “Deferred margin on distributor inventory.”  Forfurther discussion, see Note 3 to the consolidated financial statementsincluded elsewhere in this Form 10-K.

Through the quarter ended April 3,2005, revenues from our distributors were recognized upon shipment basedon the following factors:  our salesprice is fixed or determinable by contract at the time of shipment, paymentterms are fixed at shipment and are consistent with terms granted to othercustomers, the distributor has full risk of physical loss, the distributor hasseparate economic substance, we have no obligation with respect to the resaleof the distributor’s inventory, and we believed we could reasonably estimatethe potential returns from our distributor based on their history and ourvisibility in the distributor’s success with its products and into the marketplace in general. In accordance with Financial Accounting Standards Board (“FASB”)Statement No. 48 “Revenue Recognition When Right of Return Exists”, weaccrued a reserve based on our reasonable estimate of future returns based onhistorical trends and contractual limitations. Per contractual agreement, thedistributor may return product three times per year under the followingconditions:  the total value of inventoryreturned shall not exceed an amount equal to 5% of the total value of thedistributor’s stock on hand of our products as reported in the prior month’sinventory report, the inventory is returned no earlier than 6 months and nolater than 24 months from the date of the original invoice date and the product’spackaging has not been opened or any alteration or modification has beenperformed on the part. Due to our change in application of our revenue recognition policy regarding our distributors,we no longer accrue a distributor stock rotation reserve. As of December 31,2004 and 2003, our distributor stock rotation reserve was $338,000 and $196,000, respectively.

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Beginning in September 2003, we entered into aprogram where the distributor would receive a credit if it sold specificproduct at a reduced price to specific end-customers pre-authorized by us. Wemaintain a log of all such pre-authorized price reductions which we accrue as areduction to revenue in the period that the pre-authorization occurs per issue4 of EITF 01-9 “Accounting for Consideration Given by a Vendor to aCustomer (Including a Reseller of the Vendor’s Products).”  As ofDecember 31, 2005, 2004 and 2003, our Ship & Debit Allowance was$34,000, $5,000, and $29,000, respectively.

If we reduce the prices of our products as negotiatedwith the distributor, the distributor may receive a credit for the differencebetween the price paid by the distributor and the reduced price on applicableunsold products remaining in the distributor’s inventory on the effective dateof the price reduction assuming that inventory is less than 24 months old asdetermined by the original invoice date. When we recognized revenue upon shipment to our distributors, we reservedfor distributor price protection per issue 4 of EITF 01-9 based onspecific identification of our initiated price reductions and the associatedreported distributor inventory. There were no such price reductions in 2005, 2004or 2003.

We may enter intocontracts to perform research and development for others meeting therequirements of Statementof Financial Accounting Standards No. 68 “Research and DevelopmentArrangements”. Revenue under these development agreements is recognized whenapplicable contractual non-refundable milestones have been met, includingdeliverables, and in any case, does not exceed the amount that would berecognized using the percentage-of-completion accounting method based on theactual physical completion of work performed and the ratio of costs incurred tototal estimated costs to complete the contract in accordance with AccountingResearch Bulletin 45 “Long-Term Construction Type Contracts” using the relevantguidance in the American Institute of Certified Public Accountants Statement ofPosition (“SOP”) 81-1, Accounting for Performance of Construction-Typeand Certain Production-Type Contracts. Given the duration and nature of thesedevelopment contracts, we believe that recognizing revenue under the percentagecompletion method best represents the legal and economic results of contractperformance on a timely basis. Losses on contracts are recognized whendetermined. Revisions in estimates are reflected in the period in which theconditions become known. These development contracts with customers haveenabled us to accelerate our own product development efforts. Such developmentrevenues have only partially funded our product development activities, and wegenerally retain ownership of the products developed under these arrangements.As a result, we classify all development costs related to these contracts asresearch and development expenses. The achievement of contractual milestones isevidenced by written documentation provided by the customer in accordance withthe applicable terms and conditions of each contract. In any period, progresson the contract is based on input measures (direct labor dollars, directmaterial costs and direct outside processing costs) in the ratio of costsincurred to total estimated costs. Estimated costs to complete are provided byengineering personnel directly involved in the development program and arereviewed by management and finance personnel for reasonableness given the knownfacts and circumstances. A number of internal and external factors can affectour estimates, including labor rates, utilization and efficiency variances andspecification and testing requirement changes. If different conditions were toprevail such that accurate estimates could not be made, then the use of thecompleted contract method would be required and the recognition of all revenueand costs would be deferred until the project was completed. Such a changecould have a material impact on our results of operations. If we bill the customerprior to performing services under the development agreement, the amounts arerecorded as deferred revenue. We recorded revenue of $832,000 under developmentagreements in 2005. We have no deferred revenue at December 31, 2005. Nocomparable amounts were included in 2004 or 2003.

*Write-down ofExcess and Obsolete Inventory*

We write down ourinventory for estimated obsolete or unmarketable inventory for the differencebetween the cost of inventory and the estimated market value based uponassumptions about future 

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demandand market conditions. Management specifically identifies obsolete products andanalyzes historical usage, forecasted production generally based on a rollingtwelve month demand forecast, current economic trends and historical write-offswhen evaluating the valuation of our inventory. Due to rapidly changingcustomer forecasts and orders, additional write-downs of excess or obsoleteinventory, while not currently expected, could be required in the future. Inaddition, the sale of previously written down inventory could result fromsignificant unforeseen increases in customer demand.

*Valuation ofIntangible Assets and Goodwill*

We periodically evaluateour intangible assets and goodwill in accordance with SFAS No. 142, “Goodwilland Other Intangible Assets,” for indications of impairment whenever events orchanges in circumstances indicate that the carrying value may not berecoverable. Intangible assets include goodwill and purchased technology.Factors we consider important that could trigger an impairment review includesignificant under-performance relative to historical or projected futureoperating results, significant changes in the manner of our use of the acquiredassets or the strategy for our overall business, or significant negative industryor economic trends. If these criteria indicate that the value of the intangibleasset may be impaired, an evaluation of the recoverability of the net carryingvalue of the asset over its remaining useful life is made. If this evaluationindicates that the intangible asset is not recoverable, the net carrying valueof the related intangible asset will be reduced to fair value, and theremaining amortization period may be adjusted. Any such impairment charge couldbe significant and could have a material adverse effect on our reportedfinancial statements if and when an impairment charge is recorded. If animpairment charge is recognized, the amortization related to intangible assetswould decrease during the remainder of the fiscal year.

*Income Taxes*

In accordance with Statement of Financial AccountingStandards (“SFAS”) No. 5 “Accounting for Contingencies” we haveestablished reserves for income tax contingencies. These reserves relate tovarious tax years subject to audit by tax authorities including our tax filingsfor 1996 to 2000. The reserves represent our best estimate of the probableamount for our liability of income taxes, interest and penalties. The actualliability could differ significantly from the amount of the reserve, whichcould have a material effect on our results of operations. The tax benefit forthe year ended December 31, 2004 of $7.7 million resulted from a revisionof our estimated income tax contingency liability due to our receipt of thefinal assessment from the Internal Revenue Service related to the audit of theCompany’s 1996 through 2000 tax returns.

In addition, as part of the process of preparing ourconsolidated financial statements, we are required to estimate our income taxprovision (benefit) in each of the jurisdictions in which we operate. Thisprocess involves us estimating our current income tax provision (benefit)together with assessing temporary differences resulting from differingtreatment of items for tax and accounting purposes. These differences result indeferred tax assets and liabilities, which are included within our consolidatedbalance sheet.

We record a valuationallowance to reduce our deferred tax assets to the amount that is more likelythan not to be realized. While we have considered future taxable income andongoing prudent and feasible tax planning strategies in assessing the need forthe valuation allowance, in the event we were to determine that we would beable to realize our deferred tax assets in the future in excess of our netrecorded amount, an adjustment to the deferred tax asset would increase incomein the period such determination was made. Likewise, should we determine thatwe would not be able to realize all or part of our net deferred tax asset inthe future, an adjustment to the deferred tax asset would be charged to incomein the period such determination was made.

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*Restructuring*

During fiscal 2002 and 2001, we recorded significantrestructuring charges representing the direct costs of exiting certain productlines or businesses and the costs of downsizing our business. Such charges wereestablished in accordance with Emerging Issues Task Force Issue 94-3 (“EITF94-3”) “Liability Recognition for Certain Employee Termination Benefitsand Other Costs to Exit an Activity (Including Certain Costs Incurred in aRestructuring)” and Staff Accounting Bulletin No. 100, “Restructuring andImpairment Charges.” These charges include abandoned leased propertiescomprised of future lease payments net of anticipated sublease income, brokercommissions and other facility costs, and asset impairment charges on tenantimprovements deemed no longer realizable. In determining these estimates, wemake certain assumptions with regards to our ability to sublease the space andreflect offsetting assumed sublease income in line with our best estimate ofcurrent market conditions. Should there be a further significant change inmarket conditions, the ultimate losses on these could be higher and such amountcould be material. During 2002, we recorded restructuring charges of $27.9million related to restructuring activities initiated in 2002 and also recordedadditional charges of $6.3 million related to restructuring activitiesinitiated in 2001, primarily due to changes in estimated sublease income.During 2003, we revised our lease loss accrual downward for an estimated fourmonths of additional operation of our wafer fab and reduced facility costs atour other two abandoned facilities. This reversal was largely offset by anadditional lease loss accrual for reductions in estimated sublease occupancyand market rates. During 2004, we recorded a reversal of $4.0 million relatedto our assessment and subsequent decision to not close our internal waferfabrication facility (“fab”) as we believed at that time that integrating thenewly acquired fab from EiC with our pre-existing fab will offer the Companycertain benefits over outsourcing the pre-existing fab. As such, we reversed$3.9 million of our lease loss accrual and $85,000 of our severance accrual.This credit was partially offset by an additional $161,000 lease loss accrualas we revised our lease loss assumptions for our facilities based on reductionsin sublease occupancy rates and a net increasein facility operating costs.

The leased propertyabandonments have resulted in an average per year benefit of $3.1 million inreduced lease expense and $677,000 in reduced amortization of leaseholdimprovements which will continue through 2010. The leased property abandonmentshad no effect on our future cash flows. The collective asset impairments haveresulted in an average per year benefit of $2.6 million in reduced depreciationexpense of manufacturing equipment which will continue through 2007. Theequipment deemed excess in 2002 was ultimately sold for $1.8 million. Otherwise,the asset impairments had no effect on our future cash flows. The workforcereductions have resulted in reduced wages and benefits of $2.7 million per yearwith a corresponding reduction in cash flows. In total the restructuring planshave benefited our results of operations on average as follows since 2002:  $5.7 million reduction in cost of goods sold,$1.1 million reduction in research and development expense and $2.4 millionreduction in selling and administrative expense. Except for changes in thesublease estimates noted above, actual results to date have been consistent, inall material respects, with our assumptions at the time of the restructuringcharge.

*Impairment ofLong-Lived Assets*

In accordance with Statement of Financial AccountingStandards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets,” we review long-lived assets for impairment whenever eventsor changes in circumstances indicate that the carrying amount of such assetsmay not be recoverable. Factors we consider that could trigger an impairmentreview include the following: significant underperformance relative to expected historical orprojected future operating results; significant changes in the manner of ouruse of the acquired assets or the strategy for our overall business;significant negative industry or economic trends; or significant technologicalchanges, which would render equipment and manufacturing processes obsolete.Recoverability of assets to be held and used is measured by a 

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comparison of the carryingamount of these assets to future undiscounted cash flows expected to begenerated by these assets. If such assets are considered to be impaired, theimpairment to be recognized is measured by the amount by which the carrying amountof the assets exceeds the fair value of the assets.

Significant managementjudgment is required in the forecasting of future operating results which areused in the preparation of projected cash flows and should different conditionsprevail, material write downs of our long-lived assets could occur.

**Current Operations**

Thefollowing table sets forth certain statements of operations data expressed as apercentage of sales for the periods indicated. As a result of our new products,changing market conditions and other factors, the historical percentages andcomparisons set forth below may not reflect our expected future operations.

| ** **                                          | ** ** | **Percentage of Sales**          | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                          | ** ** | **Year Ended December 31,** | ** ** |
| ** **                                          | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Consolidated Statements  of Operations Data:        |       |                                       |       |   |   |   |   |
| Sales, net                                          |       | 100.0                                      | %          | 100.0 | % | 100.0 | % |
| Cost of goods sold                                  |       | 53.5                                       |       | 47.2 |   | 58.3 |   |
| Gross profit                                        |       | 46.5                                       |       | 52.8 |   | 41.7 |   |
| Operating  expenses:                                |       |                                       |       |   |   |   |   |
| Research and development                            |       | 57.2                                       |       | 53.3 |   | 63.5 |   |
| Selling and administrative                          |       | 48.4                                       |       | 38.7 |   | 38.6 |   |
| Acquired in-process research & development |       | 10.7                                       |       | 26.3 |   | — |   |
| Recapitalization merger and other                   |       | —                                     |       | — |   | 2.6 |   |
| Restructuring charge (reversals)                    |       | —                                     |       | (11.9 | ) | (0.2 | ) |
| Total operating expenses                            |       | 116.3                                      |       | 106.4 |   | 104.5 |   |
| Loss from operations                                |       | (69.8                                      | )          | (53.6 | ) | (62.8 | ) |
| Interest income                                     |       | 3.3                                        |       | 2.1 |   | 2.8 |   |
| Interest expense                                    |       | (0.3                                       | )          | (0.3 | ) | (0.4 | ) |
| Other income—net                               |       | —                                     |       | — |   | 4.1 |   |
| Loss before income taxes                            |       | (66.8                                      | )          | (51.8 | ) | (56.3 | ) |
| Income tax benefit                                  |       | .4                                         |       | 23.7 |   | 2.4 |   |
| Net loss                                            |       | (66.4                                      | )%         | (28.1 | )% | (53.9 | )% |

 

**Comparisonof Years Ended December 31, 2005, 2004 and 2003**

*Sales*—We recognized $31.6million, $32.3 million and $26.6 million in sales for the fiscal years ended December 31,2005, 2004 and 2003, respectively. The increase in sales both periods reflectsthe increase in our semiconductor and radio frequency identification (“RFID”)sales mitigated by the declines in our wireless integrated assembly and fiberoptic sales reflecting our strategic decision to focus our competitiveadvantage and dedicate our resources to the radio frequency (“RF”) semiconductormarket.

Semiconductor and RFID sales during 2005 were $31.2million, representing 99% of total sales which was a $1.4 million or 5%increase in comparison to the comparable 2004’s sales of $29.8 million (92% oftotal sales). Semiconductor and RFID sales during 2004 increased $9.6 millionor 47% in comparison to 2003 sales of $20.2 million (76% of total sales). Theincrease in our semiconductor and RFID sales during 2005 primarily related toour increasing sales in Asia (particularly China, which increased 29% andKorea, which increased 196%), our expanded product offering due to ouracquisition of the wireless infrastructure business from EiC Corporation(representing $3.8 million of our semiconductor and RFID sales in 2005 comparedto $3.4 million in 2004 after the acquisition in June 2004) and anincrease in our expanded 

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RFID product offering dueto our acquisition of Telenexus representing $1.2 million of our sales in 2005.During 2005, we have experienced an approximate 4% decrease in the averageselling price of our semiconductor products due to competitive pressure. Theincrease in our 2005 sales was partially offset by a change in the application of our revenue recognition policy fromrevenue recognition upon shipment to our distributors to revenue recognitionwhen our distributors have sold the product to the end customer as discussedabove under “Critical Accounting Policies and Estimates”.

This change in application resulted in a $4.1 millionrevenue deferral in our second quarter of 2005 which is reflected in year endedDecember 31, 2005. For further discussion, see Note 3 to the consolidatedfinancial statements included elsewhere in this Form 10-K. Theincrease in our semiconductor and RFID sales during 2004 related to an increasein the volume of products sold due, in part, to our introduction of over 60 newproducts (including our MPR family of PCMCIA form factor UHF RFID readers andour power amplifier modules for PAS/PHS telecommunication networks in China),our expanded product offering due to our acquisition of the wirelessinfrastructure business from EiC Corporation (representing $3.4 million of oursemiconductor and RFID sales in 2004) and our increasing sales in the UnitedStates (16% increase in 2004) and Asia (particularly China, which increased106% in 2004). During 2004 our average selling price of our semiconductorproducts increased by approximately 9% due to new product introductions. Alsoin 2004, approximately $661,000 of our semiconductor and RFID sales resultedfrom sales of product to EiC under a supply agreement we entered into with themas part our acquisition of their wireless infrastructure business andassociated assets. This supply agreement was substantially completed byDecember 31, 2004 and there will be no significant sales from theseproducts in future periods. In 2003, approximately $855,000 of oursemiconductor and RFID sales resulted from sales of our Thin-Film products. InMay 2003 we sold our Thin-Film product line to M/A COM (a unit of TycoElectronics).

Wireless integrated assembly and fiber optic sales for2004 totaled $2.5 million, representing 8% of total sales and a decrease of$3.8 million or 60% from sales of $6.3 million (24% of total sales) in 2003. Asthese products have reached the end of their product life cycle, they onlyrepresented $396,000 of our sales in 2005. Lucent Technologies was the majorcustomer for our wireless integrated assembly products. During 2003, theydecided to design the next generation of this type of product themselves andbuild it through the use of contract manufacturers. During our third quarterended September 28, 2003, they notified us that they would no longerpurchase significant quantities of these products and might only purchasemoderate quantities for their customers who may need to expand or maintainolder telecommunications networks. The decline in our wireless integratedassembly sales over the last two years contributed to the decline in our salesto Europe. As these products have reached the end of their product life cycle,they will not be a significant factor in our long term business. Aside frompotential and infrequent “life time buys,” our focus will predominantly besupporting the existing product base.

Based on the current business trends in the targetmarkets our products address, we believe that our revenue for our first quarterof 2006 will be in the range of $11.5 to $12.0 million equalling or showing aslight increase from our recently completed fourth quarter. Based on the sametrends, we currently believe that our revenue will be in the range of $44.0 to$46.0 million for 2006.

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*Cost of Goods Sold*—Our cost ofgoods sold for 2005 was $16.9 million, an increase of $1.6 million or 11% ascompared with cost of goods sold of $15.3 million in 2004. Our cost of goodssold for 2004 decreased by $217,000 or 1% as compared with cost of goods soldof $15.5 million in 2003. As a percentage of sales, our cost of goods soldincreased to 54% in 2005 from 47% in 2004 which decreased from 58% in 2003. The2005 increase in our cost of goods sold as a percentage of sales and inabsolute dollars reflects an increased percentage of newer products in ourproduct sales mix which have not yet achieved the volumes or yields of our moremature products. This decrease in our cost of goods sold as a percentage ofsales in 2004 reflects the change in our product sales mix to a greaterpercentage of higher margin semiconductor products from relatively lower marginwireless assembly products. This reduction in direct costs was partially offsetby increased indirect cost of goods sold of $573,000 for manufacturing supplies,$447,000 for equipment maintenance and $387,000 for increased manufacturingsupport staff all due to increased volume production including the productlines we acquired from EiC. In absolute dollars, the decrease in cost of goodssold reflects the factors previously noted.

We continue to experience unabsorbed overhead costsrelated to underutilization of our existing wafer fabrication facility. Whileprior restructuring programs have mitigated some of our unabsorbed overheadthrough the write down of excess facilities and equipment, we will still havefixed manufacturing costs that these efforts will not impact until we canfurther reduce excess capacity. We typically generate a lower gross margin onnew product introductions which we expect to be a higher percentage of oursales mix going forward. Over time, we typically become more efficient relativeto new products through learning and increased volumes as well as throughimproved yields. New product lines also contain a greater degree of inventoryrisk due to uncertainty regarding a lack of visibility and predictability ofcustomer demand and potential competition.

*Research and Development*—Our 2005research and development expense was $18.1 million, an increase of $832,000 or5% as compared with our research and development expense of $17.2 million for2004. Our research and development for 2004 increased by $356,000 or 2% ascompared with research and development expense of $16.9 million in 2003. Theincrease in absolute dollars in 2005 is primarily related to the increasedengineering staff and new product development related to the products weacquired from Telenexus and increased spending on design consulting serviceswhich was partially offset by a decrease in overall overhead. The increase inabsolute dollars in 2004 is primarily related to the increased engineeringstaff and new product development efforts related to the products and processeswe acquired from EiC and increased spending on design consulting services whichwas largely offset by a decrease in overall overhead. During 2005, research anddevelopment expenses were 57% as a percentage of sales which compares to 53% in2004 and 64% in 2003. The increase in research and development expense as apercentage of sales from 2004 to 2005 reflects the factors noted above as wellas the decrease in sales in the same period. The decrease in research anddevelopment expense as a percentage of sales from 2003 to 2004 is primarilyrelated to our increase in sales. We generate revenues from developmentcontracts with customers that have enabled us to accelerate our own productdevelopment efforts. Such development revenues have only partially funded ourproduct development activities, and we generally retain ownership of theproducts developed under these arrangements. As a result, we classify alldevelopment costs related to these contracts as research and developmentexpenses. We recorded revenue of $832,000 under such development agreements in2005. Product research and development is essential to our future success andwe expect to continue to make investments in new product development andengineering talent. In 2006 we will continue to focus our research efforts andresources on RF semiconductor development which target multiple growth marketssuch as RFID and WiMAX, adjacent markets such as power amplifiers whileexpanding our addressable market opportunities in wireless communications andbroadband cable. We will also explore process capabilities of third partyfoundries and develop products under new process technologies such as SiGeBiCMOS. In absolute dollars, we expect our 2006 research and developmentexpenditures to remain relatively constant with the prior year.

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*Selling and Administrative*—Sellingand administrativeexpense for 2005 was $15.3 million or 48% of sales, an increase of $2.8 millionor 22% as compared with selling and administrative expense of $12.5 millionor 39% of sales in 2004. During 2004 selling and administrative expenseincreased by $2.3 million or 22% as compared with selling andadministrative expense of $10.3 million or 39% of sales in 2003. The increasein absolute dollars during 2005 related to a $1.2 million charge for a formerCEO separation agreement, a $754,000 increase related to the acquiredadministrative operations of Telenexus, $445,000 of professional fees relatedto a potential strategic business combination which we decided not toconsummate, a $412,000 increase in legal fees resulting from additionalcorporate governance requirements, $646,000 charge related to severance and a$398,000 increase in external sales representatives commission due to theincrease in semiconductor sales over the prior year’s period. These increasedcosts were partially offset by a $267,000 decrease in bonus expense and a$156,000 decrease in insurance premiums. The increase in absolute dollarsduring 2004 is primarily related to a $560,000 increase in salaries and wagesdue to an increase in the number of sales and marketing personnel, $558,000increase in severance due to a stock compensation charge resulting from themodification of two option agreements (extension of the option exerciseperiod), a $484,000 increase in accounting fees resulting from additionalcorporate governance requirements, $267,000 increase in commission costs due toincreased sales of our radio frequency (‘RF”) semiconductor products and a$141,000 increase in bonus expense. Additionally, during 2003, we benefitedfrom a reduction in our Board of Directors’ compensation plan which wasapproved at our Annual Meeting of Stockholders held on July 15, 2003 andresulted in a reduction in accrued expenses of $238,000. Also, 2003 hadbenefited from the collection of $393,000 of receivables which had beenreserved in a prior period. During 2004, we reserved $51,000 of receivableswhose collection is doubtful. These increased costs were partially offset by a$347,000 reduction in our Directors and Officers and Liability insurancepremiums and a $112,000 decrease in advertising and promotion costs. As apercentage of sales, the increase in selling and administrative expense from2004 to 2005 reflects the factors noted above as well as the decrease in salesin the same period. Selling and administrative expenses remained flat from 2003to 2004 as a percentage of sales. For our first quarter of 2006, we expectselling and administrative expenses to be higher than those incurred in ourfourth quarter of 2005 primarily as a result of approximately $500,000 inprofessional service costs associated with a special project conducted onbehalf of our audit committee and completed during that quarter with nomaterial issues.

*Acquired In-process Research and DevelopmentExpenses*—During2005, $3.4 million of the purchase price for the acquisition ofTelenexus, Inc. was allocated to acquired in-process research anddevelopment expense (“IPRD”). Projects that qualify as in-process research anddevelopment represent those that have not yet reached technological feasibilityand have no future alternative use. Technological feasibility is defined asbeing equivalent to a beta-phase working prototype in which there is minimalremaining risk relating to the development. The value assigned to IPRD chargecomprises the following projects: multi-protocol readers ($1.3 million), Smart readers ($900,000) and Class 3readers ($1.2 million). As of December 31, 2005, the estimated aggregatecost to complete these projects was $344,000, $1.2 million and $737,000,respectively which is expected to occur through our fourth quarter of 2006. Thevalue of these projects was determined by estimating the discounted net cashflows from the sale of the products resulting from the completion of theprojects, reduced by the portion of the revenue attributable to developedtechnology and the percentage of completion of the project. Actual results todate have been consistent, in all material respects, with our assumptions atthe time of the acquisition. The assumptions consist primarily of expectedcompletion dates for the IPRD projects, estimated costs to complete theprojects, and revenue and expense projections for the products once they haveentered the market. Our assumptions for the multi-protocol reader project atthe time of the acquisition include an estimated completion date of the projectin 2006 at a cost of approximately $938,000, estimated future revenue of $23.4million over an estimated product life cycle of 7 years, and the followingaverage financial metrics over the life of the product:  gross margin of 40% during the first twoyears increasing to 55% by year five and remaining 

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constant throughout theremainder of the estimation periods, average operating expenses of 19% and a41% tax rate. Our assumptions for the Smart reader project at the time of theacquisition include an estimated completion date of the project in 2006 at acost of approximately $1.3 million, estimated future revenue of $31.3 millionover an estimated product life cycle of 10 years, and the following averagefinancial metrics over the life of the product: gross margin of 40% during the first two years increasing to 55% by yearfive and remaining constant throughout the remainder of the estimation periods,average operating expenses of 19% and a 41% tax rate. Our assumptions for the Class 3reader project at the time of the acquisition include an estimated completiondate of the project in 2006 at a cost of approximately $857,000, estimatedfuture revenue of $21.6 million over an estimated product life cycle of 8years, and the following average financial metrics over the life of theproduct:  gross margin of 40% during thefirst two years increasing to 55% by year five and remaining constantthroughout the remainder of the estimation periods, average operating expensesof 17% and a 41% tax rate. A discount rate of 25% was employed to determine thediscounted net cash flow for all projects.

During 2004, $8.5 million of the purchase price forthe acquisition of the wireless infrastructure business and associated assetsfrom EiC was allocated to acquired in-process research and development expense(“IPRD”). Projects that qualify as in-process research and developmentrepresent those that have not yet reached technological feasibility and have nofuture alternative use. Technological feasibility is defined as beingequivalent to a beta-phase working prototype in which there is no remainingrisk relating to the development. The IPRD charge related to the EiCacquisition which was made up of two projects: 12V heterojunction bipolar transistor (“HBT”) power amplifiers and 28VHBT high power amplifiers which had an assigned value of $1.5 million and $7.5million, respectively. As of December 31, 2004, we have completed both the12V and 28V HBT high power amplifier process development projects. The value ofthese projects was determined by estimating the discounted net cash flows fromthe sale of the products resulting from the completion of the projects, reducedby the portion of the revenue attributable to developed technology and thepercentage of completion of the project. Actual results to date have beenconsistent, in all material respects, with our assumptions at the time of theacquisition. The assumptions consist primarily of expected completion dates forthe IPRD projects, estimated costs to complete the projects, and revenue and expenseprojections for the products once they have entered the market. Our assumptionsfor the 12V HBT project at the time of the acquisition include an estimatedcompletion date of the project in early 2005 at a cost of approximately$223,000, estimated future revenue of $17.5 million over an estimated productlife cycle of 7.5 years, and the following average financial metrics over thelife of the product:  gross margin of50%, operating expenses of 23% and a 40% tax rate. A discount rate of 25% wasemployed to determine the discounted net cash flow. Our assumptions for the 28VHBT project at the time of the acquisition include an estimated completion dateof the project in early 2005 at a cost of approximately $160,000, estimatedfuture revenue of $189.6 million over an estimated product life cycle of 16.5years, and the following average financial metrics over the life of theproduct:  gross margin of 50%, operatingexpenses of 23% and a 40% tax rate. A discount rate of 25% was employed todetermine the discounted net cash flow.

The nature of the efforts to develop the acquiredin-process research and development into commercially viable productsprincipally relates to the completion of all prototyping and testing activitiesthat are necessary to establish that the product can meet its designspecification including function, features and technical performancerequirements. Therefore, the amount allocated to in-process research anddevelopment has been charged to operations.

*Recapitalization Merger*—Weincurredrecapitalization merger expense of $680,000 in 2003 related to ourconsideration of the proposed Fox Paine transaction. On September 19,2002, we announced the receipt of a proposal from an affiliate, Fox Paine &Company LLC (“Fox Paine”) to acquire all of the shares of our common stock heldby unaffiliated stockholders (the “Acquisition Proposal”). At that time, FoxPaine and its affiliates owned approximately 66% of our outstanding shares or37.0 million shares of a 

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total of 55.9 millionshares outstanding. Our Board of Directors formed a special committee composedof two independent directors not affiliated with Fox Paine (the “SpecialCommittee”) to review the Acquisition Proposal. These expenses include legaland financial consulting fees as well as compensation to the members of theSpecial Committee. On March 27, 2003, Fox Paine withdrew its AcquisitionProposal.

*Restructuring Charges*—During 2004,we reversed the lease loss associated with our internal wafer fabricationfacility (“fab”) and remaining severance accrual due to our assessment andsubsequent decision to not close our fab as we believed at that time thatintegrating the newly acquired fab from EiC with our pre-existing fab willoffer the Company certain benefits over outsourcing the pre-existing fab. Thisreversal was partially offset by a net increase in the lease loss accrual forour other leased facilities based on reductions in sublease occupancy rates anda net increase in facility operating costs.

In 2003, we revised our lease loss accrual downwardfor the four month additional operation of our wafer fab and reduced facilitycosts at our other two abandoned facilities. This reversal was largely offsetby an additional lease loss accrual for reductionsin estimated sublease occupancy and market rates and disposal of our remainingunsold assets held for sale. We also reversed a portion of our severanceaccrual for one employee slated to be terminated but instead retained foranother position.

For 2002, we recorded arestructuring charge of $25.4 million reflecting consolidation andabandonment of leased space and associated impairment of tenant improvements,severance costs, an asset impairment charge and the initiation of a program tosell excess manufacturing equipment resulting from the prolonged downturn inthe telecommunications industry, especially related to our fiber opticsproducts. In the third quarter of 2002, we decided to abandon a portion of ourleased facility based on revised anticipated demand for our products andcurrent market conditions. This excess space, for which we had a remainingeight year commitment, is located on the first floor of our current corporateheadquarters and originally housed a portion of our optics and integratedassemblies manufacturing operations. This decision resulted in a lease loss of$11.3 million, comprised of future lease payments net of anticipated subleaseincome, broker commissions and other facility costs, and an asset impairmentcharge of $3.2 million on tenant improvements deemed no longer realizable. Indetermining this estimate, we made certain assumptions with regards to ourability to sublease the space and reflected offsetting assumed sublease incomein line with our best estimate of current market conditions. In addition, ourmanagement made a decision during the third quarter of 2002 to exit the fiberoptics business after current contractual obligations had been satisfied. Thisdecision resulted in a significant overcapacity of certain manufacturingequipment and we initiated a plan to sell this equipment before the end of thefirst quarter of 2003. Our excess manufacturing equipment resulted in a totalcharge of $3.9 million. Assets to be held for sale are measured at the lower ofcarrying amount or fair value less cost to sell. Management determined fairmarket value after consideration of several factors including the condition ofthe equipment, offers made by potential buyers of the equipment and the resultsof an independent third party appraisal. The majority of these impaired assetswas sold in the fourth quarter of 2002. Also during the third quarter of 2002,our management identified manufacturing equipment exclusively supportingcertain in-warranty optics and fixed wireless products as well as manufacturingequipment supporting final orders for certain other optics and fixed wirelessproducts and determined that the estimated future cash flows did not supportthe carrying value of these assets. As such, the carrying value of these assetswere written down to the estimated future cash flows that are directlyassociated with and that are expected to arise as a direct result of the useand eventual disposition of these assets, which management determined afterconsideration of several factors including the condition and management’sintended use of the equipment, offers made for similar equipment the Companyintended to sell and the results of an independent third party appraisal. Thisaction resulted in a $200,000 asset impairment charge. During 2002, we incurredseverance expense of $507,000 related to a reduction of 50 employees.

Also during 2002, we recorded a restructuring chargeof $8.8 million related to our decision in December 2002 to completelyoutsource our internal wafer fabrication. As a result of the planned closure 

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of our wafer fabricationfacility, approximately 10% of the Company’s workforce (20 employees) wouldhave been eliminated, which would have resulted in severance payments of$279,000. The closure of this facility would have resulted in additional excessspace of approximately 35,000 square feet for which we had a remaining two yearcommitment at that time. This decision resulted in a lease loss of $4.3million, comprised of future lease payments net of anticipated sublease income,broker commissions and other facility costs. In determining this estimate, wemade certain assumptions with regards to our ability to sublease the space andreflected offsetting assumed sublease income in line with our best estimate ofcurrent market conditions. This decision triggered an impairment analysis underSFAS No. 144. Management measured the recoverability of these assetsthrough a comparison of the carrying amount of these assets to futureundiscounted cash flows expected to be generated by these assets over theirremaining year of life. As such, the carrying value of these assets werewritten down to the estimated future cash flows that are directly associatedwith and that were expected to arise as a direct result of the use and eventualdisposition of these assets. Management estimated the future cash flows using atraditional present value approach based on management’s assumptions regardingthe intended use of these assets consistent with the Company’s budget andprojections as well as the planned eventual disposition of the asset groupthrough sale. Management estimated the disposition value of these assets afterconsideration of several factors including the condition and management’sintended use of the equipment, offers made for similar equipment the Companyintended to sell and the results of an independent third party appraisal. Managementemployed a risk-free interest rate commensurate with the Company’s size,capital structure and stock volatility in relation to the overall market. Thisaction resulted in a $4.2 million asset impairment charge.

For 2001, we recorded a restructuring charge of $9.8million related to our decision to abandon an excess facility. In September 2001,we decided not to occupy a new leased facility based on revised anticipateddemand for our products and current market conditions. This excess facility,for which we had a ten year commitment, is located adjacent to our currentcorporate headquarters and was originally developed to house additionaladministrative and corporate offices to accommodate planned expansion. Thisdecision resulted in a pre-tax lease loss of $7.2 million, comprised of futurelease payments net of anticipated sublease income, broker commissions and otherfacility costs, and a pre-tax asset impairment charge of $2.6 million on tenantimprovements deemed no longer realizable. The 2002 restructuring charge alsoincludes an additional charge for the leased facility we abandoned in 2001based on our downward revised assumptions regarding sublease occupancy ratesand market rates due to an overall deteriorating real estate market anddifficulties subleasing our available space. In determining this estimate, wemade certain assumptions with regards to our ability to sublease the space andreflected off-setting assumed sublease income in line with our best estimate ofthe current market conditions.

For further discussion, seeNote 14 to the consolidated financial statements included elsewhere in this Form 10-K.

*Interest Income*—Interest incomeprimarily represents interest earned on cash equivalents and short-termavailable-for-sale investments. In 2005 our interest income was $1.0 million,an increase of $366,000 or 54% as compared with interest income of $682,000 in2004. This relative dollar increase in both comparative periods resulted froman increase in interest rates offsetting a decrease in average funds availablefor investment. Our interest income for 2004 of $682,000 had decreased $73,000or 10% as compared with interest income of $755,000 in 2003. This decreaseprimarily resulted from decreased average amounts of funds available forinvestment.

*Interest Expense*—Our interestexpense for 2005 was $96,000, a decrease of $8,000 or 8% as compared withinterest expense of $104,000 in 2004 and a decrease of $13,000 or 11% as 2004 iscompared with interest expense of $117,000 in 2003. Interest expense for allperiods relates to fees associated with our revolving credit facility andoutstanding letters of credit.

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*Other Income-Net*—The otherincome realized in 2003 was primarily related to a $1.1 million gain werecorded related to the sale of our Thin-Film product line. The sale includesequipment, inventory, intellectual property, training and services for which wereceived total proceeds of $1.8 million. For further discussion, see Note 16 tothe consolidated financial statements included elsewhere in this Form 10-K.

*Income Tax Benefit*—In2005 we recorded a net tax benefit of $120,000 as the statute had expired oncertain estimated federal tax exposures. The tax benefit for 2004 of $7.7million resulted from a revision of our estimated income tax contingencyliability due to our receipt of the final assessment from the Internal RevenueService related to the audit of the Company’s 1996 through 2000 tax returns. In2003, we recorded a tax benefit of $647,000 related to an income tax refund of$480,000 from the State of Maryland as the result of amending our 1999 statetax return and an adjustment to our tax contingency liability of $167,000 foradditional federal income tax refund determined after finalizing our 2002carryback claim filed in the first quarter of 2003 and miscellaneous taxpayments. Beginning in 2002, it was determined that it was not more likely thannot that any additional deferred tax assets would be realized through theapplication of carryforward claims.

**Liquidityand Capital Resources**

Cash, cash equivalents andshort-term investments at December 31, 2005 were $30.2 million, a decreaseof  $12.9 million or 30% compared to thebalance of $43.1 million at December 31, 2004.

On December 27, 2005,we entered into the fourth amendment (the “Amendment”) to our Amended andRestated Loan and Security Agreement between Comerica Bank and us dated September 23,2003 and as amended June 13, 2005, July 12, 2005 and September 28,2005. The effective date of the Amendment is December 22, 2005. Under thenew terms, the revolving credit facility (“Revolving Facility”) provides for amaximum credit extension of $10.0 million, with a $5.0 million sub-limit tosupport letters of credit, a $250,000 sub-limit for foreign exchangetransactions and a $200,000 sub-limit for corporate credit cards. The RevolvingFacility matures on December 21, 2006. Interest rates on outstandingborrowings are periodically adjusted based on certain financial ratios and areinitially set, at our option, at LIBOR plus 2.0% or Prime. The RevolvingFacility requires us to maintain certain financial ratios and containslimitations on, among other things, our ability to incur indebtedness, paydividends and make acquisitions without the bank’s permission. The RevolvingFacility is secured by substantially all of our assets. We were in compliancewith the covenants as of December 31, 2005. As of December 31, 2005and December 31, 2004, there were no outstanding borrowings under theRevolving Facility. We have letters of credit of $3.2 million available as of December 31,2005 against which no amounts have been drawn.

*Net Cash Used by OperatingActivities*—Net cash used by operations was $(10.4) million,($15.4) million and ($5.9) million in 2005, 2004 and 2003, respectively. Netloss in 2005, 2004 and 2003 was (21.0) million, ($9.1) million and ($14.3)million, respectively.

The most significant cashitem impacting the difference between net loss and cash flows used in operationsin 2005 was $223,000 used by working capital. The $223,000 used by workingcapital primarily relates to a $2.7 million decrease in restructuringliabilities which were partially offset by a $1.6 million increase in accrualsand accounts payable and a $516,000 decrease in inventories. The $2.7 milliondecrease in restructuring liabilities primarily relates to payments against theremaining lease loss accrual. The $1.6 million increase in accruals andaccounts payable relates primarily to the timing of payments within terms. Non-cash items included in net lossin 2005 included $3.1 million of depreciation and amortization, $3.4 million ofIPRD related to our acquisition of Telenexus, Inc. and $3.2 millionrelated to an increase in our deferred margin on distributor inventory due toour change in the application of our revenuerecognition policy from revenue recognition upon shipment to our distributorsto revenue recognition when our distributors have sold the product to the endcustomer during 2005. For furtherdiscussion, see Note 3 to the consolidated financial statementsincluded elsewhere in this Form 10-K.

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The most significant cash item impacting thedifference between net loss and cash flows used in operations in 2004 was $7.6million used in working capital. The $7.6 million used in working capitalprimarily relates to a $2.3 million increase in receivables, a $2.4 milliondecrease in restructuring liabilities, a $1.0 million increase in other assetsand a decrease of $867,000 in income tax contingency liability. Our receivablesincreased $2.3 million due to increased shipments during the fourth quarter of 2004.The $2.4 million decrease in restructuring liabilities primarily relatesto payments against the remaining lease loss accrual. The increase in otherassets of $1.0 million is primarily due to a $576,000 accrual of a settlementrelated to the termination of the supply agreement with EiC (see Note 5 to theconsolidated financial statements included elsewhere in this Form 10-K)and a $560,000 increase in accrued interest receivable related to ourinvestments. The decrease of $867,000 in income taxes payable relates topayments resulting from an audit of our 1996 through 2000 returns. Non-cashitems included in net loss in 2004 included $2.8 million of depreciation andamortization, $8.5 million of IPRD related to our acquisition of the wirelessinfrastructure business and associated assets from EiC and $7.7 million relatedto a decrease in our income tax contingency liability. The $7.7 milliondecrease in our income tax contingency liability resulted from a revisedestimate related to the audit of our 1996 through 2000 tax returns. The $7.7million decrease in our tax contingency liability resulted from a revisedestimate of our tax contingency liability related to the audit of our 1996through 2000 tax returns as a result of our receipt of the final assessmentfrom the Internal Revenue Service.

The most significant cash items impacting thedifference between net loss and cash flows used in operations in 2003 were$949,000 used in working capital and $6.0 million provided by the realizationof deferred tax assets. The $949,000 used in working capital primarily relatesto a $2.2 million decrease in restructuring liabilities, which was offset by a$1.5 million decrease in inventories. The $1.5 million decrease in inventoriesrelates to the decrease in our sales from $40.2 million in 2002 to $26.6million in 2003. The $6.0 million provided by the realization of deferred taxassets relates to the receipt of an income tax refund generated by thecarryback of our 2002 net operating loss. Starting in the second quarter of2003, we provided more favorable payment terms to significant customers inorder to remain competitive in the current business environment. As a result,our average payment terms have increased from 30 days to 60 days, which has hada negative impact to our working capital. Non-cash items included in net lossin 2004 included $4.4 million of depreciation and amortization.

*Net Cash Provided (Used) byInvesting Activities*—Net cash provided (used) by investingactivities was ($1.5) million, $18.2 million and ($27.3) million in 2005, 2004and 2003, respectively. In 2005, we used $34.9 million to purchase short-terminvestments, $3.2 million to acquire Telenexus, Inc. including associatedacquisition costs and $1.5 million to purchase equipment which was partiallyoffset by $37.6 million in proceeds we realized from the sale andmaturities of our short-term investments. In 2004, we realized $89.2 million inproceeds from the sale of short term investments which was partially offset by$59.3 million used to purchase short-term investments, $10.7 million ofacquisition and costs related to the EiC transaction (see Note 5 to theconsolidated financial statements included elsewhere in this Form 10-K)and $878,000 to invest in property, plant and equipment. In 2003, we used $92.6million to purchase short-term investments and $841,000 to invest in property,plant and equipment which was partially offset by $64.6 million provided by oursale of short-term investments and $1.6 million proceeds from the sale of our Thin-Filmproduct line (see Note 16 to the consolidated financial statements includedelsewhere in this Form 10-K). During 2006, we expect to investapproximately $2.0 to $3.0 million in capital expenditures. We have funded ourcapital expenditures from cash, cash equivalents and short-term investments andexpect to continue to do so throughout 2006.

In conjunction with our recent acquisitions, we may berequired to pay further compensation in the EiC acquisition of up to $7.0million in cash (10%) and shares (90%) if specific revenue targets are achievedby March 31, 2006 and in the Telenexus acquisition, of up to $2.5 million in cash and up to 

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833,333shares if certain revenue targets are achieved by July 28, 2006. Weexpect to fund these payments, if earned, from our cash, cash equivalents andshort-term investments, cash flows and borrowings to the extent available. As of March 20, 2006 we have not yetdetermined if the revenue targets were met for the year ending March 31,2006. We will not be able to make our determination until after we havecompleted our internal control procedures after our quarter end onApril 2, 2006.

*Net Cash Provided by Financing Activities*—Netcash provided by financing activities totaled $1.7 million, $10.7 millionand $617,000 in 2005, 2004 and 2003, respectively. In 2005, we received netproceeds of approximately $1.9 million from the sale of our common stock toemployees through our employee stock purchase and option plans which waspartially offset by $201,000 representing 117,439 shares of our common stockwithheld from our former CEO to cover the income tax withholding on his receiptof 328,500 shares of restricted stock in connection with a severance agreementand $49,000 representing shares withheld from other employees. In 2004, wereceived net proceeds of $10.2 million related to our secondary public offeringof 2 million newly issued shares of our common stock and $1.5 million fromthe sale of our common stock to employees through our employee stock purchaseand option plans which was partially offset by $920,000 of cash used torepurchase our common stock under our current stock repurchase program (seeNote 10 to the consolidated financial statements included elsewhere in theForm 10-K). In 2003, we received net cash of $3.5 million from thesale of our common stock to employees through our option plans which waspartially offset by $2.8 million of cash used to repurchase our common stockunder our stock repurchase program (see Note 10 to the consolidated financialstatements included elsewhere in the Form 10-K).

Based on our current plansand business conditions, we believe that our existing cash, cash equivalentsand short-term investments together with available borrowings under our line ofcredit will be sufficient to meet our liquidity and capital spendingrequirements for at least the next twelve months. Thereafter, we will utilizeour cash, cash flows and borrowings to the extent available and, if desirableor necessary, we may seek to raise additional capital through the sale of debtor equity. There can be no assurances, however, that future borrowings andcapital resources will be available on favorable terms or at all. Our cashflows are highly dependent on demand for our products, timing of orders andshipments with key customers and our ability to manage our working capital,especially inventory and accounts receivable, as well as controlling ourproduction and operating costs in line with our revenue.

**ContractualObligations**

Thefollowing table summarizes our contractual obligations at December 31,2005 and the effect those obligations are expected to have on our liquidity andcash flow in future periods (in thousands):

| ** **                       | ** ** | **Payments due by Period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| ** **                       | ** ** | **Less than**                        | ** ** | **More than** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Contractual obligations** | ** ** | ** **                                | ** ** | **Total** | ** ** | **1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **5 years** | ** ** |
| Capital lease  obligations       |       |                                      | $          | — |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Operating lease  obligations(1)  |       |                                      | 20,968     |   |   |   | 4,589 |   |   |   | 13,120 |   |   |   | 3,259 |   |   |   | — |   |   |
| Purchase  obligations(2)         |       |                                      | 3,644      |   |   |   | 3,569 |   |   |   | 75 |   |   |   | — |   |   |   | — |   |   |
| Other long-term  liabilities(3)  |       |                                      | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Total(4)                         |       |                                      | $          | 24,612 |   |   |   | $ | 8,158 |   |   |   | $ | 13,195 |   |   |   | $ | 3,259 |   |   |   | $ |   |   |   |
|                                  |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          We lease our threefacilities, including our executive offices in San Jose, California, underlease agreements that expire at various dates through 2011. Total future leaseobligations as of December 31, 2005, were $21.0 million, of which $13.0million was recorded as a liability for certain facilities that were includedin our restructuring accrual (current and long-term).

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(2)          Purchase obligations areprimarily orders for raw material, processed silicon wafers and assembly andtest services. While the purchase orders are generally cancelable withoutpenalty, certain vendor agreements provide for percentage-based cancellationfees or minimum restocking charges based on the nature of the product orservice. We expect to receive and pay for these materials and services withinthe next six months.

(3)          The only component ofOther Long-Term Liabilities that requires us to make cash payments is arestructuring accrual of $10.5 million relating to the future operating leasepayments on certain facilities that were included in our restructuring plans (See Note 14 to the consolidatedfinancial statements included elsewhere in this Form 10-K). We willmake these payments through 2011. We included these amounts in the operatinglease total in the table above. Excluding payments under the operating leasecomponent included in the restructuring accrual, the other components of OtherLong-Term Liabilities do not contractually require us to make cash payments andprimarily consist of estimated operating costs on restructured facilities,deferred rent and estimated environmental costs.

(4)          The table above does not include contractual obligations related to ouracquisition in June 2004 of the wireless infrastructure businessand associated assets from EiC Corporation or our acquisition inJanuary 2005 of Telenexus, Inc.as the additional consideration is contingent on certain future identifiableevents which have not occurred as of December 31, 2005. EiC may beentitled to further consideration of up to $7.0 million in cash and shares ofour common stock if certain revenue targets are achieved by March 31,2006. We shall pay EiC this additional consideration, if earned, ninety percent(90%) in our common stock and ten percent (10%) in cash. Thus, if earned, $700,000 would be payable inless than one year  As of March 20,2006 we have not yet determined if the revenue targets were met for the yearending March 31, 2006. We will not be able to make our determination untilafter we have completed our internal control procedures after our quarter endon April 2, 2006. The sellers of Telenexus, Inc. may be entitled tofurther compensation of up to $2.5 million in cash and up to 833,333 shares ofour common stock if we achieve certain revenue targets by July 28, 2006.Thus, if earned, $2.5 million would be payable in one to three years. Certainemployment agreements which may require us to pay out termination benefits uponfuture identifiable events are also excluded from the table above as no eventshave occurred as of December 31, 2005 which make the payment probable.

For purposes of the table above, obligations for thepurchase of goods or services are defined as agreements that are enforceableand legally binding and that specify all significant terms, including: fixed orminimum quantities to be purchased; fixed, minimum or variable priceprovisions; and the approximate timing of the transaction. Our purchase ordersare based on our current manufacturing needs and are typically fulfilled by ourvendors within short time horizons. We have additional purchase orders (notincluded in the table above) that represent authorizations to purchase ratherthan binding agreements. We do not have significant agreements for the purchaseof raw materials or other goods specifying minimum quantities or set pricesthat exceed our expected requirements.

The expected timing ofpayment of the obligations discussed above is estimated based on current information.Timing of payments and actual amounts paid may be different depending on thetime of receipt of goods or services or changes to agreed-upon amounts for someobligations.

**Off-Balance Sheet Arrangements**

**We donot have any special purpose entities or off-balance sheet financingarrangements except for operating leases as discussed in Note 12 to theconsolidated financial statements included elsewhere in this Form 10-K.**

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**Other Matters**

***Recent AccountingPronouncements******—On***December 16,2004, the FASB issued Statement of Financial Accounting Standards No. 123(revised 2004), “Share-Based Payment” (“SFAS 123R”). SFAS 123R eliminates thealternative of applying the intrinsic value measurement provisions of Opinion25 to stock compensation awards issued to employees. Rather, the new standardrequires enterprises to measure the cost of employee services received inexchange for an award of equity instruments based on the grant-date fair valueof the award. That cost will be recognized over the period during which anemployee is required to provide services in exchange for the award, known asthe requisite service period (usually the vesting period).

We adopted SFAS 123R in January 2006 andcurrently do not expect to restate prior periods to conform to the new accountingstandard as we will use the Modified Prospective Application Method. Under thismethod SFAS 123R is applied to new awards and to awards modified, repurchasedor cancelled after the effective date. Additionally, compensation cost for theportion of awards for which the requisite service has not been rendered (suchas unvested options) that are outstanding as of the date of adoption shall berecognized as the remaining requisite services are rendered. The compensationcost relating to unvested awards at the date of adoption shall be based on thegrant-date fair value of those awards as calculated for pro forma disclosuresunder the original SFAS 123 adjusted for estimated forfeitures. See Note 2 tothe consolidated financial statements included elsewhere in this Form 10-Kunder the caption “STOCK-BASED COMPENSATION” for information related to the proforma effect on reported net income and net earnings per share of applying thefair value provisions of the SFAS 123. The balance of unearned stock-basedcompensation to be expensed in the period 2006 through 2010 related toshare-based awards unvested at December 31, 2005, as previously calculatedunder the disclosure-only requirements of SFAS 123, is approximately $2.7million. If there are any modifications or cancellations of the underlyingunvested securities, we may be required to accelerate, increase or cancel anyremaining unearned stock-based compensation expense. To the extent that wegrant additional future stock option and other share-base awards, our futurestock-based compensation expense will be increased by the additional unearnedcompensation resulting from those additional grants. The fair value of thesegrants is not included in the amount above, as the impact of these grantscannot be predicted at this time because it will depend on the number ofshare-based payments granted and the then current fair values. We are currentlyin the process of determining our estimated forfeiture rate for purposes ofadopting SFAS 123R and we estimate that our forfeiture rate will be between 10%and 25%, which will result in a reduction to the foregoing annual amoritizationamounts.

In May 2005, the Financial Accounting StandardsBoard (“FASB”) issued Statement of Financial Accounting Standards No. 154,“Accounting Changes and Error Corrections-a replacement of APB Opinion No. 20and FASB Statement No. 3” (“SFAS 154”). This Statement replaces APBOpinion No. 20, Accounting Changes, and FASB Statement No. 3,Reporting Accounting Changes in Interim Financial Statements, and changes therequirements for the accounting for and reporting of a change in accountingprinciple. This Statement applies to all voluntary changes in accountingprinciple. It also applies to changes required by an accounting pronouncementin the unusual instance that the pronouncement does not include specifictransition provisions. When a pronouncement includes specific transitionprovisions, those provisions should be followed.

Opinion 20 previously required that most voluntarychanges in accounting principle be recognized by including in net income of theperiod of the change the cumulative effect of changing to the new accountingprinciple. This Statement requires retrospective application to prior periods’financial statements of changes in accounting principle, unless it isimpracticable to determine either the period-specific effects or the cumulativeeffect of the change. When it is impracticable to determine the period-specificeffects of an accounting change on one or more individual prior periodspresented, this Statement 

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requires that the newaccounting principle be applied to the balances of assets and liabilities as ofthe beginning of the earliest period for which retrospective application ispracticable and that a corresponding adjustment be made to the opening balanceof retained earnings (or other appropriate components of equity or net assetsin the statement of financial position) for that period rather than beingreported in an income statement. When it is impracticable to determine thecumulative effect of applying a change in accounting principle to all priorperiods, this Statement requires that the new accounting principle be appliedas if it were adopted prospectively from the earliest date practicable. ThisStatement shall be effective for accounting changes and corrections of errorsmade in fiscal years beginning after December 15, 2005. We adopted SFAS154 in January 2006 and currently do not anticipate that it will have asignificant effect on our financial statements or disclosures.

In June 2005, the FASB’s Emerging Issues TaskForce reached a consensus on Issue No. 05-6, “Determining theAmortization Period for Leasehold Improvements” (“EITF 05-6”). Theguidance requires that leasehold improvements acquired in a businesscombination or purchased subsequent to the inception of a lease be amortizedover the lesser of the useful life of the assets or a term that includesrenewals that are reasonably assured at the date of the business combination orpurchase. The guidance is effective for interim periods beginning after June 29,2005. We adopted EITF 05-6 in July 2005 and currently do notanticipate that it will have a significant effect on our financial statementsor disclosures.

***EnvironmentalMatters******—Of***ourformer production facilities, two have known environmental liabilities ofsignificance, the Scotts Valley site and the Palo Alto site. Prior to therecapitalization merger, we entered into and funded fixed price remediationcontracts, as well as cost overrun and unknown pollution conditions liabilitycoverage, with respect to both these sites. For a more detailed description,see “Business—Environmental Matters.”

***Litigation******—We***currentlyare involved in litigation and regulatory proceedings incidental to the conductof our business and expect that we will be involved in other litigation andregulatory proceedings from time to time. While we currently believe that anyadverse outcome of such pending matters will not materially affect our businessor financial condition, there can be no assurance that this will ultimately bethe case.

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**Item 7a. QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISKS**

The following discussion about our market riskdisclosures involves forward-looking statements. Actual results could differmaterially from those projected in the forward-looking statements. We areexposed to market risk related to changes in interest rates. We do not usederivative financial instruments for speculative or trading purposes.

*Cash, Cash Equivalents and Investments*—Cashand cash equivalents consist of municipal bond funds and commercial paperacquired with remaining maturity periods of 90 days or less and are stated atcost plus accrued interest which approximates market value. Short-terminvestments consist primarily of high-grade debt securities (A rating orbetter) with maturity greater than 90 days from the date of acquisition and areclassified as available-for-sale. Short-term investments classified asavailable-for-sale are reported at fair market value with unrealized gains orlosses excluded from earnings and reported as a separate component ofstockholders’ equity, net of tax, until realized. These available-for-salesecurities are subject to interest rate risk and will rise or fall in value ifmarket interest rates change. They are also subject to short-term market risk.We have the ability to hold our fixed income investments until maturity, andtherefore we would not expect our operating results or cash flows to beaffected to any significant degree by the effect of a sudden change in marketinterest rates on our investment portfolio.

The following tableprovides information about our investment portfolio and constitutes a “forward-lookingstatement.”  For investment securities,the table presents principal cash flows and related weighted average interestrates by expected maturity dates.

| ** **                            | ** ** | ** **                 | ** ** | **Weighted**              | ** ** |
|---------------------------------------|------------|----------------------------|------------|---------------------------|------------|
| ** **                            | ** ** | **Expected Maturity** | ** ** | **Average Interest** | ** ** |
| **Expected Maturity Dates** | ** ** | ** **                 | ** ** | **Amounts**               | ** ** | **Rate** | ** ** |
| ** **                            | ** ** | **(in thousands)**    | ** ** | ** **                | ** ** |
| Cash equivalents:                     |       |                       |       |                      |       |   |   |   |   |
| 2006                                  |       |                       | $          | 11,774                    |       |   |   | 3.83 | % |   |
| Short-term investments:               |       |                       |       |                      |       |   |   |   |   |
| 2006                                  |       |                       | 16,052     |                      |       |   | 4.00 | % |   |
| Fair value at December 31,  2005 |       |                       | $          | 27,826                    |       |   |   |   |   |   |
|                                       |            |                            |            |                           |            |  |  |  |  |  |  |  |

 

 

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**Item 8.CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

**INDEXTO CONSOLIDATED FINANCIAL STATEMENTS**
|                                                           | ** ** | **Page** | ** ** | ** ** |
|-----------------------------------------------------------|------------|----------|------------|------------|
| Report  of Management                                     |       | 66       |       |       |
| Reports of Independent Registered Public Accounting  Firm |       | 67       |       |       |
| Consolidated Balance Sheets                               |       | 70       |       |       |
| Consolidated Statements of Operations                     |       | 71       |       |       |
| Consolidated Statements of Comprehensive Loss             |       | 72       |       |       |
| Consolidated Statements of Stockholders’ Equity      |       | 73       |       |       |
| Consolidated Statements of Cash Flows                     |       | 75       |       |       |
| Notes to Consolidated Financial Statements                |       | 76       |       |       |
|                                                           |            |          |            |            |  |  |

 

 

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**REPORT OFMANAGEMENT**

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting to providereasonable assurance regarding the reliability of our financial reporting andthe preparation of financial statements for external purposes in accordancewith generally accepted accounting principles.

Management assessed our internal control overfinancial reporting as of December 31, 2005, the end of our fiscal year.Management based its assessment on criteria established in “Internal Control—IntegratedFramework” issued by the Committee of Sponsoring Organizations of the TreadwayCommission. Management’s assessment included evaluation of such elements as thedesign and operating effectiveness of key financial reporting controls, processdocumentation, accounting policies and our overall control environment. Thisassessment is supported by testing and monitoring is performed by or under thesupervision of our internal accounting and finance organization.

Because of its inherent limitations, internal controlsover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

Based on our assessment, management has concluded thatour internal control over financial reporting was not effective as of December 31,2005 to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external reportingpurposes in accordance with generally accepted accounting principles due solelyto the following material weakness (the results of management’s assessment werereviewed with the Audit Committee):

A material weakness in the operating effectiveness ofthe controls over the determination of excess and obsolete inventory and therelated valuation adjustments resulting in an audit adjustment to reduceinventory and increase cost of goods sold. The error occurred in our fourthquarter of 2005 and was corrected in the same period. The correction isreflected in our consolidated financial statements included in this Form 10-K.This material weakness arose from our failure to consider all current businessconditions in determining the salability of our current inventory.

Our independent registeredpublic accounting firm, Deloitte & Touche LLP, has issued anattestation report on management’s assessment of our internal control overfinancial reporting, which is included in this Item 8 of this AnnualReport on Form 10-K.

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**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors and Stockholders ofWJ Communications, Inc.

We have audited management’s assessment, included inthe accompanying Report of Management, that WJ Communications, Inc. andsubsidiaries (the “Company”) did not maintain effective internal control overfinancial reporting as of December 31, 2005, because of the effect of thematerial weakness identified in management’s assessment based on the criteriaestablished in *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission.The Company’s management is responsible for maintaining effective internalcontrol over financial reporting and for its assessment of the effectiveness ofinternal control over financial reporting. Our responsibility is to express anopinion on management’s assessment and an opinion on the effectiveness of theCompany’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinions.

A company’s internal control over financial reportingis a process designed by, or under the supervision of, the company’s principalexecutive and principal financial officers, or persons performing similarfunctions, and effected by the company’s board of directors, management, andother personnel to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions and dispositionsof the assets of the company; (2) provide reasonable assurance thattransactions are recorded as necessary to permit preparation of financialstatements in accordance with generally accepted accounting principles, andthat receipts and expenditures of the company are being made only in accordancewith authorizations of management and directors of the company; and (3) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the company’s assets that could have amaterial effect on the financial statements.

Because of the inherent limitations of internalcontrol over financial reporting, including the possibility of collusion orimproper management override of controls, material misstatements due to erroror fraud may not be prevented or detected on a timely basis. Also, projectionsof any evaluation of the effectiveness of the internal control over financialreporting to future periods are subject to the risk that the controls may becomeinadequate because of changes in conditions, or that the degree of compliancewith the policies or procedures may deteriorate.

A material weakness is a significant deficiency, orcombination of significant deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected. The following material weaknesshas been identified and included in management’s assessment:

A material weakness in the operating effectiveness ofthe controls over the determination of excess and obsolete inventory and therelated valuation adjustments resulting in an audit adjustment to reduceinventory and increase cost of sales. This material weakness arose from theCompany’s failure 

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to consider all current business conditions indetermining the salability of its current inventory. Accordingly, managementhas determined that this deficiency constituted a material weakness.

In our opinion, management’s assessment that theCompany did not maintain effective internal control over financial reporting asof December 31, 2005, is fairly stated, in all material respects, based onthe criteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission. Also in our opinion, because of the effect of the materialweakness described above on the achievement of the objectives of the controlcriteria, the Company has not maintained effective internal control overfinancial reporting as of December 31, 2005, based on the criteriaestablished in *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated financial statements and financial statementschedule as of and for the year ended December 31, 2005 of the Company andour report dated March 30, 2006 expressed an unqualified opinion on thosefinancial statements and financial statement schedule.
| /s/ DELOITTE & TOUCHE LLP |   |
|------------------------------------|--------|
| San Jose, California               |   |
| March 30, 2006                |   |

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**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors and Stockholders ofWJ Communications, Inc.

We have audited the accompanying consolidated balancesheets of WJ Communications, Inc. and subsidiaries (the “Company”) as of December 31,2005 and 2004, and the related consolidated statements of operations,comprehensive loss, stockholders’ equity, and cash flows for each of the threeyears in the period ended December 31, 2005. Our audits also included thefinancial statement schedule listed in the Index at Item 15. Thesefinancial statements and financial statement schedule are the responsibility ofthe Company’s management. Our responsibility is to express an opinion on thefinancial statements and financial statement schedule based on our audits.

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

In our opinion, such consolidated financial statementspresent fairly, in all material respects, the financial position of WJCommunications, Inc. and subsidiaries at December 31, 2005 and 2004,and the results of their operations and their cash flows for each of the threeyears in the period ended December 31, 2005, in conformity with accountingprinciples generally accepted in the United States of America. Also, in ouropinion, such financial statement schedule, when considered in relation to thebasic consolidated financial statements taken as a whole, presents fairly, inall material respects, the information set forth therein.

Wehave also audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of the Company’sinternal control over financial reporting as of December 31, 2005, basedon the criteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission and our report dated March 30, 2006, expressed an unqualifiedopinion on management’s assessment of the effectiveness of the Company’sinternal control over financial reporting and an adverse opinion on theeffectiveness of the Company’s internal control over financial reportingbecause of a material weakness.
| /s/ DELOITTE & TOUCHE LLP |   |
|------------------------------------|--------|
| San Jose,  California              |   |
| March 30,  2006               |   |

 

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**WJCOMMUNICATIONS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**(Inthousands, except share and per share amounts)

| ** **                                                                                                                                                       | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                       | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **ASSETS**                                                                                                                                                       |       |
| CURRENT ASSETS:                                                                                                                                                  |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                        |       | $                     | 14,169     |   | $ | 24,392 |   |
| Short-term investments                                                                                                                                           |       | 16,052                |       | 18,732 |   |
| Receivables (net of allowances of $122 and $496,  respectively)                                                                                                  |       | 7,135                 |       | 6,841 |   |
| Inventories                                                                                                                                                      |       | 4,826                 |       | 5,148 |   |
| Other                                                                                                                                                            |       | 2,632                 |       | 3,183 |   |
| Total current assets                                                                                                                                             |       | 44,814                |       | 58,296 |   |
| PROPERTY, PLANT AND EQUIPMENT, net                                                                                                                               |       | 7,919                 |       | 9,679 |   |
| Goodwill (Note 6)                                                                                                                                                |       | 6,806                 |       | 1,368 |   |
| Intangible  assets, net (Note 6)                                                                                                                                 |       | 1,884                 |       | 180 |   |
| Other assets                                                                                                                                                     |       | 221                   |       | 210 |   |
|                                                                                                                                                             |       | $                     | 61,644     |   | $ | 69,733 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                    |       |
| CURRENT LIABILITIES:                                                                                                                                             |       |                  |       |   |   |
| Accounts payable                                                                                                                                                 |       | $                     | 4,220      |   | $ | 2,633 |   |
| Accrued liabilities                                                                                                                                              |       | 1,047                 |       | 1,348 |   |
| Accrued professional services                                                                                                                                    |       | 740                   |       | 797 |   |
| Accrued payroll and profit sharing                                                                                                                               |       | 2,024                 |       | 1,498 |   |
| Income tax contingency liability                                                                                                                                 |       | 1,818                 |       | 1,946 |   |
| Deferred margin on distributor inventory (Note 3)                                                                                                                |       | 3,217                 |       | — |   |
| Restructuring accrual (Note 14)                                                                                                                                  |       | 3,386                 |       | 3,350 |   |
| Total current liabilities                                                                                                                                        |       | 16,452                |       | 11,572 |   |
| OTHER LONG-TERM  OBLIGATIONS (Notes 9 and 14)                                                                                                                    |       | 14,075                |       | 16,864 |   |
| COMMITMENTS AND  CONTINGENCIES (Notes 9 and 12)                                                                                                                  |       |                  |       |   |   |
| STOCKHOLDERS’  EQUITY:                                                                                                                                      |       |                  |       |   |   |
| Preferred stock, $0.01 par value—10,000,000 shares  authorized, no shares issued and outstanding                                                            |       | —                |       | — |   |
| Common stock, $0.01 par value—100,000,000 shares  authorized, 67,455,845 and 62,936,760 shares issued and outstanding in 2005  and 2004, respectively  |       | 675                   |       | 629 |   |
| Treasury stock—1,922,063 shares in 2005 and  1,769,772 shares in 2004                                                                                       |       | (19                   | )          | (18 | ) |
| Additional paid-in capital                                                                                                                                       |       | 205,320               |       | 194,262 |   |
| Accumulated deficit                                                                                                                                              |       | (174,187              | )          | (153,199 | ) |
| Other comprehensive loss                                                                                                                                         |       | (9                    | )          | (12 | ) |
| Deferred stock compensation                                                                                                                                      |       | (663                  | )          | (365 | ) |
| Total stockholders’ equity                                                                                                                                  |       | 31,117                |       | 41,297 |   |
|                                                                                                                                                             |       | $                     | 61,644     |   | $ | 69,733 |   |

 

**See notes to consolidated financial statements.**

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**WJCOMMUNICATIONS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**(In thousands, except pershare amounts)

| ** **                                          | ** ** | **Year Ended**   | ** ** |
|-----------------------------------------------------|------------|-----------------------|------------|
| ** **                                          | ** ** | **December 31,** | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                          | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| Sales, net                                          |       |                  | $          | 31,597 |   |   |   | $ | 32,336 |   |   |   | $ | 26,565 |   |   |
| Cost of goods  sold                                 |       |                  | 16,906     |   |   |   | 15,278 |   |   |   | 15,495 |   |   |
| Gross profit                                        |       |                  | 14,691     |   |   |   | 17,058 |   |   |   | 11,070 |   |   |
| Operating expenses:                                 |       |                  |       |   |   |   |   |   |   |   |   |   |   |
| Research and development                            |       |                  | 18,070     |   |   |   | 17,238 |   |   |   | 16,882 |   |   |
| Selling and administrative                          |       |                  | 15,295     |   |   |   | 12,503 |   |   |   | 10,251 |   |   |
| Acquired in-process research & development |       |                  | 3,400      |   |   |   | 8,500 |   |   |   | — |   |   |
| Recapitalization merger                             |       |                  | —     |   |   |   | — |   |   |   | 680 |   |   |
| Restructuring reversals (Note 14)                   |       |                  | —     |   |   |   | (3,845 | ) |   |   | (54 | ) |   |
| Total operating expenses                            |       |                  | 36,765     |   |   |   | 34,396 |   |   |   | 27,759 |   |   |
| Loss from  operations                               |       |                  | (22,074    | ) |   |   | (17,338 | ) |   |   | (16,689 | ) |   |
| Interest income                                     |       |                  | 1,048      |   |   |   | 682 |   |   |   | 755 |   |   |
| Interest expense                                    |       |                  | (96        | ) |   |   | (104 | ) |   |   | (117 | ) |   |
| Other income—net                               |       |                  | 14         |   |   |   | 5 |   |   |   | 1,094 |   |   |
| Loss before  income taxes                           |       |                  | (21,108    | ) |   |   | (16,755 | ) |   |   | (14,957 | ) |   |
| Income tax  benefit                                 |       |                  | 120        |   |   |   | 7,674 |   |   |   | 647 |   |   |
| Net loss                                            |       |                  | $          | (20,988 | ) |   |   | $ | (9,081 | ) |   |   | $ | (14,310 | ) |   |
| Basic and diluted net loss per share                |       |                  | $          | (0.33 | ) |   |   | $ | (0.15 | ) |   |   | $ | (0.25 | ) |   |
| Basic and diluted  average shares                   |       |                  | 64,162     |   |   |   | 60,397 |   |   |   | 56,835 |   |   |

 

**See notes to consolidated financial statements.**

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**WJCOMMUNICATIONS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF COMPREHENSIVE LOSS**(Inthousands)

| ** **                                                                                                           | ** ** | **Year Ended**   | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                           | ** ** | **December 31,** | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                                                                           | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss                                                                                                             |       |                  | $          | (20,988 | ) |   |   | $ | (9,081 | ) |   |   | $ | (14,310 | ) |   |
| Other comprehensive gains  (losses):                                                                                 |       |                  |       |   |   |   |   |   |   |   |   |   |   |
| Unrealized holding gains (losses) on securities arising  during period net of reclassification adjustments and taxes |       |                  | 3          |   |   |   | (4 | ) |   |   | 10 |   |   |
| Comprehensive loss                                                                                                   |       |                  | $          | (20,985 | ) |   |   | $ | (9,085 | ) |   |   | $ | (14,300 | ) |   |

 

**See notes to consolidated financial statements.**

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**WJCOMMUNICATIONS, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY**(Inthousands, except share amounts)

| ** **                                                                     | ** ** | ** **       | ** ** | ** **         | ** ** | ** **  | ** ** | ** **  | ** ** | **Additional** | ** ** |
|--------------------------------------------------------------------------------|------------|------------------|------------|--------------------|------------|-------------|------------|-------------|------------|----------------|------------|
| ** **                                                                     | ** ** | **Common Stock** | ** ** | **Treasury Stock** | ** ** | **Paid-in** | ** ** |
| ** **                                                                     | ** ** | **Shares**       | ** ** | **Dollars**        | ** ** | **Shares**  | ** ** | **Dollars** | ** ** | **Capital**    | ** ** |
| Balance,  December 31, 2002                                               |       | 56,358,519       |       |               | $          | 564         |       |        | —     |           |       | $ | — |   |   | $ | 179,172 |   |
| Net loss                                                                       |       | —           |       |               | —     |        |       | —      |       |           | —     |   |   | — |   |
| Common stock issued                                                            |       | 153,973          |       |               | 2          |        |       | —      |       |           | —     |   |   | 102 |   |
| Exercise of stock options                                                      |       | 2,534,724        |       |               | 24         |        |       | —      |       |           | —     |   |   | 3,435 |   |
| Deferred stock compensation                                                    |       | —           |       |               | —     |        |       | —      |       |           | —     |   |   | 287 |   |
| Repurchases of common stock                                                    |       | —           |       |               | —     |        |       | (1,340,719  | )          |           | (13        | ) |   | (2,778 | ) |
| Amortization of deferred stock compensation                          |       | —           |       |               | —     |        |       | —      |       |           | —     |   |   | — |   |
| Elimination of deferred compensation related to  stock options forfeited  |       | —           |       |               | —     |        |       | —      |       |           | —     |   |   | (55 | ) |
| Unrealized holding gains on securities—net of taxes  of $5           |       | —           |       |               | —     |        |       | —      |       |           | —     |   |   | — |   |
| Balance,  December 31, 2003                                               |       | 59,047,216       |       |               | 590        |        |       | (1,340,719  | )          |           | (13        | ) |   | 180,163 |   |
| Net loss.                                                                      |       | —           |       |               | —     |        |       | —      |       |           | —     |   |   | — |   |
| Common stock issued.                                                           |       | 2,955,437        |       |               | 30         |        |       | —      |       |           | —     |   |   | 12,942 |   |
| Exercise of stock options                                                      |       | 934,107          |       |               | 9          |        |       | —      |       |           | —     |   |   | 1,180 |   |
| Deferred stock compensation.                                                   |       | —           |       |               | —     |        |       | —      |       |           | —     |   |   | 298 |   |
| Repurchases of common stock                                                    |       | —           |       |               | —     |        |       | (429,053    | )          |           | (5         | ) |   | (915 | ) |
| Amortization of deferred stock compensation                          |       | —           |       |               | —     |        |       | —      |       |           | —     |   |   | — |   |
| Compensation charge due to option date extension                               |       | —           |       |               | —     |        |       | —      |       |           | —     |   |   | 594 |   |
| Unrealized holding gains on securities—net of taxes  of $8           |       | —           |       |               | —     |        |       | —      |       |           | —     |   |   | — |   |
| Balance,  December 31, 2004                                               |       | 62,936,760       |       |               | 629        |        |       | (1,769,772  | )          |           | (18        | ) |   | 194,262 |   |
| Net loss                                                                       |       | —           |       |               | —     |        |       | —      |       |           | —     |   |   | — |   |
| Common stock issued                                                            |       | 3,141,143        |       |               | 32         |        |       | —      |       |           | —     |   |   | 9,953 |   |
| Exercise of stock options                                                      |       | 1,377,942        |       |               | 14         |        |       | —      |       |           | —     |   |   | 1,441 |   |
| Shares repurchased for tax withholding on employee  stock transactions    |       | —           |       |               | —     |        |       | (152,291    | )          |           | (1         | ) |   | (249 | ) |
| Amortization of deferred stock compensation                          |       | —           |       |               | —     |        |       | —      |       |           | —     |   |   | — |   |
| Elimination of deferred compensation related to stock  options forfeited  |       | —           |       |               | —     |        |       | —      |       |           | —     |   |   | (87 | ) |
| Unrealized holding gains on securities—net of taxes  of $2           |       | —           |       |               | —     |        |       | —      |       |           | —     |   |   | — |   |
| Balance,  December 31, 2005                                               |       | 67,455,845       |       |               | $          | 675         |       |        | (1,922,063 | )              |       | $ | (19 | ) |   | $ | 205,320 |   |

 

**See notes to consolidated financial statements.**

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**WJCOMMUNICATIONS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY (continued)**(Inthousands, except share amounts)

| ** **                                                                    | ** ** | **Accumulated  Deficit** | ** ** | **Other  Comprehensive  Loss ** | ** ** | **Deferred  Stock  Compensation ** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|-------------------------------------------------------------------------------|------------|--------------------------|------------|--------------------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| Balance, December 31,  2002                                              |       |                     | $          | (129,808                             | )          |                                    |       | $                                     | (18        | ) |   |   | $ | (292 | ) |   |   | $ | 49,618 |   |   |
| Net loss                                                                      |       |                     | (14,310    | )                                    |       |                                    | —     |                                  |       |   | — |   |   |   | (14,310 | ) |   |
| Common stock issued                                                           |       |                     | —     |                                 |       |                                    | —     |                                  |       |   | — |   |   |   | 104 |   |   |
| Exercise of stock options                                                     |       |                     | —     |                                 |       |                                    | —     |                                  |       |   | — |   |   |   | 3,459 |   |   |
| Deferred stock compensation                                                   |       |                     | —     |                                 |       |                                    | —     |                                  |       |   | (287 | ) |   |   | — |   |   |
| Repurchases of common stock                                                   |       |                     | —     |                                 |       |                                    | —     |                                  |       |   | — |   |   |   | (2,791 | ) |   |
| Amortization of deferred stock compensation                                   |       |                     | —     |                                 |       |                                    | —     |                                  |       |   | 149 |   |   |   | 149 |   |   |
| Elimination of deferred compensation related to  stock options forfeited |       |                     | —     |                                 |       |                                    | —     |                                  |       |   | 55 |   |   |   | — |   |   |
| Unrealized holding gains on securities—net of taxes  of $5          |       |                     | —     |                                 |       |                                    | 10         |                                  |       |   | — |   |   |   | 10 |   |   |
| Balance,  December 31, 2003                                              |       |                     | (144,118   | )                                    |       |                                    | (8         | )                                     |       |   | (375 | ) |   |   | 36,239 |   |   |
| Net loss                                                                      |       |                     | (9,081     | )                                    |       |                                    | —     |                                  |       |   | — |   |   |   | (9,081 | ) |   |
| Common stock issued                                                           |       |                     | —     |                                 |       |                                    | —     |                                  |       |   | — |   |   |   | 12,972 |   |   |
| Exercise of stock options                                                     |       |                     | —     |                                 |       |                                    | —     |                                  |       |   | — |   |   |   | 1,189 |   |   |
| Deferred stock compensation                                                   |       |                     | —     |                                 |       |                                    | —     |                                  |       |   | (298 | ) |   |   | — |   |   |
| Repurchases of common stock                                                   |       |                     | —     |                                 |       |                                    | —     |                                  |       |   | — |   |   |   | (920 | ) |   |
| Amortization of deferred stock compensation                                   |       |                     | —     |                                 |       |                                    | —     |                                  |       |   | 308 |   |   |   | 308 |   |   |
| Compensation charge due to option date extension                              |       |                     | —     |                                 |       |                                    | —     |                                  |       |   | — |   |   |   | 594 |   |   |
| Unrealized holding gains on securities—net of taxes  of $8          |       |                     | —     |                                 |       |                                    | (4         | )                                     |       |   | — |   |   |   | (4 | ) |   |
| Balance,  December 31, 2004                                              |       |                     | (153,199   | )                                    |       |                                    | (12        | )                                     |       |   | (365 | ) |   |   | 41,297 |   |   |
| Net loss                                                                      |       |                     | (20,988    | )                                    |       |                                    | —     |                                  |       |   | — |   |   |   | (20,988 | ) |   |
| Common stock issued                                                           |       |                     | —     |                                 |       |                                    | —     |                                  |       |   | (1,302 | ) |   |   | 8,683 |   |   |
| Exercise of stock options                                                     |       |                     | —     |                                 |       |                                    | —     |                                  |       |   | — |   |   |   | 1,455 |   |   |
| Shares repurchased for tax withholding on employee  stock transactions        |       |                     | —     |                                 |       |                                    | —     |                                  |       |   | — |   |   |   | (250 | ) |   |
| Amortization of deferred stock compensation                                   |       |                     | —     |                                 |       |                                    | —     |                                  |       |   | 917 |   |   |   | 917 |   |   |
| Elimination of deferred compensation related to stock  options forfeited      |       |                     | —     |                                 |       |                                    | —     |                                  |       |   | 87 |   |   |   | — |   |   |
| Unrealized holding gains on securities—net of taxes  of $2          |       |                     | —     |                                 |       |                                    | 3          |                                  |       |   | — |   |   |   | 3 |   |   |
| Balance,  December 31, 2005                                              |       |                     | $          | (174,187                             | )          |                                    |       | $                                     | (9         | ) |   |   | $ | (663 | ) |   |   | $ | 31,117 |   |   |

 

**See notes to consolidated financial statements.**

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**WJCOMMUNICATIONS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**(Inthousands)

| ** **                                                                   | ** ** | **Year Ended**              | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                   | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** |
| **OPERATING ACTIVITIES:**                                                    | ** ** |                        | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Net loss                                                                     |       |                        | $          | (20,988 | ) |   |   | $ | (9,081 | ) |   |   | $ | (14,310 | ) |   |
| Adjustments to reconcile net loss to net cash used by  operating activities: |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Non-cash restructuring  charges (reversals)                                  |       |                        | 54         |   |   |   | (3,804 | ) |   |   | (69 | ) |   |
| Depreciation and  amortization                                               |       |                        | 3,117      |   |   |   | 2,825 |   |   |   | 4,374 |   |   |
| Acquired in-process research  and development                                |       |                        | 3,400      |   |   |   | 8,500 |   |   |   | — |   |   |
| Amortization of premiums  on short-term investments                          |       |                        | 161        |   |   |   | 485 |   |   |   | 106 |   |   |
| Net (gain) loss on  disposal of property, plant & equipment         |       |                        | 25         |   |   |   | (4 | ) |   |   | 91 |   |   |
| Net gain on sale of  product line                                            |       |                        | —     |   |   |   | — |   |   |   | (1,084 | ) |   |
| Deferred income taxes                                                        |       |                        | —     |   |   |   | — |   |   |   | 6,036 |   |   |
| Stock based compensation                                                     |       |                        | 920        |   |   |   | 902 |   |   |   | 253 |   |   |
| Amortization of deferred  financing costs                                    |       |                        | 39         |   |   |   | 41 |   |   |   | 32 |   |   |
| Provision (reduction) in  allowance for doubtful accounts                    |       |                        | 20         |   |   |   | 58 |   |   |   | (408 | ) |   |
| Net changes in:                                                              |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Receivables                                                                  |       |                        | 26         |   |   |   | (2,340 | ) |   |   | (173 | ) |   |
| Inventories                                                                  |       |                        | 516        |   |   |   | (689 | ) |   |   | 1,463 |   |   |
| Other assets                                                                 |       |                        | 354        |   |   |   | (1,021 | ) |   |   | (56 | ) |   |
| Accruals and accounts  payable                                               |       |                        | 1,586      |   |   |   | (311 | ) |   |   | 13 |   |   |
| Income tax contingency  liability                                            |       |                        | (128       | ) |   |   | (8,544 | ) |   |   | — |   |   |
| Deferred margin on  distributor inventory                                    |       |                        | 3,216      |   |   |   | — |   |   |   | — |   |   |
| Restructuring liabilities                                                    |       |                        | (2,697     | ) |   |   | (2,404 | ) |   |   | (2,173 | ) |   |
| Net cash provided (used)  by operating activities                            |       |                        | (10,379    | ) |   |   | (15,387 | ) |   |   | (5,905 | ) |   |
| **INVESTING ACTIVITIES:**                                                    | ** ** |                        | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Purchases of property,  plant and equipment                                  |       |                        | (1,476     | ) |   |   | (878 | ) |   |   | (841 | ) |   |
| Purchase of short-term  investments                                          |       |                        | (34,854    | ) |   |   | (59,327 | ) |   |   | (92,636 | ) |   |
| Proceeds from sale and  maturities of short-term investments                 |       |                        | 37,591     |   |   |   | 89,170 |   |   |   | 64,569 |   |   |
| Proceeds on product line  sales and assets retirements                       |       |                        | 500        |   |   |   | 9 |   |   |   | 1,572 |   |   |
| Acquisition of Telenexus  and related costs                                  |       |                        | (3,218     | ) |   |   | — |   |   |   | — |   |   |
| Acquisition of EiC and  related costs                                        |       |                        | (37        | ) |   |   | (10,747 | ) |   |   | — |   |   |
| Net cash provided (used)  by investing activities                            |       |                        | (1,494     | ) |   |   | 18,227 |   |   |   | (27,336 | ) |   |
| **FINANCING ACTIVITIES:**                                                    |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Payments on long-term  borrowings                                            |       |                        | (47        | ) |   |   | (104 | ) |   |   | (51 | ) |   |
| Net proceeds from  issuances of common stock                                 |       |                        | 1,947      |   |   |   | 11,676 |   |   |   | 3,459 |   |   |
| Repurchase of common  stock                                                  |       |                        | (250       | ) |   |   | (920 | ) |   |   | (2,791 | ) |   |
| Net cash provided by  financing activities                                   |       |                        | 1,650      |   |   |   | 10,652 |   |   |   | 617 |   |   |
| Net increase  (decrease) in cash and equivalents                             |       |                        | (10,223    | ) |   |   | 13,492 |   |   |   | (32,624 | ) |   |
| Cash and cash  equivalents at beginning of year                              |       |                        | 24,392     |   |   |   | 10,900 |   |   |   | 43,524 |   |   |
| Cash and cash  equivalents at end of year                                    |       |                        | $          | 14,169 |   |   |   | $ | 24,392 |   |   |   | $ | 10,900 |   |   |
| Other cash flow information:                                                 |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Income taxes paid  (refunded), net                                           |       |                        | $          | 10 |   |   |   | $ | 867 |   |   |   | $ | (6,678 | ) |   |
| Interest paid                                                                |       |                        | 57         |   |   |   | 63 |   |   |   | 88 |   |   |
| Noncash investing and financing activities:                                  |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Issuance of common stock  for Telenexus acquisition                          |       |                        | 8,190      |   |   |   | — |   |   |   | — |   |   |
| Issuance of common stock  for EiC acquisition                                |       |                        | —     |   |   |   | 2,484 |   |   |   | — |   |   |
| Purchase of equipment under capital lease                                    |       |                        | —     |   |   |   | — |   |   |   | 96 |   |   |

 

**See notes to consolidated financial statements.**

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**WJ COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**1. ORGANIZATION AND OPERATIONS OF THE COMPANY**

WJ Communications, Inc.(formerly Watkins-Johnson Company, the “Company”) was founded in 1957 in PaloAlto, California. The Company was originally incorporated in California andreincorporated in Delaware in August 2000. For more than 45 years, theCompany developed and manufactured radio frequency (“RF”) microwave devices forgovernment electronics and space communications systems used for intelligencegathering and communication. In 1996, the Company began to develop commercialapplications for its military technologies. The Company’s current operationsdesign, develop and market innovative, high-performance products for bothcurrent and next generation wireless and broadband cable networks, and radiofrequency identification (“RFID”) systems worldwide. The Company’s products arecomprised of advanced, highly functional RF semiconductors, components andintegrated assemblies which seek to address the RF requirements of thesevarious systems.

**2. SIGNIFICANT ACCOUNTING POLICIES**

PRINCIPLES OF CONSOLIDATION—The consolidated financialstatements include the accounts of the Company and its subsidiaries afterelimination of all intercompany balances and transactions.

RECLASSIFICATIONS—Certain prior year amounts have beenreclassified to conform with the 2005 presentation. Such reclassifications didnot have any impact on net loss or stockholders’ equity.

CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS—Cashand cash equivalents consist of money market funds and commercial paperacquired with remaining maturities of 90 days or less and are stated at costplus accrued interest which approximates market value. Short-term investmentsconsist primarily of high-grade debt securities (A rating or better) withmaturities greater than 90 days from the date of acquisition and are classifiedas available-for-sale. Short-term investments classified as available-for-saleare reported at fair market value with unrealized gains or losses excluded fromearnings and reported as other comprehensive income (loss), a separatecomponent of stockholders’ equity, net of tax, until realized. Realized gainsand losses are included in the accompanying consolidated statements ofoperations as other income—net.

FAIR VALUE OF FINANCIAL INSTRUMENTS—The carrying valueof cash and equivalents, receivables and accounts payable are a reasonableapproximation of their fair market value due to the short-term maturities ofthose instruments. Short-term investments are classified as available-for-saleand reported at fair market value with unrealized gains or losses excluded fromearnings and reported as a separate component of stockholders’ equity, net oftax, until realized.

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**WJ COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**2. SIGNIFICANTACCOUNTING POLICIES (Continued)**

INVENTORIES—Inventoriesare stated at the lower of cost, using average-cost basis, or market. Cost ofinventory items is based on purchase and production cost including labor andoverhead. Write-downs, when required, are made to reduce excess inventories totheir estimated net realizable values. Such estimates are based on assumptionsregarding future demand and market conditions. These write-downs amounted to $975,000 in the year ended December 31,2005, $670,000 and $251,000 for the years ended December 31, 2004 and2003, respectively. If actual conditions become less favorable than theassumptions used, an additional inventory write-down may be required.Inventories, at December 31, 2005 and 2004 consisted of the following (inthousands):

| ** **               | ** ** | **December 31,** | ** ** |
|--------------------------|------------|-----------------------|------------|
| ** **               | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Finished goods           |       | $                     | 1,683      |   | $ | 1,944 |   |
| Work in progress         |       | 1,697                 |       | 2,338 |   |
| Raw materials and  parts |       | 1,446                 |       | 866 |   |
|                     |       | $                     | 4,826      |   | $ | 5,148 |   |

 

PROPERTY, PLANT AND EQUIPMENT—Property, plant andequipment are stated at cost. Provision for depreciation and amortization isprimarily based on the straight-line method over the assets’ estimated usefullives ranging from four to ten years. Leasehold improvements are amortized overthe shorter of the remaining lease term or the asset’s useful life. Costsincurred to maintain property, plant and equipment that do not increase theuseful life of the underlying asset are expensed as incurred.

At December 31,2005 and 2004, property, plant and equipment consisted of the following (inthousands):

| ** **                                 | ** ** | ** **                          | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|-------------------------------------|------------|-----------------------|------------|
| ** **                                 | ** ** | **Estimated Useful Life** | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Buildings and  leasehold improvements      |       | 4-10  years                         |       | $                     | 5,063      |   | $ | 4,950 |   |
| Machinery and  equipment                   |       | 5-7  yrs                            |       | 24,696                |       | 26,239 |   |
|                                       |       |                                |       | 29,759                |       | 31,189 |   |
| Accumulated depreciation  and amortization |       |                                |       | (21,840               | )          | (21,510 | ) |
| Property, plant and  equipment—net    |       |                                |       | $                     | 7,919      |   | $ | 9,679 |   |

 

IMPAIRMENT OF LONG-LIVED ASSETS—In accordance withStatement of Financial Accounting Standards (“SFAS”) No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets”, the Company reviewslong-lived assets for impairment whenever events or changes in circumstancesindicate that the carrying amount of such assets may not be recoverable.Factors the Company considers that could trigger an impairment review includethe following:  significantunderperformance relative to expected historical or projected, future operatingresults; significant changes in the manner of use of the acquired assets or thestrategy for the overall business; significant negative industry or economictrends; or significant technological changes, which would render equipment andmanufacturing processes obsolete. Recoverability of assets to be held and usedis measured by a comparison of the carrying amount of these assets to futureundiscounted cash flows expected to be generated by these assets. If suchassets are considered to be impaired, the impairment to be recognized is 

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**WJ COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**2. SIGNIFICANTACCOUNTING POLICIES (Continued)**

measured by the amount bywhich the carrying amount of the assets exceeds the fair value of the assets.In 2002, the Company recorded an asset impairment charge of $4.4 million forassets held for use and $3.9 million for assets held for sale as part of theCompany’s restructuring initiative as detailed in Note 14.

REVENUE RECOGNITION—The Company recognizes revenue inaccordance with SEC Staff Accounting Bulletin (“SAB”) 104, “RevenueRecognition.” SAB 104 requires that four basic criteria must be met beforerevenue can be recognized:  (1) persuasiveevidence of an arrangement exists; (2) delivery has occurred or servicesrendered; (3) the fee is fixed or determinable; and (4) collectibilityis reasonably assured. Determination of criteria (3) and (4) are basedon management’s judgments regarding the fixed nature of the fee charged forproducts delivered and the collectibility of those fees. Effective for our second quarter ended July 3,2005, the Company changed the application of its revenue recognition policyregarding its distributors. The Company had previously recognized revenue uponshipment to its distributors less estimated reserves for distributorright of return, authorized price reductions for specific end-customer salesopportunities and price protection based on known events and historical trends. Effective for the second quarter ended July 3,2005, the Company recognizes revenue from its distribution channels when itsdistributors have sold the product to the end customer. Historically, we have receivedstock rotation requests from our distributors that were within the amountsestimated and contractually allowed with only one exception of an insignificantamount.  However, the request for stockrotation during our second quarter ended July 3, 2005 was higher than theamount contractually allowed. The Company’s management, with the concurrence ofthe Company’s Audit Committee, believes the increasing percentage of newproducts introduced by us makes it likely that stock rotation reserves willcontinue to be difficult to estimate based on historical patterns andcontractual provisions. Based on this change in facts and circumstances and ourmanagement’s future expectations, the Company believes that we can no longerreasonably estimate the amount of future returns from our distributors as of July 3,2005. Accordingly, recognition of revenue and associated cost of sales onshipments to distributors is deferred until the resale to the end customer. For further discussion, see Note 3.

*AuthorizedPrice Reductions for Specific End-Customer Sales Opportunities (“Ship &Debit Allowance”):*   Beginning in September 2003,the Company entered into a program where the distributor would receive a creditif it sold specific product at a reduced price to specific end-customerspre-authorized by the Company. The Company maintains a log of all such pre-authorizedprice reductions which it accrues as a reduction to revenue in the period thatthe pre-authorization occurs per issue 4 of EITF 01-9 “Accounting forConsideration Given by a Vendor to a Customer”. As of December 31, 2005, 2004 and 2003, the Company’s Ship &Debit Allowance was $34,000, $5,000 and $29,000, respectively.

*DistributorRight of Return:**  *Inaccordance with Financial Accounting Standards Board (“FASB”) Statement No. 48“Revenue Recognition When Right of Return Exists”, the Company accrued areserve based on its reasonable estimate of future returns based on historicaltrends and contractual limitations. Per contractual agreement, the distributormay return product three times per year under the following conditions:  the total value of inventory returned shall not exceed an amount equal to 5%of the total value of the distributor’s stock on hand of the Company’s productsas reported in the prior month’s inventory report, the inventory is returned noearlier than 6 months and no later than 24 months from the date of the originalinvoice date and the product’s packaging has not been opened or any alterationor modification has been performed on the part. At the end of any given period,the Company reserved revenue equal to 5% of the distributor’s current reportedinventory and cost of revenue for the associated cost of the estimated returns.Due to the Company’s change in applicationof its revenue recognition policy 

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**2. SIGNIFICANTACCOUNTING POLICIES (Continued)**

regardingits distributors, the Company no longer accrues a distributor stock rotationreserve. As of December 31, 2004, the Company’s distributor stockrotation reserve was $338,000.

*DistributorPrice Protection:*   If the Company reduces theprices of its products as negotiated with the distributor, the distributor mayreceive a credit for the difference between the price paid by the distributorand the reduced price on applicable unsold products remaining in thedistributor’s inventory on the effective date of the price reduction assumingthat inventory is less than 24 months old as determined by the original invoicedate. When the Company recognizedrevenue upon shipment to its distributors, the Company reserved fordistributor price protection per issue 4 of EITF 01-9 based on specificidentification of its initiated price reductions and the associated reporteddistributor inventory. There were no such price reductions in 2005, 2004 or2003.

*DevelopmentContracts:*   The Company may enter into contractsto perform research and development for others meeting the requirements of Statement of Financial Accounting StandardsNo. 68 “Research and Development Arrangements”. Revenue under thesedevelopment agreements is recognized when applicable contractual non-refundablemilestones have been met, including deliverables, and in any case, does notexceed the amount that would be recognized using the percentage-of-completionaccounting method based on the actual physical completion of work performed andthe ratio of costs incurred to total estimated costs to complete the contractin accordance with Accounting Research Bulletin 45 “Long-Term Construction TypeContracts” using the relevant guidance in the American Institute of CertifiedPublic Accountants Statement of Position (“SOP”) 81-1, Accounting forPerformance of Construction-Type and Certain Production-Type Contracts. Giventhe duration and nature of these development contracts, the Company believesthat recognizing revenue under the percentage completion method best representsthe legal and economic results of contract performance on a timely basis. Losseson contracts are recognized when determined. Revisions in estimates arereflected in the period in which the conditions become known. These developmentcontracts with customers have enabled the Company to accelerate its own productdevelopment efforts. Such development revenues have only partially funded itsproduct development activities, and the Company generally retains ownership ofthe products developed under these arrangements. As a result, the Companyclassifies all development costs related to these contracts as research anddevelopment expenses. The achievement of contractual milestones is evidenced bywritten documentation provided by the customer in accordance with theapplicable terms and conditions of each contract. In any period, progress onthe contract is based on input measures (direct labor dollars, direct materialcosts and direct outside processing costs) in the ratio of costs incurred tototal estimated costs. Estimated costs to complete are provided by engineeringpersonnel directly involved in the development program and are reviewed bymanagement and finance personnel for reasonableness given the known facts andcircumstances. A number of internal and external factors can affect ourestimates, including labor rates, utilization and efficiency variances andspecification and testing requirement changes. If different conditions were toprevail such that accurate estimates could not be made, then the use of thecompleted contract method would be required and the recognition of all revenueand costs would be deferred until the project was completed. If we bill thecustomer prior to performing services under the development agreement, theamounts are recorded as deferred revenue. The Company recorded revenue of$832,000 under development agreements in 2005. The Company has no deferredrevenue at December 31, 2005. No comparable amounts were included in 2004or 2003.

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**2. SIGNIFICANTACCOUNTING POLICIES (Continued)**

RECEIVABLES ALLOWANCES—Receivablesamounts on the balance sheet are shown net of the following allowances:

| ** **                                        | ** ** | **December 31,** | ** ** |
|---------------------------------------------------|------------|-----------------------|------------|
| ** **                                        | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Allowance for  doubtful accounts                  |       | $                     | 15         |   | $ | 79 |   |
| Sales return  allowance                           |       | 73                    |       | 74 |   |
| Distributor stock  rotation reserve (Note 3) |       | —                |       | 338 |   |
| Ship & debit  allowance                       |       | 34                    |       | 5 |   |
|                                              |       | $                     | 122        |   | $ | 496 |   |

 

PRODUCT WARRANTY—The Company generally sells productswith a limited warranty of product quality and a limited indemnification ofcustomers against intellectual property infringement claims related to thecompany’s products. Such warranty generally ranges from 12 to 24 months. TheCompany accrues for known warranty and indemnification issues if a loss isprobable and can be reasonably estimated, and accrues for estimated incurredbut unidentified issues based on historical activity. For further discussion,see Note 15.

INCOME TAXES—In accordance with SFAS No. 109, “Accountingfor Income Taxes,” the consolidated financial statements include provisions fordeferred income taxes using the liability method for transactions that arereported in one period for financial accounting purposes and in another periodfor income tax purposes. Deferred tax assets are recognized when managementbelieves realization of future tax benefits of temporary differences is morelikely than not. In estimating future tax consequences, generally all expectedfuture events are considered (including available carryback claims), other thanenactment of changes in the tax law or rates. Valuation allowances areestablished for those deferred tax assets where management believes it is notmore likely than not such assets will be realized.

PER SHARE INFORMATION—Basic loss per share is computedusing the daily weighted average number of common shares outstanding for theperiod. Diluted loss per share includes the above and reflects the potentialdilution that could occur if stock options whose exercise price are less thanthe average share price for the period were exercised or converted into commonstock and shares related to contributions under the Employee Stock PurchasePlan for pending purchases, however, such adjustments are excluded when theyare anti-dilutive. In determining the dilutive effect of the stock options, thenumber of shares resulting from the assumed exercise of the options is reducedby the number of shares that could have been purchased by the Company with theproceeds from the exercise of such options.

CONCENTRATION OF CREDIT RISK—Financial instrumentsthat potentially subject the Company to concentrations of credit risk consistprincipally of cash, cash equivalents, short-term investments and tradereceivables. The Company maintains cash in bank deposit accounts, which, attimes, may exceed federally insured limits. The Company has not experienced anylosses in such accounts. The Company invests in a variety of financialinstruments such as money market funds, commercial paper and high qualitycorporate bonds, and, by policy, limits the amount of credit exposure with anyone financial institution or commercial issuer. At December 31, 2005,Richardson Electronics, ZTE Corporation and Celestica represented 32%, 15% and13% of the total accounts receivable balance, respectively. At December 31,2004, Richardson Electronics and Celestica represented 46% and 10% of the totalaccounts 

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**2. SIGNIFICANTACCOUNTING POLICIES (Continued)**

receivable balance,respectively. The Company performs ongoing credit evaluations and maintains anallowance for doubtful accounts based upon the expected collectibility ofreceivables.

USE OF ESTIMATES—The preparation of financialstatements in conformity with generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the reported amountsof assets, liabilities and disclosure of contingent assets and liabilities atthe date of the financial statements and the reported amount of revenues andexpenses during the reporting period. Key estimates include allowance fordoubtful accounts, reserves for sales returns, write-down of excess andobsolete inventories, income tax contingency reserves, valuation of deferredtax assets and restructuring accruals. Actual results could differ from thoseestimates.

STOCK-BASED COMPENSATION—The Company accounts forstock-based compensation granted to employees and directors under the intrinsicvalue method as defined in Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees.”

During the year ended December 31, 2004, theCompany modified two option agreements (extension of the option exerciseperiod) resulting in $594,000 of severance expense which was recorded asselling and administrative expense.

As required under SFAS No. 123, “Accounting forStock-Based Compensation,” and SFAS 148, “Accounting for Stock-Based CompensationTransition and Disclosure,” the pro forma effects of stock-based compensationon net loss and net loss per common share have been estimated at the date ofgrant as if the Company had accounted for such awards under the fair valuemethod of SFAS 123 using the Black-Scholes option-pricing model. The Companyhas amortized to expense deferred stock compensation of $920,000, $308,000 and$149,000 in 2005, 2004 and 2003, respectively.

Theweighted average fair value of stock-based awards granted in fiscal years 2005,2004 and 2003 reported below have been estimated at the date of grant using theBlack-Scholes option pricing model with the following assumptions:

| ** **                                                 | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Employee Stock Option  Plans                               |       |     |       |     |       |     |       |
| Fair value                                                 |       | $        | 0.88       |     | $          | 2.19     |       | $ | 2.02 |   |
| Dividend yield                                             |       | 0.0      | %          | 0.0      | %          | 0.0      | %          |
| Volatility                                                 |       | 82.1     | %          | 87.1     | %          | 93.0     | %          |
| Risk free  interest rate at the time of grant              |       | 4.1      | %          | 3.0      | %          | 2.6      | %          |
| Expected term to  exercise (in months from the grant date) |       | 48.0     |       | 48.0     |       | 48.0     |       |
| Employee Stock  Purchase Plan                              |       |     |       |     |       |     |       |
| Fair value                                                 |       | $        | 0.70       |     | $          | 1.32     |       | (1 | ) |
| Dividend yield                                             |       | 0.0      | %          | 0.0      | %          | (1       | )          |
| Volatility                                                 |       | 75.4     | %          | 69.0     | %          | (1       | )          |
| Risk free interest  rate at the time of grant              |       | 2.68     | %          | 1.17     | %          | (1       | )          |
| Expected term to  exercise (in months from the grant date) |       | 6.0      |       | 6.0      |       | (1       | )          |
|                                                            |            |          |            |          |            |          |            |  |  |  |

----

(1)          No shares were issuedunder the Employee Stock Purchase Plan during 2003.

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**2. SIGNIFICANT ACCOUNTING POLICIES (Continued)**

The Black-Scholes model used by the Company tocalculate option values, as well as other currently accepted option valuationmodels, were developed to estimate the fair values of freely tradable, fullytransferable options without vesting restrictions, which significantly differfrom the Company’s stock option awards. These models also require highlysubjective assumptions, including future stock price volatility, and expectedtime until exercise, which greatly affect the calculated values.

The following tableillustrates the effect on net loss had compensation cost for all of the Company’sstock option plans been determined based upon the fair value at the grant datefor awards under these plans, and amortized to expense over the vesting periodof the awards consistent with the methodology prescribed under SFAS 123, “Accountingfor Stock-Based Compensation” (in thousands):

| ** **                                                                                             | ** ** | **Year Ending December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                             | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Reported net loss                                                                                      |       | $                                           | (20,988    | ) | $ | (9,081 | ) | $ | (14,310 | ) |
| Add: Total stock-based  employee compensation expense included in reported net loss                    |       | 920                                         |       | 308 |   | 149 |   |
| Deduct: Total  stock-based employee compensation expense under fair value based method for  all awards |       | (1,116                                      | )          | (5,474 | ) | (2,555 | ) |
| Pro forma loss                                                                                         |       | $                                           | (21,184    | ) | $ | (14,247 | ) | $ | (16,716 | ) |
| Reported net loss per  basic and diluted share                                                         |       | $                                           | (0.33      | ) | $ | (0.15 | ) | $ | (0.25 | ) |
| Pro forma net loss per  basic and diluted share                                                        |       | $                                           | (0.33      | ) | $ | (0.24 | ) | $ | (0.29 | ) |

 

**RECENT ACCOUNTING PRONOUNCEMENTS—On**December 16,2004, the FASB issued Statement of Financial Accounting Standards No. 123(revised 2004), “Share-Based Payment” (“SFAS 123R”). SFAS 123R eliminates thealternative of applying the intrinsic value measurement provisions of Opinion25 to stock compensation awards issued to employees. Rather, the new standardrequires enterprises to measure the cost of employee services received inexchange for an award of equity instruments based on the grant-date fair valueof the award. That cost will be recognized over the period during which anemployee is required to provide services in exchange for the award, known asthe requisite service period (usually the vesting period).

The Company adopted SFAS 123R in January 2006 andcurrently does not expect to restate prior periods to conform to the newaccounting standard as the Modified Prospective Application Method will beused. Under this method SFAS 123R is applied to new awards and to awardsmodified, repurchased or cancelled after the effective date. Additionally,compensation cost for the portion of awards for which the requisite service hasnot been rendered (such as unvested options) that are outstanding as of thedate of adoption shall be recognized as the remaining requisite services arerendered. The compensation cost relating to unvested awards at the date ofadoption shall be based on the grant-date fair value of those awards ascalculated for pro forma disclosures under the original SFAS 123 adjusted forestimated forfeitures. See Note 2 to the consolidated financial statementsincluded elsewhere in this Form 10-K under the caption “STOCK-BASEDCOMPENSATION” for information related to the pro forma effect on reported netincome and net earnings per share of applying the fair value provisions of theSFAS 123. The balance of unearned stock-based compensation to be expensed inthe period 2006 through 2010 related to share-based awards unvested at December 31,2005, as previously calculated under the 

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**2. SIGNIFICANTACCOUNTING POLICIES (Continued)**

disclosure-onlyrequirements of SFAS 123, is approximately $2.7 million. If there are anymodifications or cancellations of the underlying unvested securities, theCompany may be required to accelerate, increase or cancel any remainingunearned stock-based compensation expense. To the extent that the Companygrants additional future stock option and other share-base awards, its futurestock-based compensation expense will be increased by the additional unearnedcompensation resulting from those additional grants. The fair value of thesegrants is not included in the amount above, as the impact of these grantscannot be predicted at this time because it will depend on the number ofshare-based payments granted and the then current fair values. The Company iscurrently in the process of determining our estimated forfeiture rate forpurposes of adopting SFAS 123R and management estimates that the Company’sforfeiture rate will be between 10% and 25%, which will result in a reductionto the foregoing annual amoritization amounts.

In May 2005, the Financial Accounting StandardsBoard (“FASB”) issued Statement of Financial Accounting Standards No. 154,“Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20and FASB Statement No. 3” (“SFAS 154”). This Statement replaces APBOpinion No. 20, Accounting Changes, and FASB Statement No. 3,Reporting Accounting Changes in Interim Financial Statements, and changes therequirements for the accounting for and reporting of a change in accountingprinciple. This Statement applies to all voluntary changes in accountingprinciple. It also applies to changes required by an accounting pronouncementin the unusual instance that the pronouncement does not include specifictransition provisions. When a pronouncement includes specific transitionprovisions, those provisions should be followed.

Opinion 20 previously required that most voluntarychanges in accounting principle be recognized by including in net income of theperiod of the change the cumulative effect of changing to the new accountingprinciple. This Statement requires retrospective application to prior periods’financial statements of changes in accounting principle, unless it isimpracticable to determine either the period-specific effects or the cumulativeeffect of the change. When it is impracticable to determine the period-specificeffects of an accounting change on one or more individual prior periodspresented, this Statement requires that the new accounting principle be appliedto the balances of assets and liabilities as of the beginning of the earliestperiod for which retrospective application is practicable and that acorresponding adjustment be made to the opening balance of retained earnings(or other appropriate components of equity or net assets in the statement offinancial position) for that period rather than being reported in an incomestatement. When it is impracticable to determine the cumulative effect ofapplying a change in accounting principle to all prior periods, this Statementrequires that the new accounting principle be applied as if it were adoptedprospectively from the earliest date practicable. This Statement shall beeffective for accounting changes and corrections of errors made in fiscal yearsbeginning after December 15, 2005. The Company adopted SFAS 154 in January 2006and currently does not anticipate that it will have a significant effect on ourfinancial statements or disclosures.

In June 2005, theFASB’s Emerging Issues Task Force reached a consensus on Issue No. 05-6,“Determining the Amortization Period for Leasehold Improvements” (“EITF 05-6”).The guidance requires that leasehold improvements acquired in a businesscombination or purchased subsequent to the inception of a lease be amortizedover the lesser of the useful life of the assets or a term that includesrenewals that are reasonably assured at the date of the business combination orpurchase. The guidance is effective for interim periods beginning after June 29,2005. The Company adopted EITF 05-6 in July 2005 

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**2. SIGNIFICANTACCOUNTING POLICIES (Continued)**

andcurrently does not anticipate that it will have a significant effect on ourfinancial statements or disclosures.

**3. REVENUE RECOGNITION**

Historically, revenues from the Company’s distributorswere recognized upon shipment based on the following factors:  the Company’s sales prices are fixed ordeterminable by contract at the time of shipment, payment terms are fixed atshipment and are consistent with terms granted to other customers, thedistributors have full risk of physical loss, the distributors have separateeconomic substance, the Company has no obligation with respect to the resale ofthe distributors’ inventory, and the Company believed it could reasonablyestimate the potential returns from its distributors based on their history andits visibility to the distributors’ success with its products and into themarket place in general. The Company accrued for distributor right of returnbased on known events and historical trends in accordance with FinancialAccounting Standards Board (“FASB”) Statement No. 48 “Revenue RecognitionWhen Right of Return Exists,” and for price protection in accordance withEmerging Issues Task Force Issue No. 01-9, “Accounting forConsideration Given by a Vendor to a Customer (Including a Reseller of theVendor’s Products)”. Through the Company’s first quarter ended April 3,2005 the amount of those reserves had not been material. The Company accrued areserve based on its reasonable estimate of future returns based on historicaltrends and contractual limitations. Per contractual agreement, RichardsonElectronics LTD may return product three times per year under the followingconditions:  the total value of inventoryreturned shall not exceed an amount equal to 5% of the total value of thedistributor’s stock on hand of the Company’s products as reported in the priormonth’s inventory report, the inventory is returned no earlier than 6 monthsand no later than 24 months from the date of the original invoice date and theproduct’s packaging has not been opened or any alteration or modification hasbeen performed on the product. The contractual agreement with WAV Wireless Outfittersincluded identical terms though the total value of inventory returned could notexceed an amount equal to 15% of the total value of its stock on hand of theCompany’s products as reported in the prior month’s inventory report.

The Company has historically received stock rotationrequests from its distributors that were within the amounts estimated andcontractually allowed with the only exception being the stock rotation inFebruary, 2004 which was approximately $37,000 in excess of the amount contractuallyallowed. However, the request from its distributor for stock rotation withinthe Company’s second quarter ended July 3, 2005 was again higher than theamount contractually allowed by approximately $51,000. Management, with theconcurrence of the Company’s Audit Committee, believes the increasingpercentage of new products introduced by the Company makes it likely that stockrotation reserves will continue to be difficult to estimate based on historicalpatterns and contractual provisions. Based on this change in facts andcircumstances and management’s future expectations, the Company believes thatit can no longer reasonably estimate the amount of future returns from itsdistributors as of July 3, 2005. Accordingly, recognition of revenue andassociated cost of sales on shipments to distributors is deferred until theresale to the end customer. This change in application resulted in a $4.1million revenue deferral in the Company’s second quarter of 2005 which isreflected in the accompanying consolidated statements of operations for 2005.Although revenue is deferred until resale, title of products sold todistributors transfers upon shipment. Accordingly, shipments to distributorsare reflected in the consolidated balance sheets as accounts receivable and areduction of inventories at the time of shipment. Deferred revenue and 

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**3. REVENUERECOGNITION (Continued)**

the corresponding cost ofsales on shipments to distributors are reflected in the consolidated balancesheet on a net basis as “Deferred margin on distributor inventory.”

As this change in theapplication of the Company’s revenue recognition policy is the result of achange in current facts and circumstances, in accordance with AccountingPrinciples Board Opinion No. 20 “Accounting Changes” paragraph 8, theCompany accounted for the change within its second quarter ended July 3,2005.

**4. INVESTMENTS**

*Available-for-SaleInvestments*

Investments,which are classified as available-for-sale, are summarized below for December 31,2005 and 2004 (in thousands):

| ** **                | ** ** | ** **    | ** ** | ** **     | ** ** | ** **     | ** ** | ** **          | ** ** | **Classified on  Balance Sheet as:** | ** ** |
|---------------------------|------------|---------------|------------|----------------|------------|----------------|------------|---------------------|------------|-----------------------------------------------------|------------|
| ** **                | ** ** | **Purchase/** | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** **          | ** ** | **Cash**                                            | ** ** | ** ** | ** ** |
| ** **                | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Aggregate**       | ** ** | **and Cash**                                   | ** ** | **Short-term** | ** ** |
| ** **                | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Fair Value** | ** ** | **Equivalents**                                     | ** ** | **Investments** | ** ** |
| As of December 31,  2005  |       |          |       |           |       |           |       |                |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Corporate debt securities |       |          | $          | 16,069         |       |           |       | $                   | —     |                                                |       |   | $ | (9 | ) |   |   | $ | 16,060 |   |   |   | $ | 1,001 |   |   |   | $ | 15,059 |   |   |
| Money market funds        |       |          | 10,773     |           |       |           | —     |                |       |                                                | —     |   |   |   | 10,773 |   |   |   | 10,773 |   |   |   | — |   |   |
| U. S. government agency   |       |          | 999        |           |       |           | —     |                |       |                                                | (6         | ) |   |   | 993 |   |   |   | — |   |   |   | 993 |   |   |
| Total                     |       |          | $          | 27,841         |       |           |       | $                   | —     |                                                |       |   | $ | (15 | ) |   |   | $ | 27,826 |   |   |   | $ | 11,774 |   |   |   | $ | 16,052 |   |   |
| As of December 31, 2004   |       |          |       |           |       |           |       |                |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Corporate debt securities |       |          | $          | 28,504         |       |           |       | $                   | —     |                                                |       |   | $ | (19 | ) |   |   | $ | 28,485 |   |   |   | 10,759 |   |   |   | $ | 17,726 |   |   |
| Money market funds        |       |          | 12,742     |           |       |           | —     |                |       |                                                | —     |   |   |   | 12,742 |   |   |   | 12,742 |   |   |   | — |   |   |
| Other debt securities     |       |          | 1,007      |           |       |           | —     |                |       |                                                | (1         | ) |   |   | 1,006 |   |   |   | — |   |   |   | 1,006 |   |   |
| Total                     |       |          | $          | 42,253         |       |           |       | $                   | —     |                                                |       |   | $ | (20 | ) |   |   | $ | 42,233 |   |   |   | $ | 23,501 |   |   |   | $ | 18,732 |   |   |

 

As of December 31,2005 and 2004, $17.1 million and $29.5 million of fixed income securities hadcontractual maturities of six months or less, respectively. There were no fixedincome securities that had a contractual maturity beyond six months.

*Impairment ofInvestments*

The Company monitors its investment portfolio forimpairment on a periodic basis. In the event that the carrying value of aninvestment exceeds its fair value and the decline in value is determined to beother-than-temporary, an impairment charge is recorded and a new cost basis forthe investment is established. In order to determine whether a decline in valueis other-than-temporary, the Company evaluates, among other factors: theduration and extent to which the fair value has been less than the carryingvalue; the financial condition of and business outlook for the company,including key operational and cash flow metrics, current market conditions andfuture trends in the company’s industry; the company’s relative competitiveposition within the industry; and the Company’s intent and ability to retainthe investment for a period of time sufficient to allow for any anticipatedrecovery in fair value.

The duration of theunrealized losses on available-for-sale investments at December 31, 2005and December 31, 2004 did not exceed 12 months. Market values weredetermined for each individual security 

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**4. INVESTMENTS(Continued)**

in theinvestment portfolio. The decline in value of these investments is primarilyrelated to changes in interest rates. The Company does not believe that any ofthe unrealized losses represented an other-than-temporary impairment based onit evaluation of available evidence as of December 31, 2005.

*Risk Management*

TheCompany generally places its investments with high-credit-qualitycounterparties and, by policy, all financial instruments and counterpartiesmust maintain the following minimally acceptable credit ratings:  commercial deposits and corporate obligationsA2/A, commercial paper A-1/P-1, municipal notes MIG 1/S and P-1,municipal bonds AAA and asset back securities AAA. The Company, by policy, alsolimits the amount of credit exposure with any one financial institution orcommercial issuer. No significant concentration of credit risk existed at December 31,2005.

**5. ACQUISITION**

***EiC Acquisition***

On June 18, 2004, the Company completed itsacquisition of the wireless infrastructure business and associated assets fromEiC. The aggregate purchase price was $13.3 million which included payments ofcash of $10.0 million, the issuance of 737,000 shares of the Company’s commonstock valued at $2.5 million, acquisition costs of $1.2 million (including$700,000 paid to a related party for investment banking services in connectionwith the acquisition) and $152,000 registration statement related expensesreduced by a $576,000 benefit from the termination settlement of the associatedsupply agreement with EiC recognized during our quarter ended December 31,2004. In connection with the acquisition, $1.5 million in cash and 294,118 sharesof common stock were held in escrow as security against certain financialcontingencies. On March 30, 2005, the Company made a claim against theescrow account for unpaid invoices issued under the supply agreement. TheCompany received those funds on May 4, 2005. The uncontested amount wasreleased to EiC on April 5, 2005 per the escrow agreement and the residualbalance of the $1.5 million was released to EiC on May 4, 2005. The294,118 shares in the escrow account less any shares for any properly noticedunpaid or contested amounts will be distributed within five days after March 31,2006. On November 23, 2004 the Company filed a registration statementregistering for resale by the seller of up to 442,882 shares of the Company’scommon stock issued in the acquisition.

In addition to the closing consideration, EiC wasoriginally entitled to further consideration of up to $7.0 million and $7.0million in cash and shares of the Company’s common stock if certain revenue andgross margin targets were achieved by March 31, 2005 and March 31,2006, respectively. The Company has determined that the revenue and grossmargin targets were not met for the nine month period ending March 31,2005. EiC subsequently notified the Company that it disagrees with the Company’sconclusion that the revenue and gross margin targets were not met for the ninemonth period ending March 31, 2005. While the Company believes EiC’sassertions are without merit and has notified EiC of such, there can be noassurances as to the eventual outcome of this matter.

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**WJ COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**5. ACQUISITION (Continued)**

If the Company achieves certain revenue targets by March 31,2006, it will be obligated to pay EiC the remaining contingent consideration ofup to $7.0 million, ninety percent (90%) in its common stock and ten percent(10%) in cash. The number of shares of its common stock to be delivered is tobe determined by dividing the value in dollars of the portion payable in itscommon stock by the average closing price of its common stock, as quoted on theNASDAQ National Market, during the ten consecutive trading days ending onetrading day before the end of the period covered by the payment, provided,however, that in the event that the calculation of the average closing priceresults in a price per share for the first payment that would be less than$5.00 or for the second payment that would be less than $6.00, then theCompany, at its option, in its sole discretion, may elect to make the paymentpart or all in cash and the balance, if any, in shares of its common stock. IfEiC receives such consideration, the amounts will be recorded as an increase togoodwill. As of March 20, 2006 theCompany has not yet determined if the revenue targets were met for the yearending March 31, 2006. The Company will not be able to make itsdetermination until after it has completed its internal control proceduresafter its quarter end on April 2, 2006. The fair value of theCompany’s common stock was determined based on the average closing price pershare of the Company’s common stock over a 5-day period beginning twotrading days before and ending two trading days after the amended terms of theacquisition were agreed to and announced (June 21, 2004).

Theacquisition was accounted for using the purchase method of accounting inaccordance with SFAS No. 141, “Business Combinations” (“SFAS No. 141”),and accordingly the Company’s consolidated financial statements from June 18,2004 include the impact of the acquisition. The following table summarizes theallocation of the total purchase price of the EiC acquisition, as of the dateof the acquisition (in thousands):

| Property and  equipment              |   | $     | 1,124  |   |
|--------------------------------------|--------|-------|--------|--------|
| Inventory.                           |   | 2,038 |   |
| In-process  research and development |   | 8,500 |   |
| Developed  technology                |   | 200   |   |
| Goodwill                             |   | 1,405 |   |
| Total purchase price .               |   | $     | 13,267 |   |

 

The acquisition was accounted for as a purchasetransaction, and accordingly, the assets of EiC were recorded at theirestimated fair values at the date of the acquisition. With the exception of thegoodwill and acquired in-process research and development (“IPRD”), theidentified intangible assets will be amortized on a straight-line basis overtheir estimated useful lives, with a weighted average life of approximatelyfive years.

A portion of the purchase price, $8.7 million, wasallocated to developed and core technology and in-process research anddevelopment (“IPRD”). Developed and core technology and IPRD were identifiedand valued through extensive interviews, analysis of data provided by EiCCorporation concerning developmental products, their stage of development, thetime and resources needed to complete them, their expected income generatingability, target markets and associated risks. The income method was the primarytechnique utilized in valuing the developed and core technology and IPRD. Underthe income method, fair value reflects the present value of the projected cashflows that are expected to be generated by the products incorporating thecurrent technologies.

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**WJ COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**5. ACQUISITION(Continued)**

Developmental projects that reached technologicalfeasibility were classified as developed and core technology, and the $200,000value assigned to developed technology was capitalized to be amortized usingthe straight-line method over a weighted-average period of five years.Developmental projects that had not reached technological feasibility, and hadno future alternative uses were classified as IPRD. The $8.5 million valueallocated to projects that were identified as IPRD was charged to acquiredin-process research and development in 2004. The value assigned to IPRDcomprises the following projects: 12V heterojunction bipolar transistor (“HBT”)power amplifiers ($1.5 million) and 28V HBT high power amplifiers ($7.0million).

The nature of the efforts required to develop theacquired IPRD into commercially viable products principally relate to thecompletion of all planning, designing, prototyping, verification and testingactivities that are necessary to establish that the products can be produced tomeet their design specifications, including functions, features and technicalperformance requirements.

In valuing the IPRD, the Company considered, amongother factors, the importance of each project to the overall development plan,the projected incremental cash flows from the projects when completed and anyassociated risks. The projected incremental cash flows were discounted back totheir present value using an after-tax discount rate of 25%. This discount ratewas determined after consideration of the Company’s weighted average cost ofcapital and the weighted average return on assets. Associated risks include theinherent difficulties and uncertainties in completing each project and therebyachieving technological feasibility, anticipated levels of market acceptance andpenetration, market growth rates and risks related to the impact of potentialchanges in future target markets.

As part of theacquisition, the Company entered into a sublease with EiC Corporation for28,160 square feet of space at their facility in Fremont, California. Thissublease expired in December 2004 and converted into a month to monthlease thereafter. At the end of January 2005 the Company moved the waferfabrication facility from the Fremont location to its facility in Milpitas,California and ended this sublease.

***Telenexus Acquisition***

On January 28, 2005, the Company completed itsacquisition of Telenexus, Inc. (“Telenexus”). Pursuant to an Agreement andPlan of Merger, dated January 19, 2005, by and between the Company,WJ Newco, LLC (the “WJ Sub”), Telenexus and Richard J. Swanson,Wilfred K. Lau, David Fried, Kurt Christensen and Mark Sutton(collectively the “Shareholders”), Telenexus merged with and into the WJ Subeffective on January 29, 2005. The WJ Sub was the survivor in the mergerand is a wholly-owned subsidiary of the Company. Telenexus designs, develops,manufactures and markets radio frequency identification (“RFID”) readerproducts for a broad range of industries and markets. By virtue of the merger,the Company purchased through the WJ Sub all of the assets necessary for theconduct of the RFID business of Telenexus, consisting primarily of, andincluding, but not limited to RFID modules, baseband processing algorithmtechnology, applications software and realizations of several reader productdesigns. The consideration paid by the Company on the closing date inconnection with the merger consisted of cash in the amount of $3.0 million,which was paid out of the Company’s cash reserves on the closing date, and2,333,333 shares of the Company’s common stock valued at $8.2 million at theclosing date. Including acquisition costs of $230,000, the aggregate purchaseprice for the net assets of Telenexus totaled $11.4 million. Of the closingconsideration, cash in the amount of $500,000 and 333,333 shares of 

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**WJ COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**5. ACQUISITION(Continued)**

the Company’s common stockare being held in escrow with respect to any indemnification matter under themerger agreement. The outstanding cash balance of the escrow account less anyproperly noticed unpaid or contested amounts was to be distributed within twodays after October 28, 2005. The Company released the full amount of thecash balance of the escrow account on October 31, 2005. The 333,333 sharesin the escrow account less any shares for any properly noticed unpaid orcontested amounts will be distributed within five days after July 28,2006. The fair value of the Company’s common stock was determined based on theaverage closing price per share of the Company’s common stock over a 5-dayperiod beginning two trading days before and ending two trading days after theamended terms of the acquisition were agreed to and announced (January 31,2005). In addition to the closing consideration, the sellers may be entitled tofurther compensation of up to $2.5 million in cash and up to 833,333 shares ofthe Company’s common stock if the Company achieves certain revenue targets by July 28,2006. Any change in the fair value of the net assets of Telenexus or any additionalconsideration to the Shareholders will change the amount of the purchase priceallocable to goodwill. Two of the Shareholders, Richard J. Swanson and WilredK. Lau also entered into three-year employment agreements with the Company. Theacquisition was accounted for using the purchase method of accounting inaccordance with SFAS No. 141, “Business Combinations” (“SFAS No. 141”),and accordingly the Company’s consolidated financial statements from January 28,2005 include the impact of the acquisition.

Inaccordance with SFAS No. 141, the total purchase price was allocated tothe tangible and intangible assets acquired and liabilities assumed based upontheir respective estimated fair values at the acquisition date with the excesspurchase price allocated to goodwill. The Company determined that acquiringTelenexus, Inc. was a more cost effective means of developing the RFIDproducts and technology necessary to continue to enhance our RFID readerofferings to further capitalize on market opportunity than developing theproducts and technology internally. The acquisition also offers the Company theopportunity to shorten the time it takes to bring additional RFID readerproducts and technology to market. The valuation of the identifiable intangibleassets acquired reflects management’s estimates based on, among other factors,a valuation of the intangible assets prepared by an independent third party. Thefollowing table summarizes the allocation of the total purchase price of theTelenexus acquisition, as of the date of the acquisition (in thousands):

| Net tangible assets                  |   | $      | 579    |   |
|--------------------------------------|--------|--------|--------|--------|
| In-process research and  development |   | 3,400  |   |
| Amortizable intangible assets:       |   |   |   |
| Developed technology                 |   | 40     |   |
| Customer  relationships              |   | 900    |   |
| Trademarks and  trade names          |   | 700    |   |
| Non-competition  agreements          |   | 400    |   |
| Goodwill                             |   | 5,401  |   |
| Total purchase price                 |   | $      | 11,420 |   |

 

With the exception of the goodwill and IPRD, theidentified intangible assets consisting of existing technology, customerrelationships, trademarks and trade names and non-competition agreements willbe amortized on a straight-line basis over their estimated useful lives, with aweighted average life of approximately eight years. In accordance with SFAS No. 142,Goodwill and Other Intangible Assets 

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**5. ACQUISITION(Continued)**

(“SFAS No. 142”),goodwill of $5.5 million will not be amortized and will be tested forimpairment at least annually or whenever events or changes in circumstancesindicate that the carrying value may not be recoverable in accordance with theCompany’s policy on impairment analysis.

Prior to the acquisition, the Company and Telenexushad entered into an agreement to jointly design, develop and produce a PersonalComputer Memory Card International Association (“PCMCIA”) Type IIMulti-Protocol RFID reader. The Company has evaluated the effective settlementof this preexisting executory contract and the associated reacquired right tothe use of its technology in accordance with Emerging Issues Task Force (“EITF”)04-1 “Accounting for Preexisting Relationships between the Parties to aBusiness Combination.”  The Company hasdetermined that the effective settlement of the executory contract and theassociated reacquired right to use its technology was neither favorable orunfavorable as the agreement represented fair value when compared to similarmarket transactions and there were no stated settlement provisions in thecontract.

A portion of the purchase price, $3.4 million, wasallocated to developed and core technology and IPRD. Developed and coretechnology and IPRD were identified and valued through extensive interviews,analysis of data provided by Telenexus concerning developmental products, theirstage of development, the time and resources needed to complete them, theirexpected income generating ability, target markets and associated risks. Theincome method was the primary technique utilized in valuing the developed andcore technology and IPRD. Under the income method, fair value reflects thepresent value of the projected cash flows that are expected to be generated bythe products incorporating the current technologies.

Developmental projects that reached technologicalfeasibility were classified as developed and core technology, and the $40,000value assigned to developed technology was capitalized to be amortized usingthe straight-line method over a weighted-average period of fourteen months.Developmental projects that had not reached technological feasibility, and hadno future alternative uses were classified as IPRD. The $3.4 million valueallocated to projects that were identified as IPRD was charged to acquiredin-process research and development in the accompanying condensed consolidatedstatements of operations for the nine months ended October 2, 2005.  The value assigned to IPRD comprises thefollowing projects:  multi-protocolreaders ($1.3 million), Smart readers ($900,000) and Class 3 readers ($1.2million). The value of these projects was determined by estimating thediscounted net cash flows from the sale of the products resulting from thecompletion of the projects, reduced by the portion of the revenue attributableto developed technology and the percentage of completion of the project.

Products based on multi-protocol reader (“MPR”) technologyare capable of reading tags of different classes (e.g., Class 0, Class 0+,Class 1, and Gen 2 tags) with a single reader. The hardware realization ofthe MPR products is based on a hardware stack consisting of an interface board,a control board, a radio frequency (“RF”) board and an antenna. A modularconstruction technique is employed such that differing combinations of boardscan be used to produce different products. For example, the same antenna, RFboard, and control board can be used with one interface board to provide anEthernet connection to the host computer, or a different interface board toprovide a serial interface to the host. Similarly, different RF boards can beused to provide one, two or four antenna ports for reading tags without changingthe control board or interface board. This novel modular construction techniqueis a part of the MPR technology approach.

Smart reader technology is an extension of the MPRTechnology. This technology provides an operating system (e.g., Linux, Windows®CE) in the embedded microprocessor on the interface board. 

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**WJ COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**5. ACQUISITION(Continued)**

With the previous RFIDtechnologies, the host computer provided virtually every command to the reader.With Smart reader technology, the embedded controller can host middlewareapplications. These applications can take high-level commands from the host andthen provide most of the lower-level commands internal to the reader. Thusrelieving much of the command and processing burden from the host computer.

Class 3 tags are fundamentally different from theClass 0, 0+ and 1 tags in that they are battery assisted. This makes themmore powerful and capable, and provides longer read range, but at the expenseof battery life and cost. They are more appropriate for tracking higher-valueassets. The air-interface protocol is different for the Class 3 readersand tags, and to date is not standardized (as is the case for Class 0 and1 tags).

The nature of the efforts required to develop theacquired IPRD into commercially viable products principally relate to thecompletion of all planning, designing, prototyping, verification and testingactivities that are necessary to establish that the products can be produced tomeet their design specifications, including functions, features and technicalperformance requirements.

Invaluing the IPRD, the Company considered, among other factors, the importanceof each project to the overall development plan, the projected incremental cashflows from the projects when completed and any associated risks. The projectedincremental cash flows were discounted back to their present value using anafter-tax discount rate of 25%. This discount rate was determined afterconsideration of the Company’s weighted average cost of capital and theweighted average return on assets. Associated risks include the inherentdifficulties and uncertainties in completing each project and thereby achievingtechnological feasibility, anticipated levels of market acceptance andpenetration, market growth rates and risks related to the impact of potentialchanges in future target markets.

**6. GOODWILL AND INTANGIBLE ASSETS**

Inconnection with the acquisition of the wireless infrastructure business andassociated assets from EiC on June 18, 2004, the Company recorded $1.8million of goodwill. Adjustments to the EiC goodwill subsequent to the EiCacquisition date, resulted primarily from a $576,000 benefit from thetermination settlement of the associated supply agreement with EiC andpartially offset by $152,000 of additional registration statement relatedexpenses. In connection with the acquisition of Telenexus acquisition on January 28,2005, the Company recorded $5.5 million of goodwill. Adjustments to theTelenexus goodwill through December 2005, subsequent to the Telenexusacquisition date, resulted primarily from collection of a previouslyunrecognized pre-acquisition accounts receivable and finalization of directacquisition costs. This goodwill was based upon the values assigned to thetransactions at the time they were announced in accordance with SFAS No. 142,“Goodwill and Other Intangible Assets” (“SFAS No. 142”). The changes inthe carrying value of goodwill as of December 31, 2005 are as follows (inthousands):

| ** **                            | ** ** | **EiC** | ** ** | **Telenexus** | ** ** | **Total** | ** ** |
|---------------------------------------|------------|---------|------------|---------------|------------|-----------|------------|
| Balance as of  December 31, 2004 |       | $       | 1,368      |          |       | $         | —     |   |   | $ | 1,368 |   |
| Purchased  goodwill                   |       | —  |       |          | 5,464      |      |       | 5,464 |   |
| Adjustments to  goodwill              |       | 37      |       |          | (63        | )         |       | (26 | ) |
| Balance as of  December 31, 2005 |       | $       | 1,405      |          |       | $         | 5,401      |   |   | $ | 6,806 |   |

 

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**6. GOODWILLAND INTANGIBLE ASSETS (Continued)**

The Company periodically evaluates its goodwill inaccordance with SFAS No. 142 for indications of impairment whenever eventsor changes in circumstances indicate that the carrying value may not berecoverable. Factors the Company considers important that could trigger animpairment review include significant under-performance relative to historicalor projected future operating results, significant changes in the manner of theCompany’s use of the acquired assets or the strategy for the Company’s overallbusiness, or significant negative industry or economic trends. If thesecriteria indicate that the value of the goodwill may be impaired, an evaluationof the recoverability of the net carrying value is made. Irrespective of theaforementioned circumstances where impairment indicators are present, theCompany is required by SFAS No. 142 to test its goodwill for impairment atleast annually. The Company has chosen the end of its fiscal month of May asthe date of its annual impairment test.

In accordance with SFAS No. 142 paragraph 30, “Areporting unit is an operating segment or one level below an operating segment(referred to as a component). A component of an operating segment is areporting unit if the component constitutes a business for which discretefinancial information is available and segment management regularly reviews theoperating results of that component. However, two or more components of anoperating segment shall be aggregated and deemed a single reporting unit if thecomponents have similar economic characteristics. An operating segment shall bedeemed to be a reporting unit if all of its components are similar, if none ofits components is a reporting unit, or if it comprises only a single component.The relevant provisions of Statement 131 and related interpretive literatureshall be used to determine the reporting units of an entity.”  The Company’s Chief Operating Decision Maker(“CODM”) is the CEO. While the Company’s CODM monitors the sales of variousproducts, operations are managed and financial performance evaluated based uponthe sales and production of multiple products employing common manufacturingand research and development resources; sales and administrative support; andfacilities. This allows the Company to leverage its costs in an effort tomaximize return. The Company believes that any allocation of such sharedexpenses to various products would be impractical, arbitrary and currently doesnot make such allocations internally. As such, the Company considers itself asingle reporting unit.

The first step of the goodwill impairment test, usedto identify potential impairment, compares the fair value of a reporting unitwith its carrying amount, including goodwill. SFAS No. 142 paragraph 30states: “The fair value of an asset (or liability) is the amount at which thatasset (or liability) could be bought (or incurred) or sold (or settled) in acurrent transaction between willing parties, that is, other than in a forced orliquidation sale. Thus, the fair value of a reporting unit refers to the amountat which the unit as a whole could be bought or sold in a current transactionbetween willing parties. Quoted market prices in active markets are the bestevidence of fair value and shall be used as the basis for the measurement, ifavailable.”  As of June 3, 2005 (theclosest trading date prior to the end of the Company’s fiscal month of May) thefair value of the Company was $133.9 million based on a per (common) shareprice of $2.09 as reported on the NasdaqNM (ticker “WJCI”) and 64,066,380common shares outstanding. As of June 5, 2005 the Company’s carryingamount, including goodwill was $56.2 million. As the fair value of the Companyexceeds its carrying amount, the Company’s goodwill is considered not impaired.

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**WJ COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**6. GOODWILL AND INTANGIBLE ASSETS (Continued)**

Intangible assets are recorded at cost, lessaccumulated amortization. The following tables present details of the Company’spurchased intangible assets (in thousands):

As of December 31,2005:

| ** **                          | ** ** | **Useful** | ** ** | ** ** | ** ** | **Accumulated** | ** ** | ** **       | ** ** |
|-------------------------------------|------------|------------|------------|------------|------------|-----------------|------------|------------------|------------|
| **Description**                     | ** ** | ** ** | ** ** | **Life**   | ** ** | **Gross**       | ** ** | **Amortization** | ** ** | **Net** | ** ** |
| EiC acquisition                     |       |       |       |       |       |            |       |             |       |   |   |
| Purchased developed technology      |       | 5 years    |       | $          | 200        |            |       | $                | 60         |   |   | $ | 140 |   |
| Telenexus acquisition               |       |       |       |       |       |            |       |             |       |   |   |
| Purchased developed technology      |       | 1.2 years  |       | 40         |       |            | 32         |             |       | 8 |   |
| Customer relationships.             |       | 7 years    |       | 900        |       |            | 118        |             |       | 782 |   |
| Trademarks and trade names          |       | 12 years   |       | 700        |       |            | 54         |             |       | 646 |   |
| Non-competition agreements          |       | 4 years    |       | 400        |       |            | 92         |             |       | 308 |   |
| Total identified  intangible assets |       |       |       | $          | 2,240      |            |       | $                | 356        |   |   | $ | 1,884 |   |
|                                     |            |            |            |            |            |                 |            |                  |            |  |  |  |  |  |  |  |

 

As of December 31,2004:

| ** **                      | ** ** | **Useful** | ** ** | ** ** | ** ** | **Accumulated** | ** ** | ** **       | ** ** |
|---------------------------------|------------|------------|------------|------------|------------|-----------------|------------|------------------|------------|
| **Description**                 | ** ** | ** ** | ** ** | **Life**   | ** ** | **Gross**       | ** ** | **Amortization** | ** ** | **Net** | ** ** |
| EiC acquisition                 |       |       |       |       |       |            |       |             |       |   |   |   |   |
| Purchased  developed technology |       | 5 years    |       |       | $          | 200             |       |             |       | $ | 20 |   |   | $ | 180 |   |
|                                 |            |            |            |            |            |                 |            |                  |            |  |  |  |  |  |  |  |  |  |

 

Forthe year ended December 31, 2005, amortization of purchased intangible assetsincluded in cost of goods sold was approximately $72,000. For the year ended December 31,2005, amortization of purchased intangible assets included in operating expensewas approximately $264,000. For the year ended December 31, 2004,amortization of purchased intangible assets included in cost of goods sold wasapproximately $20,000. There was no amortization of purchased intangible assetsin 2003. Amortization is computed using the straight-line method over theestimated useful life of the intangible asset. The intangible assets related topurchased developed technology is amortized to cost of goods sold. Theintangible assets related to customer relationships, trademarks and trade namesand non-competition agreements with sales/engineering personnel are amortizedto operating expense. The Company expects that annual amortization of acquiredintangible assets to be as follows (in thousands):

| ** **         | ** ** | **EiC** | ** ** | **Telenexus** | ** ** | **Total** | ** ** |
|--------------------|------------|---------|------------|---------------|------------|-----------|------------|
| Fiscal year:       |       |    |       |          |       |      |       |   |   |
| 2006               |       | $       | 40         |          |       | $         | 295        |   |   | $ | 335 |   |
| 2007               |       | 40      |       |          | 287        |      |       | 327 |   |
| 2008               |       | 40      |       |          | 287        |      |       | 327 |   |
| 2009               |       | 20      |       |          | 195        |      |       | 215 |   |
| 2010               |       | —  |       |          | 187        |      |       | 187 |   |
| 2011 and beyond    |       | —  |       |          | 493        |      |       | 493 |   |
| Total amortization |       | $       | 140        |          |       | $         | 1,744      |   |   | $ | 1,884 |   |

 

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**WJ COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**7. UNAUDITED PRO FORMA RESULTS OF OPERATIONS**

Thefollowing unaudited pro forma consolidated financial data represents thecombined results of operations as if Telenexus’ business had been combined withthe Company at the beginning of the respective period. This pro forma financialdata includes the straight line amortization of intangibles over theirrespective estimated useful lives and excludes the write-off of IPRD of $3.4million (in thousands, except per share amounts):

| ** **                            | ** ** | **December 31,** | ** ** |
|---------------------------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Net sales                             |       | $                     | 31,675     |   | $ | 34,687 |   |
| Loss from  operations                 |       | $                     | (18,759    | ) | $ | (17,877 | ) |
| Net loss                              |       | $                     | (17,690    | ) | $ | (9,612 | ) |
| Basic and diluted  net loss per share |       | $                     | (0.27      | ) | $ | (0.15 | ) |
| Basic and diluted  average shares     |       | 64,335                |       | 62,731 |   |

 

The unaudited pro formaresults of operations is presented for illustrative purposes only and is notintended to represent what the Company’s results of operations would have beenif the acquisition had occurred on those dates or to project the Company’sresults of operations for any future period. Since the Company and Telenexuswere not under common control or management for any period presented prior tothe acquisition, the unaudited pro forma results of operations may not becomparable to, or indicative of, future performance. These results do notreflect any additional costs or cost savings resulting from the acquisition.

**8. BORROWING ARRANGEMENTS**

On December 27, 2005,the Company entered into the fourth amendment (the “Amendment”) to its Amendedand Restated Loan and Security Agreement between Comerica Bank and the Companydated September 23, 2003 and as amended June 13, 2005, July 12,2005 and September 28, 2005. The effective date of the Amendment is December 22,2005. Under the new terms, the revolving credit facility (“Revolving Facility”)provides for a maximum credit extension of $10.0 million, with a $5.0 millionsub-limit to support letters of credit, a $250,000 sub-limit for foreignexchange transactions and a $200,000 sub-limit for corporate credit cards. TheRevolving Facility matures on December 21, 2006. Interest rates onoutstanding borrowings are periodically adjusted based on certain financialratios and are initially set, at the Company’s option, at LIBOR plus 2.0% orPrime. The Revolving Facility requires the Company to maintain certainfinancial ratios and contains limitations on, among other things, the Company’sability to incur indebtedness, pay dividends and make acquisitions without thebank’s permission. The Revolving Facility is secured by substantially all ofthe Company’s assets. The Company was in compliance with the covenants as of December 31,2005. As of December 31, 2005 and December 31, 2004, there were nooutstanding borrowings under the Revolving Facility. The Company has letters ofcredit of $3.2 million available as of December 31, 2005 against which noamounts have been drawn.

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**WJ COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**9. OTHER LONG-TERM OBLIGATIONS**

Long-termobligations, excluding amounts due within one year, consist of the following(in thousands):

| ** **                                | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Environmental  remediation (Note 12) |       | $                     | 60         |   | $ | 69 |   |
| Restructuring accrual  (Note 14)     |       | 13,390                |       | 16,069 |   |
| Deferred rent and  deposits               |       | 596                   |       | 726 |   |
| Long-term  advances and deposits          |       | 29                    |       | — |   |
| Total                                     |       | $                     | 14,075     |   | $ | 16,864 |   |

 

**10. STOCKHOLDERS’ EQUITY**

On January 28, 2004, the Company completed asecondary underwritten public offering of 2,000,000 shares of common stock at$5.75 per share, resulting in net proceeds of $10.1 million.

In March 2003, the Company’s Board of Directors(the “Board”) authorized the repurchase of up to $2.0 million of the Company’scommon stock. In October 2003, the Board approved an additional $2.0million to expand this existing share repurchase program increasing the totalamount authorized to $4.0 million. Purchases under this stock repurchaseprogram were made in the open market, through block trades or otherwise.Depending on market conditions and other factors, these purchases werecommenced or suspended at any time or from time-to-time without prior notice.During the year ended December 31, 2003, $2.8 million was utilized topurchase 1,340,719 shares of the Company’s common stock at a weighted averagepurchase price of $2.08 per share. All of the purchases were made on the NasdaqNational Market at prevailing open market prices using general corporate funds.This stock repurchase program ended as of the annual shareholder meeting on July 22,2004. On July 27,2004 the Company announced that its Board of Directors authorized a newrepurchase program of up to $2.0 million of the Company’s common stock. Thisnew program was effective July 27, 2004 and replaced all previousrepurchase programs. Under this new program, $920,000 was utilized topurchase 429,053 shares of the Company’s common stock at a weighted averagepurchase price of $2.12 per share. This program expired on July 26, 2005. Therepurchases reduced the Company’s cash and interest income during the periodand correspondingly reduced the number of the Company’s outstanding shares ofcommon stock.

During the year ended December 31, 2004, theCompany modified two option agreements (to extend the option exercise period)resulting in $594,000 of severance expense which was recorded as selling andadministrative expense in the accompanying consolidated statements ofoperations for the year ended December 31, 2004 and an increase toadditional paid-in capital in the accompanying consolidated balance sheet at December 31,2004.

**STOCK OPTION PLANS—During******2000, the Company’s “2000 Stock Incentive Plan” and “2000Non-Employee Director Stock Compensation Plan” (collectively the “Plans”) wereadopted and approved by the Board and the Company’s stockholders. Under thePlans, the Company may grant incentive awards in the form of options topurchase shares of the Company’s common stock, restricted shares, common stockand stock appreciation rights to participants, which include non-employee directors,officers and employees of and consultants to the Company and its affiliates. OnMay 22, 2002, the Board approved the 

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**10. STOCKHOLDERS’EQUITY (Continued)**

adoption of an amendmentto the Company’s “2000 Stock Incentive Plan” to increase the number of sharesof common stock authorized for issuance from 16,500,000 to 19,000,000 shares.This plan amendment did not affect any other terms of the “2000 Stock IncentivePlan.” On May 29, 2003, the Board approved the adoption of an amendment tothe Company’s “2000 Non-Employee Director Compensation Plan” to increase thenumber of shares of common stock authorized for issuance from 570,000 to800,000, which was approved by the Company’s stockholders on July 15, 2003at the Company’s Annual Meeting of Stockholders. Also on May 29, 2003, theBoard approved the adoption of a second amendment to the Company’s “2000 StockIncentive Plan” so that options granted to employees under the “2000 StockIncentive Plan” will qualify as performance-based compensation under InternalRevenue Code Section 162(m) and thereby not be subject to a deductionlimitation. Particularly, the amendment to the “2000 Stock Incentive Plan”provides that no employee or prospective employee shall be granted one or moreoptions within any fiscal year which in the aggregate are for the purchase ofmore than 3,000,000 shares. The total number of shares of common stockauthorized for issuance pursuant to the Plans is 19,800,000 shares.

On May 23, 2001, the Company’s 2001 EmployeeStock Incentive Plan (the “Plan”) was adopted and approved by the Board and theCompany’s stockholders. The Plan may grant incentive awards in the form ofoptions to purchase shares of the Company’s common stock, restricted shares,common stock and stock appreciation rights to participants, which includeemployees which are not officers and directors of the Company and itsaffiliates and consultants to the Company and its affiliates. The total numberof shares of common stock reserved and available for grant under the Plan is2,000,000 shares. Shares subject to award under the Plan may be authorized andunissued shares or may be treasury shares. Stock options may include incentivestock options, nonqualified stock options or both, in each case, with orwithout stock appreciation rights.

The Company’s stock option plans (“Plans”) providethat options granted under the Plans will have a term of no more than 10 years.Options granted under the Plans have vesting periods ranging from two to fouryears. The provisions of the Plans provide that under certain circumstances,such as a change in control, the achievement of certain performance objectives,or certain liquidity events, the outstanding option may be subject toaccelerated vesting. As of December 31, 2005 the number of sharesavailable for future grants under the above plans was 5,734,342. Stock optionsmay include incentive stock options, nonqualified stock options or both, ineach case, with or without stock appreciation rights.

Activityunder the stock option plans during 2005, 2004 and 2003 are set forth below:

| ** **                                                 | ** ** | ** ** | ** ** | **Weighted Average** | ** ** |
|------------------------------------------------------------|------------|------------|------------|---------------------------|------------|
| ** **                                                 | ** ** | **Shares** | ** ** | **Exercise Price**   | ** ** |
| **2003**                                                   |       |       |       |                      |       |   |   |
| Granted (weighted  average fair value of $2.02 per option) |       | 1,470,000  |       |                      | $          | 2.93 |   |   |
| Exercised                                                  |       | (2,534,724 | )          |                      | $          | 1.37 |   |   |
| Cancelled                                                  |       | (1,771,901 | )          |                      | $          | 1.50 |   |   |
| At December 31:                                       |       |       |       |                      |       |   |   |
| Outstanding                                                |       | 12,428,034 |       |                      | $          | 1.88 |   |   |
| Exercisable                                                |       | 5,076,882  |       |                      | $          | 1.66 |   |   |

 

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**10. STOCKHOLDERS’EQUITY (Continued)**

| ** **                                                 | ** ** | ** ** | ** ** | **Weighted Average** | ** ** |
|------------------------------------------------------------|------------|------------|------------|---------------------------|------------|
| ** **                                                 | ** ** | **Shares** | ** ** | **Exercise Price**   | ** ** |
| **2004**                                                   |       |       |       |                      |       |   |   |
| Granted (weighted  average fair value of $2.19 per option) |       | 3,046,500  |       |                      | $          | 3.27 |   |   |
| Exercised                                                  |       | (934,107   | )          |                      | $          | 1.27 |   |   |
| Cancelled                                                  |       | (813,031   | )          |                      | $          | 0.98 |   |   |
| At December 31:                                       |       |       |       |                      |       |   |   |
| Outstanding                                                |       | 13,727,396 |       |                      | $          | 2.26 |   |   |
| Exercisable                                                |       | 6,389,431  |       |                      | $          | 2.03 |   |   |

 

| ** **                                                 | ** ** | ** ** | ** ** | **Weighted Average** | ** ** |
|------------------------------------------------------------|------------|------------|------------|---------------------------|------------|
| ** **                                                 | ** ** | **Shares** | ** ** | **Exercise Price**   | ** ** |
| **2005**                                                   |       |       |       |                      |       |   |   |
| Granted (weighted  average fair value of $0.87 per option) |       | 1,728,000  |       |                      | $          | 1.43 |   |   |
| Exercised                                                  |       | (1,377,960 | )          |                      | $          | 1.06 |   |   |
| Cancelled                                                  |       | (4,710,677 | )          |                      | $          | 3.08 |   |   |
| At December 31:                                       |       |       |       |                      |       |   |   |
| Outstanding                                                |       | 9,366,759  |       |                      | $          | 1.87 |   |   |
| Exercisable                                                |       | 5,225,843  |       |                      | $          | 2.02 |   |   |

 

The following tablesummarizes information concerning currently outstanding and exercisable optionsat December 31, 2005:

| ** **                                 | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|--------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                 | ** ** | ** **                   | ** ** | **Weighted**                 | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                 | ** ** | ** **                   | ** ** | **Average Years**       | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                 | ** ** | **Number**                   | ** ** | **of Remaining**        | ** ** | **Average** | ** ** | **Number** | ** ** | **Exercise** | ** ** |
| **Range of Exercise Price** | ** ** | ** **                   | ** ** | **Outstanding**              | ** ** | **Contractual Life** | ** ** | **Exercise Price** | ** ** | **Exercisable** | ** ** | **Price** | ** ** |
| $0.01 to $0.01                             |       |                         | 40,945     |                         |       |   | 2.5 |   |   |   | $ | 0.01 |   |   | 30,135 |   |   | $ | 0.01 |   |   |
| $0.80 to $1.14                             |       |                         | 872,024    |                         |       |   | 8.7 |   |   |   | $ | 0.92 |   |   | 111,524 |   |   | $ | 0.81 |   |   |
| $1.37 to $1.91                             |       |                         | 5,565,840  |                         |       |   | 4.7 |   |   |   | $ | 1.39 |   |   | 3,198,654 |   |   | $ | 1.37 |   |   |
| $2.09 to $2.96                             |       |                         | 2,182,400  |                         |       |   | 3.3 |   |   |   | $ | 2.68 |   |   | 1,641,950 |   |   | $ | 2.83 |   |   |
| $3.19 to $4.25                             |       |                         | 611,500    |                         |       |   | 8.3 |   |   |   | $ | 3.43 |   |   | 167,875 |   |   | $ | 3.49 |   |   |
| $5.48 to $6.67                             |       |                         | 17,000     |                         |       |   | 7.0 |   |   |   | $ | 5.89 |   |   | 6,575 |   |   | $ | 6.07 |   |   |
| $9.75 to $12.94                            |       |                         | 63,500     |                         |       |   | 1.3 |   |   |   | $ | 10.00 |   |   | 61,000 |   |   | $ | 9.88 |   |   |
| $15.00 to $15.00                           |       |                         | 750        |                         |       |   | 4.6 |   |   |   | $ | 15.00 |   |   | 450 |   |   | $ | 15.00 |   |   |
| $26.75 to $26.75                           |       |                         | 12,800     |                         |       |   | 4.8 |   |   |   | $ | 26.75 |   |   | 7,680 |   |   | $ | 26.75 |   |   |
| $0.01 to $26.75                            |       |                         | 9,366,759  |                         |       |   | 5.0 |   |   |   | $ | 1.87 |   |   | 5,225,843 |   |   | $ | 2.02 |   |   |
|                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

EMPLOYEE STOCK PURCHASEPLAN (“ESPP”)—In May 2001, the Company’s stockholders approved theadoption of the Company’s 2001 Employee Stock Purchase Plan (the “Purchase Plan”).Up to 1,500,000 shares of Common Stock may be issued under the Purchase Plan.Under the plan, all eligible employees may purchase shares of the Company’scommon stock at six-month intervals at 85% of fair market value (calculated inthe manner provided under the plan). Employees purchase such stock usingpayroll deductions, which may not exceed 15% of their total cash compensation.In fiscal 2005, 142,453 shares and 267,417 shares were issued under this planat an average price of $1.99 and $1.11 for the plans 

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**10. STOCKHOLDERS’EQUITY (Continued)**

ended April 2005and October 2005, respectively. In fiscal 2004, 54,912 shares and 103,689shares were issued under this plan at an average price of $3.25 and $1.97 forthe plans ended April 2004 and October 2004, respectively. The planwas suspended in the fourth quarter of 2002 due to the Fox Paine AcquisitionProposal (see Note 18) and was not reinstated until the fourth quarter of2003, therefore there were no shares issued under the Employee Stock PurchasePlan in 2003. At December 31, 2005, 546,574 shares were available forfuture issuance under the plan.

**11. INCOME TAXES**

Thebenefit from federal and state income taxes is as follows. Foreign income(loss) before income taxes was insignificant for all years.

| ** **     | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **     | ** ** | **(in thousands)** | ** ** |
| Current:       |       |                    |       |     |       |     |       |
| Federal        |       | $                       | (123       | )        | $          | (7,674   | )          | $ | (167 | ) |
| State          |       | 3                       |       | —   |       | (480     | )          |
| Total current  |       | (120                    | )          | (7,674   | )          | (647     | )          |
| Deferred:      |       |                    |       |     |       |     |       |
| Federal        |       | —                  |       | —   |       | —   |       |
| State          |       | —                  |       | —   |       | —   |       |
| Total deferred |       | —                  |       | —   |       | —   |       |
| Total          |       | $                       | (120       | )        | $          | (7,674   | )          | $ | (647 | ) |

 

In 2005, The Company recorded a net tax benefit of$120,000 as the statute had expired on certain estimated federal tax exposuresduring the current year. The tax benefit for 2004 of $7.7 million resulted froma revision of the Company’s estimated income tax contingency liability due tothe receipt of the final assessment from the Internal Revenue Service relatedto the audit of the Company’s 1996 through 2000 tax returns. In 2003, theCompany recorded a tax benefit of $647,000 related to an income tax refund of$480,000 from the State of Maryland as the result of amending the Company’s1999 state tax return and an adjustment to the tax contingency liability of$167,000 for additional federal income tax refund determined after finalizingthe 2002 carryback claim filed in the first quarter of 2003 and miscellaneoustax payments.

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**11. INCOME TAXES (Continued)**

Thedifferences between the effective income tax rate as applied to loss fromoperations and the statutory federal income tax rate are as follows:

| ** **                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Statutory federal tax rate              |       | (35.0    | )%         | (35.0    | )%         | (35.0    | )%         |
| Foreign sales benefit                   |       | —   |       | —   |       | (2.3     | )          |
| Research and development credit         |       | (3.0     | )          | (3.1     | )          | (3.2     | )          |
| State taxes, net of federal tax benefit |       | (5.7     | )          | (5.7     | )          | (5.7     | )          |
| In-process research and development     |       | 6.6      |       | —   |       | —   |       |
| Expired foreign tax credit              |       | 2.1      |       | —   |       | —   |       |
| Other                                   |       | 1.6      |       | 0.3      |       | (2.0     | )          |
| Tax reserve no longer required          |       | (0.6     | )          | (45.8    | )          | —   |       |
| Change in valuation allowance           |       | 33.4     |       | 43.5     |       | 43.7     |       |
| Effective tax  rate                     |       | (0.6     | )%         | (45.8    | )%         | (4.5     | )%         |

 

Deferredtax assets are recognized when management believes realization of future tax benefitsof temporary differences is more likely than not. In estimating future taxconsequences, all expected future events are considered (including availablecarryback claims), other than enactment of changes in the tax law or rates.Valuation allowances are established for those deferred tax assets wheremanagement believes it is not more likely than not such assets will berealized. Deferred tax amounts are comprised of the following at December 31(in thousands):

| ** **                        | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|
| Net operating loss                |       | $        | 19,304     |     | $          | 14,498 |   |
| Restructuring accrual             |       | 6,835    |       | 7,913    |       |
| Depreciation and amortization     |       | 12,998   |       | 11,257   |       |
| Accounts receivable valuation     |       | 38       |       | 32       |       |
| Inventory valuation               |       | 2,394    |       | 996      |       |
| Tax credits                       |       | 8,158    |       | 8,631    |       |
| Employee benefit related accruals |       | 477      |       | 492      |       |
| Other                             |       | 398      |       | 290      |       |
| Total deferred tax assets         |       | 50,602   |       | 44,109   |       |
| Valuation  allowance              |       | (50,602  | )          | (44,109  | )          |
| Total deferred tax assets         |       | $        | —     |     | $          | — |   |
| Income tax  contingency liability |       | $        | 1,818      |     | $          | 1,946 |   |

 

As of December 31, 2005, the Company had$1,709,000 in federal minimum tax credit carryforwards which are availableindefinitely. The Company also had R&D tax credit carryforwards of$4,873,000 which begin to expire in 2012. Additionally, the Company had statetax credit carryforwards of $2,424,000 of which $583,000 begin to expire in2009 and $1,841,000 are available indefinitely.

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**11. INCOMETAXES (Continued)**

At December 31, 2005 the Company had $47,594,000of federal net operating loss carryforwards which will expire beginning in2023. The Company also had state net operating loss carryforwards of$46,042,000 which begin to expire in 2013.

Current federal and statetax laws include substantial restrictions on the utilization of net operatinglosses and tax credits in the event of an “ownership change” of a corporation.Accordingly, the Company’s ability to utilize net operating loss and tax creditcarryforwards may be limited as a result of such an ownership change. Such alimitation could result in the expiration of carry forwards before they areutilized.

**12. COMMITMENTS ANDCONTINGENCIES**

***Commitments***

The Company leases its corporate headquarters andmanufacturing facilities under various non-cancelable operating leases expiringthrough January, 2011. See Note 14 for a discussion of restructuring chargesrecorded related to these leases.

Minimumlease commitments as of December 31, 2005 under noncancellable leases areas follows (in thousands):

| ** **      | ** ** | **Operating  Leases** | ** ** |
|-----------------|------------|-----------------------|------------|
| Lease payments: |       |                  |       |   |   |
| 2006            |       |                  | $          | 4,589 |   |   |
| 2007            |       |                  | 4,261      |   |   |
| 2008            |       |                  | 4,417      |   |   |
| 2009            |       |                  | 4,442      |   |   |
| 2010            |       |                  | 3,117      |   |   |
| Remaining years |       |                  | 142        |   |   |
| Total           |       |                  | $          | 20,968 |   |   |

 

Rent expense in 2005, 2004 and 2003 was $3.1 million,$3.2 million and $3.1 million, respectively.

The Company subleases to third parties approximately31,800 square feet of its abandoned leased space under noncancellable operatingleases expiring through January, 2008. This sublease income is incorporated inthe restructuring charges related to our lease loss accruals.

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**12. COMMITMENTS ANDCONTINGENCIES (Continued)**

Minimumsublease income commitments as of December 31, 2005 under noncancellableleases are as follows (in thousands):

| ** **               | ** ** | **Operating  Leases** | ** ** |
|--------------------------|------------|-----------------------|------------|
| Sublease rental  income: |       |                  |       |   |   |
| 2006                     |       |                  | $          | 365 |   |   |
| 2007                     |       |                  | 218        |   |   |
| 2008                     |       |                  | 15         |   |   |
| 2009                     |       |                  | —     |   |   |
| 2010                     |       |                  | —     |   |   |
| Remaining years          |       |                  | —     |   |   |
| Total                    |       |                  | $          | 598 |   |   |

 

Sublease rental incomeearned in 2005, 2004 and 2003 was $424,000 $759,000 and $965,000, respectively.

***Environmental Remediation***

Our current operations are subject to federal, stateand local laws and regulations governing the use, storage, disposal of andexposure to hazardous materials, the release of pollutants into the environmentand the remediation of contamination.  The Company has an accrued liability of$66,000 as of December 31, 2005 to offset estimated program oversight,remediation actions and  record retentioncosts. In 2005 the accrued liability was reduced by $100,000 when it wasdetermined that the probability of an assessment for a prior violation wasremote. Expenditures charged against the provision totaled $9,000, $14,000 and$11,000 in 2005, 2004 and 2003, respectively.

The Company continues to be in compliance with theremedial action plans being monitored by various regulatory agencies at itsformer Palo Alto and Scotts Valley sites. The Company has entered into fundedfixed price remediation contracts and obtained cost-overrun and unknownpollution conditions insurance coverage. The Company believes that it is remotethat it would incur any liability beyond which it has recorded. The Companydoes ultimately retain responsibility for these environmental liabilities andin the unlikely event that the environmental firm and the insurance company donot meet their obligations.

With respect to ourremaining current or former production facilities, to date either nocontamination of significance has been identified or reported to us or theregulatory agency involved has granted closure with respect to the identifiedcontamination. Nevertheless, we may face environmental liabilities related tothese sites in the future.

***Indemnification***

As part of the Company’s normal ongoing businessoperations and consistent with industry practice, the Company enters intonumerous agreements with other parties, which apportion future risks among theparties to the transaction or relationship governed by the agreements. Onemethod of apportioning risk is 

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**12. COMMITMENTSAND CONTINGENCIES (Continued)**

the inclusion ofprovisions requiring one party to indemnify the other against losses that mightotherwise be incurred by the other party in the future. Many of the Company’sagreements contain an indemnity or indemnities that require us to performcertain acts, such as remediation, as a result of the occurrence of atriggering event or condition. The Company is a party to a variety ofagreements pursuant to which it may be obligated to indemnify the other partywith respect to certain matters. Typically, these obligations arise in thecontext of contracts entered into by the Company, under which the Companycustomarily agrees to hold the other party harmless against losses arising froma breach of representations and covenants related to such matters as title toassets sold, certain IP rights, specified environmental matters, and certainincome taxes. In each of these circumstances, payment by the Company isconditioned on the other party making a claim pursuant to the proceduresspecified in the particular contract, which procedures typically allow theCompany to challenge the other party’s claims. Further, the Company’sobligations under these agreements may be limited in terms of time and/oramount, and in some instances, the Company may have recourse against thirdparties for certain payments made by the Company.

The nature of these numerous indemnity obligations arediverse and each has different terms, business purposes, and triggering eventsor conditions. Consistent with customary business practice, any particularindemnity obligation incurred is the result of a negotiated transaction orcontractual relationship for which we have accepted a certain level of risk inreturn for a financial or other type of benefit. In addition, the indemnitiesin each agreement vary widely in their definitions of both triggering eventsand the resulting obligations contingent on those triggering events. It is notpossible to predict the maximum potential amount of future payments under theseor similar agreements due to the conditional nature of the Company’s obligationsand the unique facts and circumstances involved in each particular agreement.Historically, payments made by the Company under these agreements have not hada material effect on the Company’s business, financial condition or results ofoperations and the Company is unable to estimate the maximum potential impactof these indemnification provisions on its future results of operations.

As permitted underDelaware law, the Company has agreements whereby we indemnify our officers anddirectors for certain events or occurrences while the officer or director is,or was serving, at our request in such capacity. The indemnification periodcovers all pertinent events and occurrences during the officer’s or director’slifetime. The maximum potential amount of future payments the Company could berequired to make under these indemnification agreements is unlimited; however,the Company has director and officer insurance coverage that reduces itsexposure and enables it to recover a portion of any future amounts paid. TheCompany believes the estimated fair value of these indemnification agreementsin excess of applicable insurance coverage is minimal.

***Other Contingencies***

In addition to the abovematters, the Company is involved in various legal actions which arose in theordinary course of its business activities. Management does not currentlybelieve that the final resolution of these matters will ultimately have amaterial impact on the Company’s results of operations or financial position.

**13. EMPLOYEE BENEFIT PLANS**

The Company has anEmployees’ Investment 401(k) Plan that covers substantially all employeesand provides that the Company match employees’ salary deferrals up to 3% ofeligible employee 

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**13. EMPLOYEEBENEFIT PLANS (Continued)**

compensation.The amounts charged to operations were $414,000, $391,000 and $359,000 in 2005,2004 and 2003, respectively.

**14. RESTRUCTURING CHARGES**

**FourthQuarter 2002 Restructuring Plan**

Over the course of 2002, the Company began to designand manufacture semiconductors utilizing additional manufacturing technologiesat external wafer fabrication foundries. The Company believed that thisapproach was required in order to continue to offer competitive products andexpected that a greater number of its future products would be developed inthis fashion. The Company at that time believed that this business strategyoffered considerable other advantages such as allowing it to focus itsresources on product development and marketing, minimizing capitalexpenditures, reducing operating expenses, allowing it to continue to offercompetitive pricing, reducing time to market, reducing technology and productrisks and facilitating the migration of the Company’s products to new processtechnologies, which reduce costs and optimize performance. On December 17,2002, the Company’s Board of Directors approved a plan to completely outsourcethe Company’s internal wafer fabrication within one year and close its ownwafer fabrication facility (the “fab closure”), which original plan wassubsequently modified in 2003 and 2004 as described below.

*LeaseLoss—**The* fab closure would have resultedin additional excess space of approximately 35,000 square feet for which theCompany would have had a remaining two year commitment after the anticipatedfab closure. The original decision resulted in a lease loss of $4.3 million,comprised of future lease payments net of broker commissions and other facilitycosts. In determining this estimate, the Company made certain assumptions withregards to its ability to sublease the space in line with the Company’s bestestimate of current market conditions.

During the fourth quarter of 2003 the Company decidedthat additional time would be needed to effect the complete outsourcing of itsinternal wafer fabrication due to an unplanned increase in near-term productdemand and additional qualification procedures associated with outsourced waferfabrication. The Company planned to continue to operate its fab through April 2004.As such, the additional four months of rent and facility costs would beincurred as an operating expense resulting in an approximate $364,000 reductionin the lease loss accrual.

During the second quarter of 2004, the Company delayedthe closure of its internal wafer fabrication facility (“fab”) for a minimum ofthree additional months to assess the integration of the EiC acquisition (seeNote 5) into its existing operations which resulted in a $430,000 reduction inits lease loss accrual. During the third quarter of 2004, the Company decidednot to close its fab as the Company believed that integrating the newlyacquired fab from EiC with its pre-existing fab will offer the Company certainbenefits over outsourcing the pre-existing fab. As such, the Company reversedthe remainder of this lease loss accrual of $3.6 million in the second quarterof 2004. The Company continues to evaluate the use of outside wafer fabricationfacilities and potential benefits from outsourcing where practicable under thecircumstances.

*Workforcereduction—**As*a result of the originallyplanned fab closure, approximately 10% of the Company’s workforce (20employees) would have been eliminated, which would have resulted in severancepayments of $279,000 during 2004. The Company ultimately paid out $194,000 ofthe accrued severance to 

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**14. RESTRUCTURINGCHARGES (Continued)**

terminated employees. Theremaining accrual of $85,000 was reversed upon the Company’s decision not toclose the fab.

*Impairment of Long LivedAssets—Assets to be held and used—**The* original 2002decision to utilize the Company’s internal wafer fabrication equipment andrelated leasehold improvements for only one more year triggered an impairmentunder SFAS No. 144. Management measured the recoverability of these assetsthrough a comparison of the carrying amount of these assets to futureundiscounted cash flows expected to be generated by these assets over theirremaining year of life. As such, the carrying value of these assets werewritten down to the estimated future cash flows that are directly associatedwith and that were expected to arise as a direct result of the use and eventualdisposition of these assets. Management estimated the future cash flows using atraditional present value approach based on management’s assumptions regardingthe intended use of these assets consistent with the Company’s budget andprojections as well as the planned eventual disposition of the asset groupthrough sale. Management estimated the disposition value of these assets afterconsideration of several factors including the condition and management’sintended use of the equipment, offers made for similar equipment the Companyintended to sell and the results of an independent third party appraisal. Managementemployed a risk-free interest rate commensurate with the Company’s size,capital structure and stock volatility in relation to the overall market. Thisaction resulted in a $4.2 million asset impairment charge in 2002.

**ThirdQuarter 2002 Restructuring Plan**

As a result of the prolonged downturn in thetelecommunications industry and the uncertainty as to when thetelecommunications equipment market will recover, in July 2002 the Companyannounced a workforce reduction and its second restructuring program in theprevious two years.

*Workforcereduction—**Approximately***22%of the Company’s workforce (50 employees) was eliminated, which resulted inseverance payments of $507,000 during the third quarter of 2002.

During the first quarter of 2003, it was determinedthat one of the employees slated to be terminated would instead be retained foranother position. As such, $21,000 of the third quarter 2002 restructuringcharge was reversed in 2003.

*LeaseLoss—**In*the third quarter of 2002, theCompany decided to abandon a portion of its leased facility based on revisedanticipated demand for its products and current market conditions. This excessspace, for which the Company had a remaining eight year commitment, is locatedon the first floor of the Company’s current corporate headquarters andoriginally housed a portion of the Company’s optics and integrated assembliesmanufacturing operations. This decision resulted in a lease loss of $10.6million, comprised of future lease payments net of anticipated sublease income,broker commissions and other facility costs, and an asset impairment charge of$3.2 million for tenant improvements deemed no longer realizable. Indetermining this estimate, the Company made certain assumptions with regards toits ability to sublease the space and reflected offsetting assumed subleaseincome in line with the Company’s best estimate of current market conditions.

During the fourth quarter of 2002, based on acontinuing deterioration in the real estate market and difficulties subleasingits available space, the Company revised its assumptions regarding subleaseoccupancy rates and market rates downward resulting in an additional lease lossof $674,000.

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**WJ COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**14. RESTRUCTURINGCHARGES (Continued)**

During the fourth quarter of 2003, after reviewingcurrent information regarding continuing deterioration in the real estatemarket, difficulties subleasing its available space and facility costs, theCompany revised its lease loss assumptions. $23,000 of the lease loss wasreversed as reduced facility costs (mainly property taxes and utilities) werelargely offset by reductions in estimated sublease occupancy and market rates.

During the third quarter of 2004, after reviewingcurrent information regarding reduced facility operating costs (predominantlybuilding maintenance costs), the Company revised its lease loss assumptionsresulting in a reversal of $377,000 of the lease loss.

As of December 31,2005, the maximum potential amount of the lease loss for this property is $7.1million.

*Impairment of LongLived Assets:*

*Assetsheld for sale—**Due*to the prolonged downturn inthe telecommunications industry, especially related to the Company’s fiberoptics products, management made a decision during the third quarter of 2002 toexit the fiber optics business after current contractual obligations have beensatisfied. This decision resulted in a significant overcapacity of certainmanufacturing equipment and the Company initiated a plan to sell this equipment.The Company’s excess capacity resulted in a total charge of $3.9 millionrelated to these assets. Assets to be held for sale were measured at the lowerof carrying amount or fair value less cost to sell. Management determined fairmarket value after consideration of several factors including the condition ofthe equipment, offers made by potential buyers of the equipment and the resultsof an independent third party appraisal. The majority of these impaired assetswere sold in the fourth quarter of 2002.

During the fourth quarter of 2003, managementdetermined that the remaining assets held for sale could not be sold. As such,the assets were scrapped resulting in an additional charge of $151,000.

*Assets to be held and used—**During*the thirdquarter of 2002, management identified manufacturing equipment exclusivelysupporting certain in-warranty optics and fixed wireless products as well asmanufacturing equipment supporting final orders for certain other optics andfixed wireless products and determined that the estimated future undiscountedcash flows did not support the carrying value of these assets. As such, thecarrying value of these assets was written down to the estimated future cashflows that are directly associated with and that are expected to arise as adirect result of the use and eventual disposition of these assets, whichmanagement determined after consideration of several factors including thecondition and management’s intended use of the equipment, offers made forsimilar equipment the Company intended to sell and the results of anindependent third party appraisal. This action resulted in a $200,000 assetimpairment charge.

**ThirdQuarter 2001 Restructuring Plan**

*LeaseLoss and Leasehold Impairment—**In*September 2001,the Company decided to abandon a leased facility based on revised anticipateddemand for its products and current market conditions. This excess facility,for which the Company had a ten year commitment, is located adjacent to theCompany’s current corporate headquarters and was originally developed to houseadditional administrative and corporate offices to accommodate plannedexpansion. This decision resulted in a lease loss of $7.2 million, 

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**WJ COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**14. RESTRUCTURINGCHARGES (Continued)**

comprised of future leasepayments net of anticipated sublease income, broker commissions and otherfacility costs, and an asset impairment charge of $2.6 million on tenantimprovements deemed no longer realizable. In determining this estimate, theCompany made certain assumptions with regards to its ability to sublease thespace and reflected offsetting assumed sublease income in line with the Company’sbest estimate of current market conditions.

During the third and fourth quarters of 2002, based onan overall deteriorating real estate market and difficulties subleasing itsavailable space, the Company revised its assumptions regarding subleaseoccupancy rates and market rates downward resulting in additional lease lossaccruals of $4.5 million and $1.8 million, respectively.

During the fourth quarter of 2003, after reviewingcurrent information regarding continuing deterioration in the real estatemarket, difficulties subleasing its available space and facility costs, theCompany revised its lease loss assumptions. $203,000 of additional lease losswas accrued as reductions in estimated sublease occupancy and market rates werepartially offset by reduced facility costs (mainly property taxes andutilities).

During the third quarter of 2004, after reviewingcurrent information regarding continuing deterioration in the real estatemarket, difficulties subleasing its available space and increasing facilityoperating costs, the Company revised its lease loss assumptions resulting in$538,000 of additional lease loss.

As of December 31, 2005, the maximum potentialamount of the lease loss for this property is $10.8 million which ispartially offset by $604,000 of minimum sublease income commitments undernoncancellable sublease rental agreements and $540,000 of estimated netsublease income.

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**WJ COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**14. RESTRUCTURING CHARGES(Continued)**

Thefollowing table summarizes restructuring accrual activity recorded during theyears 2001 though December 31, 2005 (in thousands):

| ** **                         | ** ** | **Q3 2001**  | ** **         | ** **                                    | ** ** | ** **                                    | ** **                | ** **     | ** ** | ** **                                        | ** ** | ** ** | ** **                                  | ** **     | ** ** | ** ** | ** **                |   |
|------------------------------------|------------|-------------------|--------------------|-----------------------------------------------|------------|-----------------------------------------------|---------------------------|----------------|------------|---------------------------------------------------|------------|------------|---------------------------------------------|----------------|------------|------------|---------------------------|--------|
| ** **                         | ** ** | **Restructuring** | ** **         | ** **                                    | ** ** | ** **                                    | ** **                | ** **     | ** ** | ** **                                        | ** ** | ** ** | ** **                                  | ** **     | ** ** | ** ** | ** **                |   |
| ** **                         | ** ** | **Plan**          | ** **         | **Q3 2002 Restructuring Plan** | ** ** | **Q4 2002 Restructuring Plan** | ** **                | ** **     | ** ** |                                              |
| ** **                         | ** ** | **Lease**         | ** **         | **Workforce**                                 | ** ** | **Lease**                                     | ** **                | **Asset**      | ** ** | **Workforce**                                     | ** ** | **Lease**  | ** **                                  | **Asset**      | ** ** | ** ** | ** **                |   |
| ** **                         | ** ** | **Loss**          | ** **         | **Reduction**                                 | ** ** | **Loss**                                      | ** **                | **Impairment** | ** ** | **Reduction**                                     | ** ** | **Loss**   | ** **                                  | **Impairment** | ** ** | **Total**  | ** **                |   |
| Q3 2001 charge to expense          |       |              | $  9,797 |                                          |       |                                          | $   — |           |       | $       — |       |       | $      — |           |       |       | $   — |   |   | $      — |   |   | $      — |   |   | $   9,797 |   |
| Non-cash charges(1)                |       |              | (2,503             | )                                             |       |                                          | —                    |           |       | —                                            |       |       | —                                      |           |       |       | —                    |   |   | — |   |   | — |   |   | (2,503 | ) |
| Cash payments                      |       |              | (463               | )                                             |       |                                          | —                    |           |       | —                                            |       |       | —                                      |           |       |       | —                    |   |   | — |   |   | — |   |   | (463 | ) |
| Balance at December 31, 2001  |       |              | 6,831              |                                          |       |                                          | —                    |           |       | —                                            |       |       | —                                      |           |       |       | —                    |   |   | — |   |   | — |   |   | 6,831 |   |
| Q3 2002 charge to expense          |       |              | —             |                                          |       |                                          | 507                       |           |       | 13,841                                            |       |       | 4,087                                       |           |       |       | —                    |   |   | — |   |   | — |   |   | 18,435 |   |
| Q4 2002 charge to expense          |       |              | —             |                                          |       |                                          | —                    |           |       | —                                            |       |       | —                                      |           |       |       | 279                       |   |   | 4,285 |   |   | 4,277 |   |   | 8,841 |   |
| 2002 additional charge             |       |              | 6,283              |                                          |       |                                          | —                    |           |       | 674                                               |       |       | —                                      |           |       |       | —                    |   |   | — |   |   | — |   |   | 6,957 |   |
| Non-cash charges(2)                |       |              | (22                | )                                             |       |                                          | —                    |           |       | (2,930                                            | )          |       | (4,087                                      | )              |       |       | —                    |   |   | — |   |   | (4,277 | ) |   | (11,316 | ) |
| Cash payments                      |       |              | (1,002             | )                                             |       |                                          | (437                      | )              |       | (290                                              | )          |       | —                                      |           |       |       | —                    |   |   | — |   |   | — |   |   | (1,729 | ) |
| Balance at December 31, 2002  |       |              | 12,090             |                                          |       |                                          | 70                        |           |       | 11,295                                            |       |       | —                                      |           |       |       | 279                       |   |   | 4,285 |   |   | — |   |   | 28,019 |   |
| 2003 additional charge (credit)    |       |              | 203                |                                          |       |                                          | (21                       | )              |       | (23                                               | )          |       | 151                                         |           |       |       | —                    |   |   | (364 | ) |   | — |   |   | (54 | ) |
| Non-cash charges                   |       |              | —             |                                          |       |                                          | —                    |           |       | (15                                               | )          |       | (151                                        | )              |       |       | —                    |   |   | — |   |   | — |   |   | (166 | ) |
| Cash payments                      |       |              | (782               | )                                             |       |                                          | (49                       | )              |       | (1,316                                            | )          |       | —                                      |           |       |       | (26                       | )      |   | — |   |   | — |   |   | (2,173 | ) |
| Balance at December 31, 2003  |       |              | 11,511             |                                          |       |                                          | —                    |           |       | 9,941                                             |       |       | —                                      |           |       |       | 253                       |   |   | 3,921 |   |   | — |   |   | 25,626 |   |
| 2004 additional charge (credit)    |       |              | 538                |                                          |       |                                          | —                    |           |       | (377                                              | )          |       | —                                      |           |       |       | (85                       | )      |   | (3,921 | ) |   | — |   |   | (3,845 | ) |
| Non-cash charges                   |       |              | 12                 |                                          |       |                                          | —                    |           |       | 30                                                |       |       | —                                      |           |       |       | —                    |   |   | — |   |   | — |   |   | 42 |   |
| Cash payments                      |       |              | (1,003             | )                                             |       |                                          | —                    |           |       | (1,233                                            | )          |       | —                                      |           |       |       | (168                      | )      |   | — |   |   | — |   |   | (2,404 | ) |
| Balance at December 31, 2004  |       |              | 11,058             |                                          |       |                                          | —                    |           |       | 8,361                                             |       |       | —                                      |           |       |       | —                    |   |   | — |   |   | — |   |   | 19,419 |   |
| 2005 additional charge (credit)    |       |              | —             |                                          |       |                                          | —                    |           |       | —                                            |       |       | —                                      |           |       |       | —                    |   |   | — |   |   | — |   |   | — |   |
| Non-cash charges                   |       |              | 46                 |                                          |       |                                          | —                    |           |       | 8                                                 |       |       | —                                      |           |       |       | —                    |   |   | — |   |   | — |   |   | 54 |   |
| Cash payments                      |       |              | (1,420             | )                                             |       |                                          | —                    |           |       | (1,277                                            | )          |       | —                                      |           |       |       | —                    |   |   | — |   |   | — |   |   | (2,697 | ) |
| Balance at  December 31, 2005 |       |              | $  9,684 |                                          |       |                                          | $   — |           |       | $  7,092                                |       |       | $      — |           |       |       | $   — |   |   | $      — |   |   | $      — |   |   | $ 16,776 |   |

----

(1)          Non-cash charges relatedto the Q3 2001 Restructuring Plan lease loss represents $2.5 million of tenantimprovements deemed no longer realizable.

(2)          Non-cash charges relatedto the Q3 2002 Restructuring Plan lease loss represents $3.2 million of tenantimprovements deemed no longer realizable net of a $310,000 write-off of accrueddeferred rent.

Of the accruedrestructuring charge at December 31, 2005, the Company expects $3.4million of the lease loss to be paid out over the next twelve months. As such,this amount is recorded as a current liability and the remaining $13.4 millionto be paid out over the remaining life of the lease of approximately four yearsis recorded as a long-term liability.

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**WJ COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**15. WARRANTIES**

TheCompany generally sells products with a limited warranty of product quality anda limited indemnification of customers against intellectual propertyinfringement claims related to the company’s products. Such warranty generallyranges from 12 to 24 months. The Company accrues for known warranty andindemnification issues if a loss is probable and can be reasonably estimated,and accrues for estimated incurred but unidentified issues based on historicalactivity. The Company estimates the cost of warranty based on the warrantyperiod for the product, the historical field return rates for a given productor family of products and the average cost required to repair or replace theproduct. Allowances forestimated warranty costs are recorded during the period of sale. Thedetermination of such allowances requires us to make estimates of productreturn rates and expected costs to repair or replace the products underwarranty. If actual return rates and/or repair and replacement costs differsignificantly from our estimates, adjustments to recognize additional cost ofsales may be required in future periods. Components of the reserve for warrantycosts during 2005 and 2004 consisted of the following (in thousands):

| ** **                                              | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------|------------|-----------------------|------------|
| ** **                                              | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| Beginning balance                                       |       | $                     | 54         |   | $ | 36 |   | $ | 54 |   |
| Additions related  to current period sales              |       | 22                    |       | 74 |   | 36 |   |
| Warranty costs  incurred in the current period          |       | (24                   | )          | (58 | ) | (48 | ) |
| Adjustments to  accruals related to prior period sales. |       | (12                   | )          | 2 |   | (6 | ) |
| Ending balance                                          |       | $                     | 40         |   | $ | 54 |   | $ | 36 |   |

 

**16. BUSINESS SEGMENTREPORTING**

In 1997, the Company adopted SFAS 131, “Disclosuresabout Segments of an Enterprise and Related Information.” As an integratedproducts provider, the Company currently has one reportable segment. TheCompany’s Chief Operating Decision Maker (“CODM”) is the CEO. While the Company’sCODM monitors the sales of various products, operations are managed andfinancial performance evaluated based upon the sales and production of multipleproducts employing common manufacturing and research and development resources;sales and administrative support; and facilities. This allows the Company toleverage its costs in an effort to maximize return. Management believes thatany allocation of such shared expenses to various products would beimpractical, and currently does not make such allocations internally.

The CODM does, however,monitor sales by products at a more detailed level than those depicted in theCompany’s historical general purpose financial statements as follows (inthousands): 

| ** **                                       | ** ** | **Year Ended**   | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **December 31,** | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                       | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| Semiconductor and  RFID                          |       |                  | $          | 31,201 |   |   |   | $ | 29,808 |   |   |   | $ | 20,246 |   |   |
| Wireless  Integrated Assemblies and Fiber Optics |       |                  | 396        |   |   |   | 2,528 |   |   |   | 6,319 |   |   |
| Total                                            |       |                  | $          | 31,597 |   |   |   | $ | 32,336 |   |   |   | $ | 26,565 |   |   |

 

On May 14, 2003, theCompany completed the sale of its Thin-Film product line to M/A-COM, aunit of Tyco Electronics previously announced in December, 2002. The saleincluded equipment, inventory, intellectual property, training and services.The Company received total proceeds of $1.8 million and recorded a net gain of$1.1 million as other income in the accompanying financial statements for 2003.The 

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**WJ COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**16. BUSINESSSEGMENT REPORTING (Continued)**

Company had initiallyreceived an advance payment on this agreement of $272,000 in 2002 which wasincluded as accrued liabilities in the Company’s consolidated balance sheets.That advance payment is now recognized as part of the $1.8 million of proceedsduring 2003. The Thin-Film product line contributed $855,000 to oursemiconductor sales in 2003.

TheCompany believes it is more meaningful in terms of concentration of risk tocombine the sales to manufacturing subcontractors with the end customer whoultimately controls product demand. Sales to individual customers representinggreater than 10% of Company consolidated sales during at least one of the pastthree years are as follows (in thousands):

| ** **                         | ** ** | **Year Ended**   | ** ** |
|------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **December 31,** | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                         | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| Lucent  Technologies, Inc.(1) |       |                  | $          | 392 |   |   |   | $ | 2,233 |   |   |   | $ | 6,047 |   |   |
| Celestica                          |       |                  | 4,060      |   |   |   | 3,768 |   |   |   | 1,347 |   |   |
| Richardson Electronics  Ltd.(2)    |       |                  | 14,194     |   |   |   | 16,681 |   |   |   | 12,440 |   |   |

----

(1)          Includes sales to LucentTechnologies, Inc. and sales to its manufacturing subcontractors.

(2)          Richardson ElectronicsLtd. is the sole worldwide distributor of the Company’s complete line of RFsemiconductor products.

Salesto unaffiliated customers by geographic area are as follows (in thousands):

| ** **                        | ** ** | **Year Ended**   | ** ** |
|-----------------------------------|------------|-----------------------|------------|
| ** **                        | ** ** | **December 31,** | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                        | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| United States                     |       |                  | $          | 17,800 |   |   |   | $ | 20,904 |   |   |   | $ | 17,987 |   |   |
| Export Sales from United  States: |       |                  |       |   |   |   |   |   |   |   |   |   |   |
| Europe                            |       |                  | 1,632      |   |   |   | 2,435 |   |   |   | 2,658 |   |   |
| China                             |       |                  | 4,900      |   |   |   | 3,800 |   |   |   | 1,848 |   |   |
| Other                             |       |                  | 7,265      |   |   |   | 5,197 |   |   |   | 4,072 |   |   |
| Total                             |       |                  | $          | 31,597 |   |   |   | $ | 32,336 |   |   |   | $ | 26,565 |   |   |

 

Long-lived assets locatedoutside of the United States are insignificant.

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**WJ COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**17. LOSS PER SHARECALCULATION**

Per share amounts arecomputed based on the weighted average number of basic and diluted (dilutivestock options) common and common equivalent shares outstanding during therespective periods. The net loss per share calculation is as follows (inthousands, except per share amounts):

| ** **                                             | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                             | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss (numerator)                                   |       | $                                          | (20,988    | ) | $ | (9,081 | ) | $ | (14,310 | ) |
| Denominator for basic and diluted net loss per  share: |       |                                       |       |   |   |   |   |
| Weighted average shares  outstanding                   |       | 64,162                                     |       | 60,397 |   | 56,835 |   |
| Basic and diluted net loss per share from operations   |       | $                                          | (0.33      | ) | $ | (0.15 | ) | $ | (0.25 | ) |

 

For the years ended December 31,2005, 2004 and 2003, the incremental shares from the assumed exercise of9,366,759, 13,727,396, and 12,428,034 stock options, respectively, and 65,936and 158,601 shares for the years ended December 31, 2005 and 2004,respectively, related to contributions under the Employee Stock Purchase Planfor pending purchases were not included in computing the dilutive per shareamounts because operations resulted in a loss and the effect of such assumedexercise would be anti-dilutive. The Employee Stock Purchase Plan was suspendeddue to the pending resolution of the Fox Paine Acquisition Proposal (see Note18) and was not reinstated until the fourth quarter of 2003 and therefore therewere no shares related to contributions under the Employee Stock Purchase Planas of December 31, 2003.

**18. RELATED PARTY TRANSACTIONS**

On January 31,2000, the Company entered into a management agreement with Fox Paine &Company, LLC (“Fox Paine”). Fox Paine was the majority stockholder in theCompany at that time. Under that agreement, the Company would pay Fox Paine amanagement fee in the amount of 1% of the prior year’s income before interestexpense, interest income, income taxes, depreciation and amortization andequity in earnings (losses) of minority investments, calculated without regardto the fee. Due to the Company’s loss incurred in 2004, 2003 and 2002, nomanagement fee was paid to Fox Paine for the year ended December 31, 2005,2004 and 2003, respectively. In exchange for its management fee, Fox Paineassists the Company with its strategic planning, budgets and financialprojections and helps the Company identify possible strategic acquisitions andto recruit qualified management personnel. Fox Paine also helps develop andenhance customer and supplier relationships on behalf of the Company andconsults with management on various matters including tax planning and public relationsstrategies, economic and industry trends and executive compensation. Inconnection with this agreement, the Company has agreed to indemnify Fox Paineagainst various liabilities that may arise as a result of the managementservices it will perform. The Company has also agreed to reimburse Fox Painefor its expenses incurred in providing these services. The Company paid FoxPaine $29,000, $108,000 and $6,000 for the reimbursement of expenses incurredby Fox Paine in 2005, 2004 and 2003, respectively. The Company also paid FoxPaine $700,000 in July of 2004 for investment banking services rendered inconnection with the EiC Acquisition that was completed on June 18, 2004(see Note 5).

In September 2002 the Company announced thereceipt of a proposal from Fox Paine to acquire all of the shares of theCompany’s common stock held by unaffiliated stockholders (the “AcquisitionProposal”). Fox Paine and its affiliates own approximately 64% of the Company’soutstanding shares or 37.0 million shares of a total of 57.7 million sharesoutstanding as of December 31, 2003. The Company’s Board of Directorsformed a special committee composed of two independent directors not affiliatedwith Fox Paine (the “Special Committee”) to review the Acquisition Proposal. On March 27, 2003, Fox Paine withdrewits Acquisition Proposal. In 2003, the Company incurred $680,000 of costs andexpenses related to the Acquisition Proposal.

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**WJ COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**QUARTERLY FINANCIAL DATA—UNAUDITED**

Thefollowing table sets forth, for the periods presented, selected data from ourconsolidated statements of operations on a quarterly basis. The consolidatedstatements of operations data have been derived from our unaudited consolidatedfinancial statements. In the opinion of management, these statements have beenprepared on substantially the same basis as the audited consolidated financialstatements and include all adjustments, consisting only of normal recurring adjustments,necessary for a fair presentation of the financial information for the periodspresented. This information should be read in conjunction with the consolidatedfinancial statements and notes to those financial statements included elsewherein this filing.

| ** **                                                     | ** ** | **Three Months Ended**                                   | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **April 3,**                                                  | ** ** | **July 3,** | ** ** | **Oct. 2,** | ** ** | **Dec. 31,** | ** ** |
| ** **                                                     | ** ** | **2005**                                                           | ** ** | **2005** | ** ** | **2005** | ** ** | **2005** | ** ** |
| ** **                                                     | ** ** | **(In thousands, except per share data)** | ** ** |
| Consolidated Statements  of Operations Data:                   |       |                                                               |       |   |   |   |   |   |   |
| Sales                                                          |       | $                                                                  | 7,774      |   | $ | 4,023 | (1) | $ | 8,094 |   | $ | 11,706 |   |
| Cost of goods sold                                             |       | 4,348                                                              |       | 2,870 |   | 3,774 |   | 5,914 |   |
| Gross profit                                                   |       | 3,426                                                              |       | 1,153 |   | 4,320 |   | 5,792 |   |
| Operating  expenses:                                           |       |                                                               |       |   |   |   |   |   |   |
| Acquired in-process research and development(2)                |       | 3,400                                                              |       | — |   | — |   | — |   |
| Research and development                                       |       | 4,743                                                              |       | 4,397 |   | 4,451 |   | 4,480 |   |
| Selling and administrative                                     |       | 3,189                                                              |       | 4,824 | (3) | 3,632 |   | 3,650 |   |
| Total operating expenses                                       |       | 11,332                                                             |       | 9,221 |   | 8,083 |   | 8,130 |   |
| Loss from operations                                           |       | (7,906                                                             | )          | (8,068 | ) | (3,763 | ) | (2,338 | ) |
| Interest income                                                |       | 240                                                                |       | 261 |   | 272 |   | 275 |   |
| Interest expense.                                              |       | (23                                                                | )          | (24 | ) | (29 | ) | (20 | ) |
| Other income—net                                          |       | 5                                                                  |       | 3 |   | 3 |   | 3 |   |
| Loss from operations before income taxes                       |       | (7,684                                                             | )          | (7,828 | ) | (3,517 | ) | (2,080 | ) |
| Income tax benefit/(provision)                                 |       | —                                                             |       | — |   | 123 |   | (3 | ) |
| Net loss                                                       |       | $                                                                  | (7,684     | ) | $ | (7,828 | ) | $ | (3,394 | ) | $ | (2,083 | ) |
| Basic and diluted net loss per share                           |       | $                                                                  | (0.12      | ) | $ | (0.12 | ) | $ | (0.05 | ) | $ | (0.03 | ) |
| Basic and diluted  shares used to calculate net loss per share |       | 63,027                                                             |       | 64,055 |   | 64,516 |   | 65,084 |   |

----

1)               Effective for theCompany’s second quarter ended July 3, 2005, the Company changed theapplication of our revenue recognition policy regarding its distributors (seeNote 3 to the consolidated financialstatements). This change in application resulted in a $4.1 million revenuedeferral in the Company’s second quarter of 2005.

2)               During the firstquarter of 2005, $3.4 million of the purchase price for the acquisition ofTelenexus, Inc. was allocated to acquired in-process research anddevelopment expense  (see Note 5 to the consolidated financial statements).

3)               The second quarterof 2005 includes a $1.2 million charge for separation expenses related to theCompany’s former CEO.

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**WJ COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**QUARTERLY FINANCIAL DATA—UNAUDITED (Continued)**

| ** **                                        | ** ** | **Three Months Ended**                                   | ** ** |
|---------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                        | ** ** | **March 28,**                                                 | ** ** | **June 27,** | ** ** | **Sept. 26,** | ** ** | **Dec. 31,** | ** ** |
| ** **                                        | ** ** | **2004**                                                           | ** ** | **2004** | ** ** | **2004** | ** ** | **2004** | ** ** |
| ** **                                        | ** ** | **(In thousands, except per share data)** | ** ** |
| Consolidated Statements  of Operations Data:      |       |                                                               |       |   |   |   |   |   |   |   |   |
| Sales                                             |       |                                                               | $          | 7,071 |   |   | $ | 8,414 |   | $ | 8,929 |   | $ | 7,921 |   |
| Cost of goods sold                                |       |                                                               | 3,195      |   |   | 3,308 |   | 4,536 |   | 4,240 |   |
| Gross profit                                      |       |                                                               | 3,876      |   |   | 5,106 |   | 4,393 |   | 3,681 |   |
| Operating  expenses:                              |       |                                                               |       |   |   |   |   |   |   |   |   |
| Acquired in-process research and development(1)   |       |                                                               | —     |   |   | 8,500 |   | — |   | — |   |
| Research and development                          |       |                                                               | 4,103      |   |   | 4,131 |   | 4,354 |   | 4,650 |   |
| Selling and administrative                        |       |                                                               | 2,846      |   |   | 2,958 |   | 3,523 |   | 3,176 |   |
| Restructuring reversals(2)                        |       |                                                               | —     |   |   | (430 | ) | (3,416 | ) | — |   |
| Total operating expenses                          |       |                                                               | 6,949      |   |   | 15,159 |   | 4,461 |   | 7,826 |   |
| Loss from operations                              |       |                                                               | (3,073     | ) |   | (10,053 | ) | (68 | ) | (4,145 | ) |
| Interest income                                   |       |                                                               | 166        |   |   | 155 |   | 167 |   | 195 |   |
| Interest expense                                  |       |                                                               | (25        | ) |   | (28 | ) | (20 | ) | (32 | ) |
| Other income—net                             |       |                                                               | —     |   |   | — |   | — |   | 5 |   |
| Income (loss) from operations before income taxes |       |                                                               | (2,932     | ) |   | (9,926 | ) | 79 |   | (3,977 | ) |
| Income tax benefit                                |       |                                                               | 6,542      |   |   | — |   | 1,133 |   | — |   |
| Net income (loss)                                 |       |                                                               | $          | 3,610 |   |   | $ | (9,926 | ) | $ | 1,212 |   | $ | (3,977 | ) |
| Basic net income (loss) per share                 |       |                                                               | $          | 0.06 |   |   | $ | (0.16 | ) | $ | 0.02 |   | $ | (0.07 | ) |
| Basic average shares                              |       |                                                               | 59,396     |   |   | 60,254 |   | 60,908 |   | 60,968 |   |
| Diluted net income (loss) per share               |       |                                                               | $          | 0.05 |   |   | $ | (0.16 | ) | $ | 0.02 |   | $ | (0.07 | ) |
| Diluted average  shares                           |       |                                                               | 67,476     |   |   | 60,254 |   | 65,913 |   | 60,968 |   |

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1)               During the secondquarter of 2004, $8.5 million of the purchase price for the acquisition of thewireless infrastructure business and associated assets from EiC was allocatedto acquired in-process research and development expense (see Note 5 to the consolidatedfinancial statements).

2)               During the secondquarter of 2004, the Company delayed the closure of its internal waferfabrication facility (“fab”) for a minimum of three months to assess theintegration of the EiC acquisition into its existing operations which resultedin an approximate $430,000 reduction in its lease loss accrual. During thethird quarter of 2004, the Company decided to not close its fab as the Companybelieves that integrating the newly acquired fab from EiC with its pre-existingfab will offer the Company certain benefits over outsourcing the pre-existingfab. As such, the Company reversed the remainder of this lease loss accrual of$3.6 million. Also during the third quarter of 2004, the Company revised itslease loss assumptions for its other facilities based on reductions in subleaseoccupancy rates and current facility costs. As such the Company accrued$161,000 of additional lease loss.

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**Item9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIALDISCLOSURE**

None.

**Item 9a. CONTROLS AND PROCEDURES**

**ConclusionRegarding the Effectiveness of Disclosure Controls and Procedures.**

We carried out an evaluation, under the supervisionand with the participation of our Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures as of the end of the period covered by this reportpursuant to Exchange Act  Rule 13a-15.Based on this evaluation, our Chief Executive Officer and Chief FinancialOfficer concluded that our disclosure controls and procedures were noteffective as of December 31, 2005 to provide reasonable assuranceregarding the reliability of financial reporting and the preparation offinancial statements for external reporting purposes in accordance withgenerally accepted accounting principles due solely to the following materialweakness (the results of management’s assessment were reviewed with the AuditCommittee):

A material weakness in the operating effectiveness ofthe controls over the determination of excess and obsolete inventory and therelated valuation adjustments resulting in an audit adjustment to reduceinventory and increase cost of goods sold. The error occurred in our fourthquarter of 2005 and was corrected in the same period. The correction isreflected in our consolidated financial statements included in thisForm 10-K. This material weakness arose from our failure to considerall current business conditions in determining the salability of our currentinventory.

Although we have already taken some actions toremediate the material weakness described above, we believe that further actionis required to complete our remediation, including the need to develop andimplement enhanced processes. The effectiveness of the steps we have taken todate and the steps we are still in the process of completing is subject tocontinued management review, as well as Audit Committee oversight, and we maymake additional changes to our internal control over financial reporting otherthan those described above.

Not withstanding this material weakness, we believethat the consolidated financial statements included in this report fairlypresent our consolidated financial position as of, and the consolidated resultsof operations for the year ended, December 31, 2005.

**Changes in InternalControl Over Financial Reporting.**

Other than the material weakness described above,there has been no change in our internal control over financial reportingduring the fourth quarter of 2005 that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

**Management’s AnnualReport on Internal Control Over Financial Reporting.**

The “Report of Management” regarding management’sassessment of our internal control over financial reporting as of December 31,2005 is set forth in Part II Item 8 of this Annual Report on Form 10-K which is incorporatedherein by reference. Based on an assessment of such criteria, our managementconcluded that we did not maintain effective internal control over financialreporting as of December 31, 2005 due solely to the material weaknessnoted above. Our management’s assessment of the effectiveness of our internalcontrol over financial reporting as of  December 31,2005 has been audited by Deloitte & Touche LLP, an independentregistered public accounting firm, as stated in their report set forth in Part IIItem 8 of this Annual Report on Form 10-K which is incorporatedherein by reference.

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**InherentLimitations on Effectiveness of Controls**

The company’s management, including the ChiefExecutive Officer and Chief Financial Officer, does not expect that ourdisclosure controls and procedures or our internal control over financialreporting will prevent or detect all error and all fraud. A control system, nomatter how well designed and operated, can provide only reasonable, notabsolute, assurance that the control system’s objectives will be met. Thedesign of a control system must reflect the fact that there are resourceconstraints, and the benefits of controls must be considered relative to theircosts. Further, because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that misstatements due toerror or fraud will not occur or that all control issues and instances offraud, if any, within the company have been detected. These inherentlimitations include the realities that judgments in decision-making can befaulty and that breakdowns can occur because of simple error or mistake.Controls can also be circumvented by the individual acts of some persons, bycollusion of two or more people, or by management override of the controls. Thedesign of any system of controls is based in part on certain assumptions aboutthe likelihood of future events, and there can be no assurance that any designwill succeed in achieving its stated goals under all potential futureconditions. Projections of any evaluation of controls effectiveness to futureperiods are subject to risks. Over time, controls may become inadequate becauseof changes in conditions or deterioration in the degree of compliance withpolicies or procedures.

**Item 9b. OTHER INFORMATION**

None.

**PART III**

**Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THEREGISTRANT**

Thefollowing table sets forth information about our directors and executiveofficers (ages are as of March 21, 2006):

| **Name**                   | ** ** | ** ** | ** ** | **Age**                                                                     | ** ** | **Position** |
|----------------------------|------------|------------|------------|-----------------------------------------------------------------------------|------------|--------------|
| W.  Dexter Paine, III |       | 45         |       | Chairman  of the Board                                                      |
| Bruce W. Diamond           |       | 46         |       | President,  Chief Executive Officer and Director                            |
| Herald  Y. Chen            |       | 36         |       | Director                                                                    |
| Michael E. Holmstrom       |       | 63         |       | Director                                                                    |
| Catherine P. Lego          |       | 49         |       | Director                                                                    |
| Jack G. Levin              |       | 58         |       | Director                                                                    |
| Liane J. Pelletier         |       | 48         |       | Director                                                                    |
| Robert Whelton.            |       | 66         |       | Director                                                                    |
| Dag F. Wittusen            |       | 61         |       | Director                                                                    |
| Rainer N. Growitz          |       | 50         |       | Interim Chief Financial  Officer, Vice President—Finance and Secretary |
| Mark S. Knoch              |       | 42         |       | Vice President—Operations                                              |
| Haresh P. Patel            |       | 44         |       | Senior Vice President—Sales  and Marketing                             |
| David R. Pulvino           |       | 46         |       | Chief Accounting Officer—Principal  Accounting Officer                 |
| Morteza Saidi              |       | 53         |       | Vice President—Engineering                                             |

 

**Directorsof the Company**

***W. Dexter Paine, III,*** the Chairman of the Board of Directors and adirector since January 2000, is the co-founder of Fox Paine &Company, LLC and has been its President since its inception in 1997. Mr. Painealso serves as a director of Alaska Communications Systems Group Inc.(NasdaqNM: ALSK), the leading 

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diversifiedfacilities-based telecommunications provider in Alaska and since September 2003he has served as a director of United America Indemnity, Ltd. (NasdaqNM:INDM). From1994 until founding Fox Paine, Mr. Paine served as a senior partner ofKohlberg & Company. Prior to joining Kohlberg & Company, Mr. Paineserved as a general partner at Robertson Stephens & Company. Mr. Painehas a B.A. in economics from Williams College.

***Bruce W. Diamond*** wasappointed to President, Chief Executive Officer of WJ Communications in June 2005and has served as a director since July 2003. Mr. Diamond has thestrategic and overall operating responsibility for continuing to position WJCommunications into a leading supplier of RF solutions for the wirelessinfrastructure and RFID reader markets. From November 2002 to June 2005,Mr. Diamond served as Chief Operating Officer and Executive Vice Presidentfor ZiLOG, Inc., a provider of integrated 8-bit microcontrollers(MCU) and universal remote control solutions. From January 2001 through October 2002he served as President and Chief Operating Officer for Sipex, Inc., ananalog semiconductor company, where he was responsible for day-to-dayoperations including development of the optical storage, power and interfaceproducts. From October 1997 to December 2000, Mr. Diamond servedas Senior Vice President of Operations for ANADIGICS, Inc., an RF-basedsemiconductor integrated circuit company, where he was responsible for buildingan industry leading GaAs (Gallium Arsenide) wafer fabrication facility. He alsoheld various senior positions within National Semiconductor Corporation. Mr. Diamondreceived his B.S. degree in electrical engineering from the University ofIllinois at Champaign-Urbana.

***Herald Y. Chen,*** adirector since January 2006, Mr. Chen  has served as a Managing Director of FoxPaine & Company, LLC since December 2002. Prior to joining FoxPaine, Mr. Chen was co-founder and CFO of Jamcracker, Inc., anon-demand, infrastructure software and services company where he served from July 1999to December 2002. Prior to joining Jamcracker, Inc., he was aninvestment professional at Kohlberg Kravis Roberts & Company, andGoldman, Sachs & Co. Mr. Chen received his B.S. in bothMechanical Engineering and in Finance, from the University of Pennsylvania andhis M.B.A. from Stanford’s Graduate School of Business.

***Michael E. Holmstrom,*******a directorsince July 2004, has over 35 years financial experience inthe telecommunications industry and has been providing financial consultingservices since March 2002. Previously, Mr. Holmstrom was at ElektryonInc. where he served as President until March 2002. On February 1,2002, Elektryon filed a voluntary petition under Chapter 11 of the UnitedStates Bankruptcy Code in connection with the sales of its assets to a thirdparty. Prior to joining Elektryon as Chief Financial Officer in 2000, Mr. Holmstromserved as Senior Vice President and Chief Financial Officer at AlaskaCommunications Systems Group beginning in 1999. From 1998 to 1999 Mr. Holmstromwas Chief Financial Officer for Atlantic Tele-Network in the U.S. VirginIslands. From 1996 to 1998 he was the Chief Operating Officer for SpectrumNetwork Systems, Ltd. in Sydney, Australia. Prior to 1996, Mr. Holmstromheld numerous senior management and consulting positions including VicePresident of Unregulated Operations, Chief Financial Officer and then Presidentof CP National Corporation, Executive-in-Residence professor of businessstrategy at Texas A&M University, Vice President of Financial and BusinessPlanning at Pacific Telecom, and Vice President of Finance at Alascom, Inc.Mr. Holmstrom has a B.S. in Business Administration from GannonUniversity.

***Catherine P. Lego,*** adirector since October 2004, Ms. Lego is currently Managing Partnerof The Photonics Fund which is focused on investing in early stage component,module and systems companies in the fiber optic telecommunications market sinceDecember 1999. Ms. Lego also serves on the Board of Directors ofSanDisk Corporation (NasdaqNM:SNDK), LAM Research Corporation (NasdaqNM:LRCX)and private photonics company K2 Optronics. Prior to forming The PhotonicsFund, Ms. Lego provided consulting services to early stage electroniccompanies at Lego Ventures and was a General Partner at Oak InvestmentPartners. Prior to Oak Investment Partners, Ms. Lego was a CPA withCoopers and Lybrand. She received her M.S. from NY University School ofBusiness and her B.A. from Williams College.

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***Jack G. Levin,*** a directorsince July 2004, Mr. Levin was the Chief Operation Officer with FoxPaine and Company from February 2004 through March  2005. Prior tojoining Fox Paine, Mr. Levin was a founder and served as a managing memberof Kalkhoven, Pettit and Levin Ventures, LLC, a venture capital firm focused onthe fiber optic and telecommunications industry since 2001. Previously, Mr. Levinwas  a partner of, and Director of Legaland Regulatory Affairs for Montgomery Securities. During his 17 years atMontgomery Securities (and it’s successor firm, Banc of America Securities,LLC), Mr. Levin was an active member of the investment banking commitmentcommittee, the investment committees of the firm’s venture capital partnershipsand the managing partner of MontWest Capital Partners, a joint venture ofMontgomery Securities and Westinghouse Financial Corporation, established to doleveraged buyouts. Mr. Levin attended Amherst College (A.B., PoliticalScience, Cum Laude, Woodruff Fellowship Award, 1969) and the ColumbiaUniversity School of Law, (J.D., Harlan Fiske Stone Scholar, 1973). Mr. Levinis a retired member of the Bar of the State of New York.

***Liane J. Pelletier,*** adirector since October 2003, Ms. Pelletier serves as Chairwoman,Chief Executive Officer and President of Alaska Communications Systems GroupInc. (NasdaqNM: ALSK). Prior to joining Alaska Communications Systems Group Incin October 2003, Ms. Pelletier was with Sprint Corporation for 17years, where she served in numerous capacities including Chief IntegrationOfficer and Senior Vice President, Corporate Strategy & BusinessDevelopment. Ms. Pelletier also served as a Vice President in a widevariety of departments, including corporate strategy, customer acquisition andretention, and marketing positions to both business and consumer customers.Before joining Sprint, Ms. Pelletier worked as a consultant at Touche Rossand Temple, Barker, Sloane. Ms. Pelletier has an MBA from M.I.T. and B.A.from Wellesley College.

***Robert Whelton,*** adirector since February 2006, Mr. Whelton is currently an ExecutiveVice President of Operations for Micrel, Inc. (NasdaqNM:MCRL), a leadingmanufacturer of IC solutions for the worldwide analog, Ethernet and highbandwidth markets. Prior to joining Micrel in January 1998, Mr. Wheltonwas the Executive Vice President of Operations for Micro Linear Corp., afabless semiconductor company specializing in wireless integrated circuits.Prior to joining Micro Linear Corp., he was employed by National SemiconductorCorp., where he served as Vice President of the Analog division. Mr. Wheltonreceived his B.S.E.E. from the University of California, Berkeley and hisM.S.E.E. from the University of Santa Clara.

***Dag F. Wittusen,*******a director since July 2003, has over thirty years offinancing and investment banking experience. Mr. Wittusen has served asChief Executive Officer of his own investment and financial advisory firm,Beddingen Finans AS since April 2005. From 1996 through March 2005, Mr. Wittusenwas a partner and Senior Executive with the Aker ASA and Kvaerner ASA group ofindustrial investment companies in Norway. Prior to this, he was co-founder andmanaging partner of Orkla Finans AS, Oslo based investment bank. Mr. Wittusenpreviously served as Senior Vice President of Eksportfinans, Oslo,  and on the staff of the World Bank,Washington, D.C. He received a B.A. degree with Honors in Political Science andEconomics from Brown Unversity and an M.P.A. in International Economics fromPrinceton University. Mr.Wittusen resides in Oslo, Norway.

**ExecutiveOfficers of the Company**

***Bruce W. Diamond*** wasappointed as President and Chief Executive Officer of WJ Communications in June 2005.Mr. Diamond’s previous work experience is described above.

***Rainer N. Growitz*** isserving as our Interim Chief Financial Officer since August 31, 2005.Mr. Growitz was appointed Vice President Finance and Secretary followingour recapitalization merger in January 2000 and is responsible forcorporate financial planning, forecasting and management for WJ Communications.From 1997 until January 2000, Mr. Growitz served as Director ofFinance. He joined WJ Communications 

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in 1978 and held a varietyof finance, contracts and managerial positions. Mr. Growitz received aB.S. in Accounting from San Jose State University.

***Mark S. Knoch*** wasappointed Vice President of Operations of WJ Communications in August of2005 and is responsible for overseeing the manufacturing of RF semiconductorand RFID products. Prior to joining WJ Communications, Mr. Knoch was Vicepresident of Operations at ZiLOG, Inc. (“ZiLOG”) where he was responsiblefor all manufacturing and supply chain activities for the company. While atZiLOG he also served as president of ZiLOG’s manufacturing facility in thePhilippines. Prior to joining ZiLOG in 2004, he served as Vice President,Supply Chain for Sipex, Inc., an analog semiconductor company, where hemanaged the supply chain and order fulfillment from 2001 to 2004. Mr. Knochalso held senior planning and operations positions at ANADIGICS, Inc., andAmerican Microsystems Incorporated, and Advanced Micro Devices in Austin, TX. Mr. Knochreceived his B.S. in Electrical Engineering from Kansas State University.

***Haresh P. Patel*** wasappointed to Senior Vice President of Sales and Marketing of WJ Communicationsin October 2005. Mr. Patel brings over 22 years of experience in thesemiconductor industry. Previously, Mr. Patel served as Vice President ofWorldwide Sales and Marketing at Agilent Technology’s $2B SemiconductorDivision. Prior to joining Agilent Technology in 2000, Mr. Patel was withPMC-Sierra Inc. a leader in Datacom, Telecom and Storage Semiconductor Productswhere he served as Vice President of Worldwide Sales beginning in 1997. Mr. Patelhas also held various senior sales and product management positions at Hyundai,Fujitsu, and Texas Instruments. Throughout his career Mr. Patel hasfocused on and built relationships with leading customers including, Cisco, LG,Samsung, Sony Ericsson, Siemens, Nokia, Huawei, Lucent and ZTE. He received hisB.S. degree in Electrical Engineering from the University of Notre Dame, SouthBend, IN.

***David R. Pulvino*** wasappointed Chief Accounting Officer—Principal Accounting Officer in January 2005   and is currently responsible for SECreporting, Corporate Governance/GAAP compliance and Tax. Previously, Mr. Pulvinoserved as our Corporate Controller following our recapitalization merger in January 2000where he was responsible for directing all of our accounting operations. From1997 through January 2000, Mr. Pulvino served as Director ofAccounting. Mr. Pulvino joined WJ Communications in 1981 and has held avariety of accounting and managerial positions. Mr. Pulvino received aB.S. in Accounting from Santa Clara University, California.

***Morteza Saidi*** joined WJ Communications in January 2006 asVice President of Engineering. In this position Mr. Saidi is responsiblefor directing and managing the engineering groups within the Company includingdeveloping new technologies and new products for the wireless and RFID markets.From 2004 to 2006 he served as founder and CEO at S-Communications, aleading-edge fabless semiconductor company. Prior to that Mr. Saidi servedas a consultant for PCI Communications from 2003 to 2004. Previously, Mr. Saidico-founded Resonext Communications in 2000 and where he served as ChiefTechnology Officer and Vice President of RF and Analog  until the company was acquired by RF MicroDevices in December 2002. Previously, he held the director of RFdevelopment position at VLSI Technology. In addition, Mr. Saidi has held anumber of management positions with Philips Semiconductor, has published anumber of articles in the technical journals, and has assisted in filing 30patents. Mr. Saidi received both his Bachelor of Science degree andMasters of Science in Electrical Engineering from the University of Michigan.

**AuditCommittee and Audit Committee Financial Expert**

The Audit Committee iscurrently composed of directors Holmstrom and Lego. The Board of Directors hasdetermined that both Mr. Holmstrom and Ms. Lego are an “independentdirector” as that term is defined in Rule 4200(15) of the NasdaqMarketplace Rules. Our Board of Directors has determined that Mr. Holmstromqualifies as an “audit committee financial expert” as such term is defined 

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in Item 401(h) ofRegulation S-K. Stockholders should understand that this designation is adisclosure requirement of the SEC related to Mr. Holmstrom’s experienceand understanding with respect to certain accounting and auditing matters. Thedesignation does not impose on Mr. Holmstrom any duties, obligations orliability that are greater than are generally imposed on him as a member of theAudit Committee and Board of Directors, and his designation as an auditcommittee financial expert pursuant to this SEC requirement does not affect theduties, obligations or liability of any other member of the Audit Committee orBoard of Directors.

On January 10, 2006, we received a letter fromthe staff of the Listings Qualification Department of the Nasdaq Stock Market, Inc.(“Nasdaq”) dated January 10, 2006, notifying the Company that as a resultof the Board of Directors vacancy created by the resignation of Jan Loeber as adirector and member of the Company’s Audit Committee on December 31, 2005,the Company does not comply with Nasdaq’s Marketplace Rule 4350(d)(2),which requires the company to have an audit committee of at least threeindependent directors as defined by Nasdaq’s rules. Consistent with MarketplaceRule 4350(d)(4), the Company has a cure period until the earlier of December 31,2006 or the Company’s next annual meeting of stockholders to fill the vacancyand regain compliance.

**Section 16(a) BeneficialOwnership Reporting Compliance**

For the fiscal year ended December 31, 2005, webelieve, based solely on a review of Forms 3, 4 and 5 (including amendments)with which it has been furnished, that all filings required pursuant to Section 16(a) ofthe Securities Exchange Act of 1934, as amended, relating to us were timelymade.

**Codeof Ethics**

We have adopted a written code of ethics that appliesto our principal executive officer, principal financial officer and principalaccounting officer, responsive to Section 406 of the Sarbanes-Oxley Act of2002 and the rules of the SEC. A copy of our code of ethics which iscaptioned “Senior Financial Officer Code of Business Conduct and Ethics Policy”is posted and publicly available on our internet website at *www.wj.com*. This website address is intended to be aninactive, textual reference only; none of the material on this website is partof this report. If there are any amendments to or waivers, of the code ofethics, we intend to promptly disclose the nature of any such amendment orwaiver on our website.

**Item 11. EXECUTIVE COMPENSATION**

**Compensation of Directors**

**General**

Directorswho are also employed by us do not receive any additional compensation fortheir services as a director. Non-employee directors are eligible toparticipate in the WJ Communications, Inc. amended and restated 2000Non-Employee Director Stock Compensation Plan (the “Non-Employee Director Plan”)approved by the stockholders at the Company’s 2003 annual meeting:

·       Eachnon-employee director who joins the Board will receive an option to acquire25,000 shares of common stock with an exercise price equal to the fair market valueof the common stock upon the commencement of his or her directorship. Anydirector, officer, employee, partner or other affiliate of Fox Paine and/or itscontrolled affiliates who becomes a member of the Board shall not be eligiblefor the initial option award;

·       Eachnon-employee director who is re-elected to the Board will receive an option toacquire 10,000 shares of common stock with an exercise price equal to the fairmarket value of the common stock upon the re-election of his or her directorship;

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·       Eachnon-employee director will receive an annual cash award of $15,000 for everyfull year in which he or she serves;

·       Eachnon-employee director that serves as chair of the Audit Committee will receivean annual cash award of $10,000 for every full year in which he or she serves;

·       Each othernon-employee director that serves as a member of the Audit Committee willreceive an annual cash award of $5,000 for every full year in which he or sheserves;

·       Annual cashawards shall be payable quarterly in four equal installments beginning on thedate on which the annual meeting of stockholders is held. In the event that anon-employee director’s directorship is terminated before completion of a fullservice year, the annual cash award will be prorated according to the timeserved during such service year;

·       Eachnon-employee director will receive $1,000 in cash for each Board or Committeemeeting attended except if there are multiple meetings on the same day in whichcase the maximum payment will be $1,000;

·       Each non-employee director shall be reimbursed for reasonable,out-of-pocket expenses incurred in attending meetings of the Board or anycommittee thereof.

**Option Vesting**

Options to purchase shares ofCommon Stock issued pursuant to the Non-Employee Director Plan will vest andbecome exercisable in cumulative annual installments of 25% on each of thefirst, second, third and fourth anniversaries of the date of the grant of theoption, unless a change in control (as defined in the Non-Employee Director Plan)occurs, whereby all options vest and become immediately exercisable in exchangefor the per share consideration to be received in the change in control byholders of Common Stock, or the cash equivalent of the same, at the discretionof the Board of Directors or any committee thereof to which the Board delegatesadministration of the Non-Employee Director Plan (the “Plan Administrator”).

**Deferral**

Each non-employee director mayelect to defer receipt of all or a portion of the cash otherwise payable.  In the event such an election is made, theelecting non-employee director will receive his or her cash in one or a seriesof distributions to commence as soon as practicable following the date oftermination of his or her directorship. In the event a change in control occurs, all deferred cash isdistributed to the electing non-employee director.

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**Compensation of ExecutiveOfficers**

Thefollowing table sets forth the compensation earned for services rendered to theCompany in all capacities for the fiscal years ended December 31, 2005,2004 and 2003 by the Company’s Chief Executive Officer and its four next mosthighly compensated executive officers who earned more than $100,000 during thefiscal year ended December 31, 2005 (the “Named Executive Officers”):

|                                                | ** ** | ** **                   | ** ** | ** ** | ** ** | ** **     | ** ** | **Long-Term Compensation** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|------------|------------|----------------|------------|---------------------------------|------------|
| ** **                                     | ** ** | ** **                   | ** ** | ** ** | ** ** | ** **     | ** ** | **Restricted**                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | ** **                   | ** ** | **Stock**  | ** ** | **Securities** | ** ** | **All Other**              | ** ** |
| **Name and**                              | ** ** | **Annual Compensation** | ** ** | **award**  | ** ** | **Underlying** | ** ** | **Compensation**                | ** ** |
| **Principal Position**                    | ** ** | ** **                   | ** ** | **Year**   | ** ** | **Salary($)**  | ** ** | **Bonus($)**                    | ** ** | **($)** | ** ** | **Options** | ** ** | **($) (1)** | ** ** |
| **Current Officers:**                          | ** ** |                         | ** ** | ** ** |       |           | ** ** | ** **                      |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Bruce W. Diamond(2)                            |       |                         | 2005       | ** ** |       |           | 166,924    | ** **                      |       |   | — | ** ** |   |   | 745,000 | ** ** |   |   | — | ** ** |   |   | 4,442 | ** ** |   |
| President and Chief Executive  Officer         |       |                         | 2004       | ** ** |       |           | —     | ** **                      |       |   | — | ** ** |   |   | — | ** ** |   |   | 10,000 | ** ** |   |   | — | ** ** |   |
|                                                |       |                         | 2003       | ** ** |       |           | —     | ** **                      |       |   | — | ** ** |   |   | — | ** ** |   |   | 25,000 | ** ** |   |   | — | ** ** |   |
| Thomas R. Kritzer(3)                           |       |                         | 2005       | ** ** |       |           | 200,200    | ** **                      |       |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | 6,006 | ** ** |   |
| Senior Vice President, Corporate Development   |       |                         | 2004       | ** ** |       |           | 200,200    | ** **                      |       |   | 17,000 | ** ** |   |   | — | ** ** |   |   | 25,000 | ** ** |   |   | 6,006 | ** ** |   |
|                                           |       |                         | 2003       | ** ** |       |           | 200,200    | ** **                      |       |   | 10,000 | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | 6,000 | ** ** |   |
| Ronald N. Buswell(3)                      |       |                         | 2005       | ** ** |       |           | 185,120    | ** **                      |       |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | 5,340 | ** ** |   |
| Vice President, Sales and Marketing            |       |                         | 2004       | ** ** |       |           | 185,120    | ** **                      |       |   | 29,500 | ** ** |   |   | — | ** ** |   |   | 30,000 | ** ** |   |   | 5,554 | ** ** |   |
|                                                |       |                         | 2003       | ** ** |       |           | 185,120    | ** **                      |       |   | 5,000 | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | 5,554 | ** ** |   |
| Rainer N. Growitz                              |       |                         | 2005       | ** ** |       |           | 159,632    | ** **                      |       |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | 4,789 | ** ** |   |
| Interim Chief Financial Officer                |       |                         | 2004       | ** ** |       |           | 150,020    | ** **                      |       |   | 16,000 | ** ** |   |   | — | ** ** |   |   | 25,000 | ** ** |   |   | 4,501 | ** ** |   |
| Vice President Finance and Corporate Secretary |       |                         | 2003       | ** ** |       |           | 150,020    | ** **                      |       |   | 3,000 | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | 3,289 | ** ** |   |
| David R. Pulvino                               |       |                         | 2005       | ** ** |       |           | 143,102    | ** **                      |       |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | 4,293 | ** ** |   |
| Chief Accounting Officer                       |       |                         | 2004       | ** ** |       |           | 140,036    | ** **                      |       |   | 23,000 | ** ** |   |   | — | ** ** |   |   | 34,500 | ** ** |   |   | 4,201 | ** ** |   |
|                                           |       |                         | 2003       | ** ** |       |           | 140,036    | ** **                      |       |   | 3,500 | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | 4,075 | ** ** |   |
| **Former  Officers:**                          |       |                         |       | ** ** |       |           |       | ** **                      |       |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |
| Michael R. Farese, Ph.D(4)                     |       |                         | 2005       | ** ** |       |           | 183,078    | ** **                      |       |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | 1,126,650 | ** ** |   |
| Former President and Chief  Executive Officer  |       |                         | 2004       | ** ** |       |           | 350,000    | ** **                      |       |   | 65,000 | ** ** |   |   | — | ** ** |   |   | 1,400,000 | ** ** |   |   | 8,708 | ** ** |   |
|                                                |       |                         | 2003       | ** ** |       |           | 350,000    | ** **                      |       |   | 40,000 | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | 6,000 | ** ** |   |
|                                                |            |                              |            |            |            |                |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          RepresentsCompany’s annual contribution to the Named Executive Officers 401(k) planaccount.

(2)          Mr. Diamondwas appointed President and Chief Executive Officer on June 28, 2005. Pursuantto his employment agreement, Mr. Diamond was granted 500,000 shares oftime-vesting restricted stock on July 29, 2005 which had a dollar value of$745,000 on the date of the grant and $810,000 as of December 31, 2005. For2003 and 2004 Securities Underlying Options represents grants Mr. Diamondreceived in connection with his service as a non-employee member of the Boardof Directors. Mr. Diamond voluntarily forfeited his 2005 bonus as providedin his employment agreement.

(3)          As of January 10,2006 Mssrs. Kritzer and Buswell are deemed not to be executive officers of theCompany due to the nature of their current positions though they continue to beemployed by the Company.

(4)          Dr. Fareseserved as the Company’s President and Chief Executive Officer until hisresignation on June 27, 2005. Dr. Farese’s 2005 All OtherCompensation total includes severance payments of $559,423 in cash and 328,500shares of restricted stock having a value, as of the June 28, 2005 grantdate, of $561,735, in connection with his separation agreement. His separationagreement also provided for the cancellation of the 1,400,000 stock optionsgranted to him in 2004.

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**Option/SAR Grants in LastFiscal Year.****  **Thefollowing table sets forth grants of options to purchase shares of Common Stockduring the fiscal year ended December 31, 2005 to each of the NamedExecutive Officers:

| Individual Grants                 | ** ** | **Potential**        | ** ** |
|----------------------------------------|------------|----------------------|------------|
| ** **                             | ** ** | ** **           | ** ** | **Percent Of** | ** ** | ** ** | ** ** | ** ** | ** ** | **Realizable Value At** | ** ** |
| ** **                             | ** ** | **Number of**   | ** ** | **Total** | ** ** | ** ** | ** ** | ** ** | ** ** | **Assumed Annual** | ** ** |
| ** **                             | ** ** | **Securities**       | ** ** | **Options** | ** ** | ** ** | ** ** | ** ** | ** ** | **Rates Of Stock** | ** ** |
| ** **                             | ** ** | **Underlying**       | ** ** | **Granted to** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Price Appreciation** | ** ** |
| ** **                             | ** ** | **Options**          | ** ** | **Employees** | ** ** | **Price** | ** ** | **Expiration** | ** ** | **For Option Term** | ** ** |
| **Name**                               | ** ** | **Granted (#)** | ** ** | **In Fiscal Year** | ** ** | **($/Sh)** | ** ** | **Date** | ** ** | **5% ($)** | ** ** | **10% ($)** | ** ** |
| **(a)**                                | ** ** | **(b)**              | ** ** | **(c)** | ** ** | **(d)** | ** ** | **(e)** | ** ** | **(f)** | ** ** | **(g)** | ** ** |
| **Current  Officers:**                 | ** ** |                 | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Bruce W. Diamond                       |       |                 | —     | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |
| President and Chief Executive  Officer |       |                 |       | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |
| Thomas R. Kritzer(1)                   |       |                 | —     | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |
| Senior Vice President, Corporate       |       |                 |       | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |
| Development                            |       |                 |       | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |
| Ronald N. Buswell(1)                   |       |                 | —     | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |
| Vice President, Sales and Marketing    |       |                 |       | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |
| Rainer N. Growitz                      |       |                 | —     | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |
| Interim Chief Financial Officer        |       |                 |       | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |
| Vice President Finance and             |       |                 |       | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |
| Corporate Secretary                    |       |                 |       | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |
| David R. Pulvino                       |       |                 | —     | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |
| Chief Accounting Officer               |       |                 |       | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |
| **Former Officers:**                   |       |                 |       | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |
| Michael R. Farese, Ph.D.               |       |                 | —     | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |
| Former President and Chief             |       |                 |       | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |
| Executive Officer                      |       |                 |       | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |

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(1)          As of January 10,2006 Mssrs. Kritzer and Buswell are deemed not to be executive officers of theCompany due to the nature of their current positions though they continue to beemployed by the Company.

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**Aggregated Option/SARExercises in Last Fiscal Year and Fiscal Year-End Option/SAR Values.****  **The following table sets forth information withrespect to the Named Executive Officers concerning option exercises for thefiscal year ended December 31, 2005, and exercisable and unexercisableoptions held as of December 31, 2005:

| Name                     | ** ** | ** ** | ** ** | **Shares Acquired  On Exercise (#)** | ** ** | **Value  Realized** | ** ** | **Number of Securities  Underlying  Unexercised  Options/SARs at  Fiscal Year-End(#)  Exercisable/Unexercisable** | ** **      | **Value of Unexercised  In-the-Money  Options/SARs at  Fiscal Year-End($)(1)  Exercisable/Unexercisable** | ** ** |
|--------------------------|------------|------------|------------|-----------------------------------------------------|------------|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------|-----------------|-------------------------------------------------------------------------------------------------------------------------------|------------|
| **Current  Officers:**   |       |       |       |                                                |       |                |       |                                                                                                                                  |            |                                                                                                                          |       |   |   |   |   |
| Bruce W. Diamond         |       |       | —     |                                                |       | —              |       |                                                                                                                                  | 15,000 / 20,000 |                                                                                                                          |       |   | $9,125 / $9,125 |   |   |
| President and Chief      |       |       |       |                                                |       |                |       |                                                                                                                                  |            |                                                                                                                          |       |   |   |   |   |
| Executive Officer        |       |       |       |                                                |       |                |       |                                                                                                                                  |            |                                                                                                                          |       |   |   |   |   |
| Thomas R. Kritzer (2)    |       |       | 27,500     |                                                |       | $                   | 54,660     |                                                                                                                                  |            | 549,279 / 738,500                                                                                                             |       |   |   | $ | 103,178 / $146,312 |   |   |
| Senior Vice President,   |       |       |       |                                                |       |                |       |                                                                                                                                  |            |                                                                                                                          |       |   |   |   |   |
| Corporate Development    |       |       |       |                                                |       |                |       |                                                                                                                                  |            |                                                                                                                          |       |   |   |   |   |
| Ronald N. Buswell (2)    |       |       | 25,000     |                                                |       | $                   | 50,544     |                                                                                                                                  |            | 215,507 / 144,000                                                                                                             |       |   |   | $35,037 / $21,335 |   |   |
| Vice President, Sales    |       |       |       |                                                |       |                |       |                                                                                                                                  |            |                                                                                                                          |       |   |   |   |   |
| and Marketing            |       |       |       |                                                |       |                |       |                                                                                                                                  |            |                                                                                                                          |       |   |   |   |   |
| Rainer N. Growitz        |       |       | 14,000     |                                                |       | $                   | 27,753     |                                                                                                                                  |            | 233,064 / 155,000                                                                                                             |       |   |   | $40,383 / $25,100 |   |   |
| Interim Chief Financial  |       |       |       |                                                |       |                |       |                                                                                                                                  |            |                                                                                                                          |       |   |   |   |   |
| Officer Vice President   |       |       |       |                                                |       |                |       |                                                                                                                                  |            |                                                                                                                          |       |   |   |   |   |
| Finance and Corporate    |       |       |       |                                                |       |                |       |                                                                                                                                  |            |                                                                                                                          |       |   |   |   |   |
| Secretary                |       |       |       |                                                |       |                |       |                                                                                                                                  |            |                                                                                                                          |       |   |   |   |   |
| David R. Pulvino         |       |       | 3,933      |                                                |       | $                   | 9,034      |                                                                                                                                  |            | 127,735 / 81,562                                                                                                              |       |   |   | $26,725 / $11,550 |   |   |
| Chief Accounting         |       |       |       |                                                |       |                |       |                                                                                                                                  |            |                                                                                                                          |       |   |   |   |   |
| Officer                  |       |       |       |                                                |       |                |       |                                                                                                                                  |            |                                                                                                                          |       |   |   |   |   |
| **Former Officers:**     |       |       |       |                                                |       |                |       |                                                                                                                                  |            |                                                                                                                          |       |   |   |   |   |
| Michael R. Farese, Ph.D. |       |       | 20,000     |                                                |       | $                   | 11,865     |                                                                                                                                  |            | 1,450,000 /—                                                                                                             |       |   |   | $—/ $— |   |   |
| Former President         |       |       |       |                                                |       |                |       |                                                                                                                                  |            |                                                                                                                          |       |   |   |   |   |
| and Chief Executive      |       |       |       |                                                |       |                |       |                                                                                                                                  |            |                                                                                                                          |       |   |   |   |   |
| Officer                  |       |       |       |                                                |       |                |       |                                                                                                                                  |            |                                                                                                                          |       |   |   |   |   |
|                          |            |            |            |                                                     |            |                     |            |                                                                                                                                       |                 |                                                                                                                               |            |  |  |  |  |  |  |  |  |

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(1)          Aggregate values inthese two columns represent the excess of $1.58 per share, the market value ofthe Common Stock as of December 31, 2005, over the respective exerciseprices of the options. The actual amount, if any, realized upon exercise ofstock options will depend upon the market price of the Common Stock relative tothe exercise price per share of the stock option at the time the stock optionis exercised. There is no assurance that the values of unexercised in-the-moneyoptions reflected above will be realized.

(2)          Asof January 10, 2006 Mssrs. Kritzer and Buswell are deemed not to beexecutive officers of the Company due to the nature of their current positionsthough they continue to be employed by the Company.

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**Employment Contracts, Termination of Employment, andChange in Control Arrangements**

***Employment Agreement with Bruce W. Diamond.***

On June 28, 2005, the Company entered into anemployment agreement with Mr. Diamond (the “Employment Agreement”), theCompany’s new President and Chief Executive Officer. The Employment Agreement,which was approved by the Compensation Committee of the Board of Directors (the“Compensation Committee”), is effective for three years with automatic one-yearextensions thereafter.

The material termsof the Employment Agreement include the following: (i) Mr. Diamond’sannual base salary will be $350,000. The annual base salary may be increased inthe years following the first anniversary of the effective date, but may not bedecreased; (ii) beginning in fiscal year 2006, Mr. Diamond iseligible for an annual bonus target opportunity of one-hundred percent (100%)of his current annual base salary, of which fifty percent (50%) is based onachievement of defined financial performance objectives and fifty percent (50%)is based on defined major business objectives as determined by the CompensationCommittee, (iii) an annual bonus target opportunity for the fiscal yearending December 31, 2005 of fifty percent (50%) of annual base salary isbased on defined objectives but will not be less than $50,000 if Mr. Diamondremains employed through December 31, 2005; and (iv) a grant of 1,000,000shares of restricted common stock at a purchase price equal to the par value ofthe common stock of $0.01 per share of which 500,000 shares are Time-VestedRestricted Stock and vest over 36 months and 500,000 shares ofPerformance-Vested Restricted Stock which shall vest conditioned upon thesatisfaction of certain performance targets and objectives to be determined bythe Company with the performance period for such award to be not more than two (2) yearsor in the case of performance criteria conditioned on appreciation in the valueof the Company’s common stock, the price targets designated by the Company.

Mr.  Diamond’semployment agreement also provides for other benefits including the right toparticipate in fringe benefit plans, life and disability insurance plans,expense reimbursement, reimbursement for documented supplemental lifeinsurance, estate and tax planning, and vacation in accordance with the Company’stop management vacation policy.

Pursuant to the EmploymentAgreement, if the Company terminates Mr. Diamond’s employment other thanfor cause or disability or if Mr. Diamond terminates his employment withthe Company for good reason, and Mr. Diamond’s employment is notterminated automatically as a result of his death, the Company will pay him anamount equal to one hundred fifty percent of his annual base salary as ineffect immediately prior to the termination of the employment period andeighteen months accelerated vesting with respect to any outstanding, unvestedtime-vested restricted stock and reimbursement for premiums paid for continuedhealth benefits for Mr. Diamond and his dependents under the Company’shealth plans for eighteen months following the termination of his employmentwith the Company. Notwithstanding the preceding sentence, the severance benefitshall be computed as an amount equal to two hundred ninety-nine percent of hisannual base salary as in effect immediately prior to the termination of theemployment period, full vesting with respect to any outstanding, unvestedtime-vested restricted stock and performance-vested restricted stock andreimbursement for premiums paid for continued health benefits for Mr. Diamondand his dependents under the Company’s health plans for thirty-six months withsuch amounts to be paid within thirty days of the date of such termination, ineach case solely in a circumstance in which there is a termination of Mr. Diamond’semployment within three months prior to or nine months following the occurrenceof a change in control either by the Company other than for cause or by himwith good reason.

***Employment Agreement with Rainer N. Growitz***

Effective January 31, 2000, the Company enteredinto an employment agreement with Mr. Growitz for the position of VicePresident of Finance. The employment agreement is effective for three yearswith 

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automatic one-yearextensions thereafter unless advance written notice of an intention not toextend the term is provided by either the Company or Mr. Growitz.

Under the employment agreement, Mr. Growitz is entitledto receive an annual base salary of $150,020 and will be eligible toparticipate in the Company’s discretionary cash bonus plan, up to a maximum of60% of base salary, based on appropriate business and financial targets andindividual objectives. Mr. Growitz’s employment agreement also providesfor other benefits including the right to participate in fringe benefit plans,life and disability insurance plans, expense reimbursement, reimbursement fordocumented supplemental life insurance, estate and tax planning, and vacationin accordance with the Company’s top management vacation policy.

Pursuant to the employmentagreement, if the Company terminates Mr. Growitz’s employment other thanfor cause or disability or if Mr. Growitz terminates his employment withthe Company for good reason, and Mr. Growitz’s employment is notterminated automatically as a result of his death, the Company will pay him anamount equal to one hundred percent of his annual base salary. Not withstandingthe preceding sentence, the Company shall pay Mr. Growitz an amount equalto one hundred fifty percent of his annual base salary solely in a circumstancein which there has occurred a change in control within three months prior toany termination for good reason or by the Company other than for cause.

***Separation Agreement with Michael R. Farese, PhD.***

The Company entered into aseparation agreement dated June 28, 2005 with Dr. Farese (the “SeparationAgreement”), the Company’s former President and Chief Executive Officer.  The material terms of the Separation Agreementinclude the following:  (i) paymentof any unpaid but accrued base salary and payment for 20 days of vacationtime;  (ii) a single payment equalto one hundred fifty percent (150%) of Dr. Farese’s annual base salary (inthe aggregate amount of $525,000); (iii) 1.5 million of the optionsgranted to Dr. Farese pursuant to the Executive Time Vesting Stock OptionAgreement dated March 4, 2002 are fully vested and the time period duringwhich these vested options can be exercised following the separation date shallbe eighteen months per the terms of Dr. Farese’s amended and restatedemployment agreement dated November 11, 2004;  (iv) 328,500 shares of Company stockpursuant to a customary form of Restricted Stock Agreement issued under theCompany’s 2000 Stock Incentive Plan which shares are fully vested andnon-forfeitable and (v) other incidental benefits including continuedhealth insurance benefits for Dr. Farese and his dependents for one year. Asa result of the Separation Agreement, the 1.4 million share option grantpreviously made to Dr. Farese in March 2004 and referenced in theproxy statement filed in 2005 were cancelled in lieu of Dr. Farese’sacceptance of the 328,500 restricted stock unit awarded in the separationagreement. Furthermore, Dr. Farese did not receive the restricted stockunits referenced in the Company’s proxy statement filed during 2005.

**CompensationCommittee Interlocks and Insider Participation**

Mr.  Paine and Ms. Pelletierserved as members of the Compensation Committee of our board of directorsduring the fiscal year ended December 31, 2005. None of these individualswas an officer or employee of the Company or of any of its subsidiaries duringthe fiscal year ended December 31, 2005, or ever has been an officer ofthe Company or any of its subsidiaries. Mr. Paine is affiliated with FoxPaine. See Item 13 “Certain Relationships and Related Transactions” forinformation regarding Fox Paine.

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**Item12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATEDSTOCKHOLDER MATTERS**

Thefollowing table lists, as of March 15, 2006, information as to thebeneficial ownership of Common Stock by (i) each of the Company’sdirectors and nominee for directorship, (ii) each executive officer of theCompany for whom information is given in the Summary Compensation Table under “Compensationof Executive Officers” below, (iii) all directors and executive officersas a group, and (iv) each person or entity believed by the Company tobeneficially own more than five percent (5%) of the Common Stock outstanding.Except as otherwise indicated in the footnotes below, each beneficial owner hasthe sole power to vote and to dispose of all shares held by that holder. Ineach instance, information as to the number of shares owned and the nature ofownership has been provided by the individuals identified or described and isnot within the direct knowledge of the Company.

| **Name and Address of Beneficial Owner (1)** | ** ** | ** ** | ** ** | **Amount and Nature  of Beneficial  Ownership (2)** | ** ** | **Percent of  Common Stock (2)** | ** ** |
|----------------------------------------------------------------------------|------------|------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| Fox Paine Capital, LLC(3)                                                  |       |       | 25,492,044 |                                                                    |       |                                            | 38.8       | % |   |
| Fox Paine Capital Fund, L.P.(3)                                            |       |       | 24,155,413 |                                                                    |       |                                            | 36.8       | % |   |
| FPC Investors, L.P.(3)                                                     |       |       | 358,422    |                                                                    |       |                                            | *          |   |   |
| Kopp Investment Advisors, LLC(4)                                           |       |       | 10,123,791 |                                                                    |       |                                            | 15.4       | % |   |
| W. Dexter Paine, III(5)                                               |       |       | 25,547,173 |                                                                    |       |                                            | 38.9       | % |   |
| Herald Y. Chen(6)                                                          |       |       | 25,492,044 |                                                                    |       |                                            | 38.8       | % |   |
| Liane J. Pelletier(7)                                                      |       |       | 15,000     |                                                                    |       |                                            | *          |   |   |
| Dag F. Wittusen(8)                                                         |       |       | 15,000     |                                                                    |       |                                            | *          |   |   |
| Michael E.  Holmstrom(9)                                                   |       |       | 16,250     |                                                                    |       |                                            | *          |   |   |
| Jack G. Levin                                                              |       |       | —     |                                                                    |       |                                            | *          |   |   |
| Catherine P.  Lego(10)                                                     |       |       | 36,250     |                                                                    |       |                                            | *          |   |   |
| Robert Whelton                                                             |       |       | —     |                                                                    |       |                                            | *          |   |   |
| Bruce W. Diamond(11)                                                       |       |       | 998,671    |                                                                    |       |                                            | 1.5        | % |   |
| Rainer N. Growitz(12)                                                      |       |       | 291,198    |                                                                    |       |                                            | *          |   |   |
| David R. Pulvino(13)                                                       |       |       | 212,112    |                                                                    |       |                                            | *          |   |   |
| Michael R. Farese, Ph.D.(14)                                               |       |       | 1,664,061  |                                                                    |       |                                            | 2.5        | % |   |
| *All  directors and executive officers as a group (14 persons)(15)         |       |       | 27,141,574 |                                                                    |       |                                            | 41.0       | % |   |

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*                    The percentageof shares beneficially owned does not exceed 1%.

** **(1)   Unlessotherwise indicated, the address of e        achof the beneficial owners identified is c/o WJ Communica tions, Inc., 401 River Oaks Parkway, San Jose, California95134.

** **(2)   Unlessotherwise noted, each person has voting and investment power, with respect toall such shares.****Based on 65,689,880 shares ofCommon Stock outstanding. Pursuant to the rules of the Securities andExchange Commission, certain shares of Common Stock which a person has theright to acquire within 60 days of the date hereof pursuant to the exercise ofstock options are deemed to be outstanding for the purpose of computing the percentage ownership of such person but arenot deemed outstanding for the purpose of computing the percentage ownership ofany other person.

** **(3)   FoxPaine & Company, LLC is the manager of (i) Fox Paine CapitalFund, LP (“LP1”), a direct owner of 24,155,413 shares of Common Stock of WJCommunications, Inc. (the “Issuer”), and (ii) FPC Investors, LP (“LP2”)(collectively, LP1 and LP2 are “LPs”), a direct owner of 358,422 shares ofCommon Stock of the Issuer. Fox Paine Capital, LLC is the General Partner ofeach of the LPs and the manager of each of WJ Coinvestment Fund I, LLC, WJCoinvestment Fund III, LLC and WJ Coinvestment Fund IV, LLC (collectively, the “Funds”),which directly own 601,478, 251,155 and 125,576 shares, respectively, of CommonStock (the “Shares”) of the Issuer. As a result, each of the 

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Reporting Persons may bedeemed to be the indirect beneficial owners of 25,492,044 shares of CommonStock of the Issuer owned by the LPs and the Funds.

** **(4)   Asreported by Kopp Investment Advisors, LLC and related entities on Schedule 13Gfiled with the Securities and Exchange Commission on January 30, 2006. Inits Schedule 13G, Kopp Investment Advisors, LLC states that as of December 31,2005, it has sole voting power as to 7,356,841 shares, shared voting power asto no shares, sole dispositive power with respect to 2,500,000 shares andshared dispositive power with respect to 5,404,891 shares. In addition, Mr. LeRoyC. Kopp, who controls Kopp Holding Company, LLC which owns 100% of KoppInvestment Advisors, LLC, has sole voting power as to 2,218,900 shares, sharedvoting power as to no shares, sole dispositive power with respect to 2,218,900shares and shared dispositive power with respect to no shares. The addressof  Kopp Investment Advisors, LLC andrelated entities is 7701 France Avenue South, Suite 500, Edina, MN 55435

** **(5)   Includes25,492,044 shares beneficially owned as described in footnote 3, 47,629 sharesawarded to Mr. Paine under the amended and restated 2000 Non EmployeeDirector Stock-Compensation Plan receipt of which has been deferred, and 7,500shares issuable to Mr. Paine subject to currently exercisable options.

** **(6)   Includes25,492,044 shares beneficially owned as described in footnote 3.

** **(7)   Represents15,000 shares issuable to Ms. Pelletier subject to currently exercisableoptions.

** **(8)   Represents15,000 shares issuable to Mr. Wittusen subject to currently exercisableoptions.

** **(9)   Represents10,000 shares held of record by Mr. Holmstrom and 6,250 shares issuable tosubject to currently exercisable options.

(10)   Represents    30,000 shares held of record by Ms. Legoand 6,250 shares issuable subject to currently exercisable options.

(11)   Represents 20,000 shares heldof record by Mr. Diamond, 15,000 shares issuable subject to currentlyexercisable options and 963,671 shares of restricted stock. Pursuant to hisemployment agreement, Mr. Diamond was granted 500,000 shares of time-vestingrestricted stock on July 29, 2005 and 500,000 shares ofperformance-vesting restricted stock on January 16, 2006. The number ofshares in the table includes the net number of shares of restricted stockbeneficially owned as of such date after the disposition of an aggregate of36,329 shares of vested time-vesting shares of restricted stock solely forwithholding tax purposes

(12)   Represents 48,054 shares heldof record by Mr. Growitz and 243,064 shares issuable subject to currentlyexercisable options.

(13)   Represents 84,382 shares heldof record by Mr. Pulvino and 127,730 shares issuable subject to currentlyexercisable options.

(14)   Represents 214,061 shares heldof record by Dr. Farese and 1,450,000 shares issuable subject to currentlyexercisable options. Dr. Farese was our CEO until June 27, 2005andthe number of shares is as of such date.

(15)   Includesshares deemed to be beneficially owned by Mr. Paine as a result of theirrelationships with and to Fox Paine Capital. Excluding such shares, all directorsand executive officers as a group beneficially own 1,649,530 shares held ofrecord and 435,794 shares issuable under currently exercisable options.

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**Item13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**

**Management Agreement**

On January 31, 2000, Fox Paine Capital Fund, aninvestment fund managed by Fox Paine & Company, LLC (“Fox Paine &Company” or “Fox Paine”), became the controlling stockholder of the Company.Fox Paine Capital Fund acquired its controlling position in an all cash mergerbetween FP-WJ Acquisition Corp. and the Company, then called Watkins-JohnsonCompany (the “Recapitalization Merger”), whereby Fox Paine Capital Fund and itsco-investors paid a total of $50.8 million for approximately 91.1% of theCommon Stock of the Company (or $41.125 per pre-split share as the Common Stockwas then constituted). Messrs. Paine and Chen are affiliated with FoxPaine.

As part of the Recapitalization Merger, the Companyentered into a management agreement with Fox Paine & Company. Sincethe Recapitalization Merger, and for each subsequent year, the Company will payFox Paine a fee in the amount of 1% of the Company’s net income before interestexpense, interest income, income taxes, depreciation and amortization andequity in earnings (losses) of minority investments, calculated without regardto the fee. In exchange for its management fee, Fox Paine assists the Companywith its strategic planning, budgets and financial projections and helps theCompany identify possible strategic acquisitions and recruit qualifiedmanagement personnel. Fox Paine also assists in customer and supplierrelationships on behalf of the Company and consults with the Company on variousmatters including tax planning and public relations strategies, economic andindustry trends and executive compensation. Due to the Company’s loss incurredfrom 2002, 2003 and 2004, no management fees were paid to Fox Paine for theyears ended December 31, 2003, December 31, 2004 and December 31,2005. The Company has agreed to reimburse Fox Paine for its expenses incurredin providing these services. The Company paid Fox Paine $29,000, $108,000 and$6,000 for the reimbursement of expenses incurred by Fox Paine for the yearsended December 31, 2005, December 31, 2004 and December 31,2003, respectively. The Company also paid Fox Paine $700,000 in July of2004 for investment banking services rendered in connection with the EiCAcquisition that was completed on June 18, 2004 (For further discussion, see Note 5 to the consolidated financial statements includedelsewhere in this Form 10-K).

Fox Paine will continue toprovide management services under this agreement until its affiliates no longerown shares of Common Stock or are no longer represented on the Board ofDirectors. The management agreement with the Company is similar to thoseentered into between Fox Paine and each of the other companies acquired by FoxPaine’s affiliates. In connection with this agreement, the Company has agreedto indemnify Fox Paine against various liabilities that may arise as a resultof the management services it will perform for the Company. The Company hasalso agreed to reimburse Fox Paine for its expenses incurred in providing theseservices.

**Shareholders’ Agreement**

On January 31,2000, the Company entered into a shareholders’ agreement with Fox Paine CapitalFund, investors affiliated with Fox Paine Capital Fund and several non-fundinvestors, including co-investors and certain employees of the Company. Underthe shareholders’ agreement, subject to limited exceptions:

·       FoxPaine Capital Fund and its affiliates, as a group, may make up to five demandsfor registration under the Securities Act of their shares of Common Stock;

·       Inthe event the Company registers any of its equity securities under the SecuritiesAct, or shares of Common Stock of Fox Paine Capital Fund pursuant to a demandregistration, each of the Company’s other stockholders who are a party to theagreement, may exercise piggyback registration rights to include all or aportion of its shares of Common Stock in the registration.

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In the event that either Fox Paine Capital Fund andits affiliates makes a demand for registration, the Company has agreed to payall expenses related to that registration. The Company has also agreed toindemnify Fox Paine Capital Fund against various liabilities associated withsuch registration.

The shareholders’ agreement also provides that theCompany’s stockholders who are a party to the agreement will vote their sharesin order to ensure that if and to the extent Fox Paine Capital Fund owns sharesof Common Stock, Fox Paine Capital Fund will be represented on the Board ofDirectors.

Fox Paine exercisedregistration rights in connection with the secondary underwritten publicoffering that we completed January 28, 2004.

**Item14. PRINCIPAL ACCOUNTANT FEES AND SERVICES**

**Feesbilled by our principal accounting firm, Deloitte & Touche LLP, themember firms of deloitte touche tohmatsu, and their respective affiliates(collectively, the “Deloitte Entities”) are as follows:**

| ** **          | ** ** | **Year Ended**   | ** ** |
|---------------------|------------|-----------------------|------------|
| ** **          | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **          | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Audit fees          |       |                  | $          | 708,600 |   |   |   | $ | 781,258 |   |   |
| Audit-related  fees |       |                  | 161,195    |   |   |   | 53,116 |   |   |
| Tax fees            |       |                  | 134,546    |   |   |   | 261,526 |   |   |
| All other fees      |       |                  | —     |   |   |   | — |   |   |
| Total               |       |                  | $          | 1,004,341 |   |   |   | $ | 1,095,900 |   |   |

 

Audit fees billed or expected to be billed by theDeloitte Entities include professional services rendered for the audit of ourannual financial statements, the reviews of the financial statements includedin our Quarterly Reports on Form 10-Q and the filing of RegistrationStatements with the Securities and Exchange Commission and fees required by theSarbanes-Oxley Act of 2002. Audit-related fees are fees billed for assuranceand related services that are reasonably related to the performance of theaudit or review of financial statements and included due diligence related tomergers and acquisitions, and consulting on financial accounting/reportingstandards and controls. Tax fees are professional services rendered for taxcompliance, tax consulting and tax planning including services related to theaudit of our 1996 through 2000 tax returns by the Internal Revenue Service andassociated amended state returns. All Other Fees consist of fees for productsand services other than the services reported above.

The Audit Committee hasconsidered whether the provision of non-audit services is compatible withmaintaining the principal accountant’s independence and has concluded that thenon-audit services provided by the Deloitte Entities are compatible withmaintaining the Deloitte Entities’ independence.

**Pre-ApprovalPolicies and Procedures**

The Audit Committee approves in advance all audit andpermissible non-audit services to be performed by our independent registeredpublic accounting firm. The Audit Committee considers whether the provision ofany proposed non-audit services is consistent with the SEC’s rules onauditor independence and has pre-approved certain specified audit and non-auditservices to be provided by the Deloitte Entities for up to twelve (12) monthsfrom the date of the pre-approval. If there are any additional services to beprovided, a request for pre-approval must be submitted by management to theAudit Committee for its consideration.  The Audit Committee pre-approved all of theservices performed in 2005 and 2004 by the Deloitte Entities relating to the “AuditFees,” “Audit-Related Fees,” “Tax Fees” and “All Other Fees” described above asrequired by the Sarbanes-Oxley Act of 2002.

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**PART IV**

**Item 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**

**1. FinancialStatements**

The consolidated financialstatements, and related notes thereto, of the Company, and the Report of IndependentRegistered Public Accounting Firm listed in the accompanying Index toConsolidated Financial Statements on page 3 are filed as part of this Form 10-K.

**2. FinancialStatement Schedules**

Thefollowing financial statement schedule of the Company is filed as part of this Form 10-K.All other schedules have been omitted because they are not applicable, notrequired, or the information is included in the consolidated financialstatements or notes thereto.

|                                                     | ** ** | **Page** | ** ** |
|-----------------------------------------------------|------------|----------|------------|
| Schedule II—Valuation  and Qualifying Accounts |       |     | 135        |   |   |
|                                                     |            |          |            |  |  |

 

**3. Exhibits**

Theexhibits listed on the following index to exhibits are filed as part of, orhereby incorporated by reference into, this Form 10-K.

|             | ** ** | ** **                                                                                                                                                                                         | ** ** | **Incorporated   by Reference** | ** ** | ** ** |
|-------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|------------|
| **Exhibit** | ** ** | ** **                                                                                                                                                                                         | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | **Filing** | ** ** | **Filed** |
| ** **  | **Number** | ** **                                                                                                                                                                                         | ** ** | **Exhibit Description**    | ** ** | **Form**   | ** ** | **File No** | ** ** | **Exhibit** | ** ** | **Date** | ** ** | **Herewith** |
| 2.1         |       | Agreement and Plan of  Merger, dated October 25, 1999, by and between FP-WJ Acquisition Corp.  and the Registrant                                                                             |       | 8-K                             |       | 1-5631     |   | 2.1 |   | 10/28/99 |   |   |
| 3.1         |       | Certificate of  Incorporation of the Registrant                                                                                                                                                    |       | S-1/A                           |       | 333-38518  |   | 3.1 |   | 7/12/00 |   |   |
| 3.2         |       | By-Laws of the  Registrant                                                                                                                                                                         |       | S-1/A                           |       | 333-38518  |   | 3.2 |   | 7/12/00 |   |   |
| 4.1         |       | Specimen of Common Stock  Certificate                                                                                                                                                              |       | 8-A                             |       | 000-31337  |   | 4.1 |   | 8/14/00 |   |   |
| 4.2*        |       | Shareholders’ Agreement,  dated as of January 31, 2000, by and among the Registrant, the Parties  listed on the signature pages thereto and certain stockholders of the  Registrant |       | S-1/A                           |       | 333-38518  |   | 4.2 |   | 7/26/00 |   |   |
| 10.1*       |       | Employment Agreement,  dated as of January 31, 2000, by and between the Registrant and Thomas  R. Kritzer                                                                                     |       | S-1/A                           |       | 333-38518  |   | 10.4 |   | 7/12/00 |   |   |
| 10.2*       |       | Employment Agreement,  dated as of January 31, 2000, by and between the Registrant and  Rainer N. Growitz                                                                                     |       | S-1/A                           |       | 333-38518  |   | 10.6 |   | 7/12/00 |   |   |
| 10.3*       |       | WJ  Communications, Inc. 2000 Stock Incentive Plan                                                                                                                                            |       | S-1/A                           |       | 333-38518  |   | 10.8 |   | 7/12/00 |   |   |
|             |            |                                                                                                                                                                                                    |            |                                 |            |            |  |  |  |  |  |  |  |  |

 

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|             | ** ** | ** **                                                                                                                                                                                                                              | ** ** | **Incorporated by Reference** | ** ** | ** ** |
|-------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|------------|
| **Exhibit** | ** ** | ** **                                                                                                                                                                                                                              | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** | **Filing** | ** ** | **Filed** |
| ** **  | **Number** | ** **                                                                                                                                                                                                                              | ** ** | **Exhibit Description**  | ** ** | **Form**   | ** ** | **File No** | ** ** | **Exhibit** | ** ** | **Date** | ** ** | **Herewith** |
| 10.4        |       | Lease (Phase I) dated  March 24, 2000, by and between the Registrant and 401 River Oaks, LLC                                                                                                                                       |       | S-1/A                         |       | 333-38518  |   | 10.9 |   | 7/12/00 |   |   |
| 10.5        |       | Lease (Phase II) dated  March 24, 2000, by and between the Registrant and 401 River Oaks, LLC                                                                                                                                      |       | S-1/A                         |       | 333-38518  |   | 10.10 |   | 7/12/00 |   |   |
| 10.6        |       | Management Agreement,  dated as of January 31, 2000, by and between Registrant and Fox  Paine & Company, LLC                                                                                                              |       | S-1/A                         |       | 333-38518  |   | 10.17 |   | 7/12/00 |   |   |
| 10.7        |       | WJ  Communications, Inc. 2000 Non-Employee Director Stock Compensation Plan                                                                                                                                                        |       | S-8                           |       | 333-52408  |   | 99.2 |   | 12/21/00 |   |   |
| 10.8*       |       | Employment Agreement, by  and between the Registrant and Michael R. Farese, Ph.D.                                                                                                                                                       |       | 8-K                           |       | 000-31337  |   | 10.1 |   | 11/15/04 |   |   |
| 10.9        |       | Amended and Restated WJ  Communications, Inc. 2002 Non-Employee Director Stock Compensation Plan                                                                                                                                   |       | 10-Q                          |       | 000-31337  |   | 10.1  and 10.2 |   | 8/12/03 |   |   |
| 10.10*      |       | Second Amendment to WJ  Communications, Inc. 2000 Stock Incentive Plan                                                                                                                                                             |       | 10-Q                          |       | 000-31337  |   | 10.1  and 10.2 |   | 8/12/03 |   |   |
| 10.11       |       | Amended and Restated  Loan and Security Agreement, dated September 29, 2003, by and among the  Registrant and Comerica Bank                                                                                                        |       | 10-Q                          |       | 000-31337  |   | 10.1 and 10.2 |   | 10/30/03 |   |   |
| 10.12       |       | Intellectual Property  Security Agreement, dated September 29, 2003, by and among the  Registrant and Comerica Bank                                                                                                                |       | 10-Q                          |       | 000-31337  |   | 10.1 and 10.2 |   | 10/30/03 |   |   |
| 10.13       |       | Acquisition related  agreements by and between WJ Communications, Inc., EiC Corporation and  EiC Enterprises Limited dated June 18, 2004                                                                                      |       | 8-K                           |       | 000-31337  |   | 2.1,  2.2, 4.1,   4.2 and 10.1 |   | 7/2/04 |   |   |
| 10.14*      |       | Employment Agreement, by  and between the Registrant and Ephraim Kwok                                                                                                                                                                   |       | 8-K                           |       | 000-31337  |   | 10.1 |   | 12/21/04 |   |   |
| 10.15       |       | Acquisition related  agreements by and among WJ Communications, Inc., WJ Newco, LLC,  Telenexus, Inc. and Richard J. Swanson, Wilfred K. Lau, David  Fried, Kurt Christensen and Mark Sutton dated January 28, 2005 |       | 8-K                           |       | 000-31337  |   | 2.1  and 4.1 |   | 2/3/05 |   |   |
|             |            |                                                                                                                                                                                                                                         |            |                               |            |            |  |  |  |  |  |  |  |  |  |

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|                    | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          | ** ** | **Incorporated by Reference** | ** ** | ** ** |
|--------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|------------|
| **Exhibit**        | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** | **Filing** | ** ** | **Filed** |
| ** **         | **Number** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          | ** ** | **Exhibit Description**  | ** ** | **Form**   | ** ** | **File No** | ** ** | **Exhibit** | ** ** | **Date** | ** ** | **Herewith** |
| 10.16*†† |       | Employment Agreement by and between WJ  Communications, Inc. and Richard J. Swanson dated January 28, 2005                                                                                                                                                                                                                                                                                                                                                                                                |       | 8-K                           |       | 000-31337  |   | 10.1 |   | 2/3/05 |   |   |
| 10.17*†† |       | Employment Agreement by and between WJ  Communications, Inc. and Wilfred K. Lau dated January 28, 2005                                                                                                                                                                                                                                                                                                                                                                                                    |       | 8-K                           |       | 000-31337  |   | 10.2 |   | 2/3/05 |   |   |
| 10.18*             |       | Employment agreement  between the Registrant and Javed S. Patel                                                                                                                                                                                                                                                                                                                                                                                                                                                     |       | 10-Q                          |       | 000-31337  |   | 10.1 |   | 5/18/05 |   |   |
| 10.19*             |       | Employment agreement  between the Registrant and Neil Morris, Ph.D.                                                                                                                                                                                                                                                                                                                                                                                                                                                 |       | 10-Q                          |       | 000-31337  |   | 10.2 |   | 5/18/05 |   |   |
| 10.20*             |       | Employment agreement  between the Registrant and Robert J. Bayruns                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       | 10-Q                          |       | 000-31337  |   | 10.3 |   | 5/18/05 |   |   |
| 10.21              |       | Acquisition  related agreements by and among WJ Communications, Inc., WJ Newco, LLC,  Telenexus, Inc. and Richard J. Swanson, Wilfred K. Lau, David  Fried, Kurt Christensen and Mark Sutton dated January 28, 2005 to refile  Exhibit 2.1 to include certain information that was previously redacted  pursuant to a confidential treatment request. The Exhibit 2.1 attached  hereto supersedes in its entirety the exhibit previously filed on Form 8-K  on February 3, 2005. |       | 8-K/A                         |       | 000-31337  |   | 2.1 |   | 6/24/05 |   |   |
| 10.22*             |       | Separation Agreement,  dated as of June 28, 2005, by and between the Registrant and Michael R.  Farese, Ph.D.                                                                                                                                                                                                                                                                                                                                                                                                  |       | 8-K                           |       | 000-31337  |   | 10.1 |   | 7/1/05 |   |   |
| 10.23*             |       | Employment Agreement,  dated as of June 28, 2005, by and between the Registrant and Bruce W.  Diamond                                                                                                                                                                                                                                                                                                                                                                                                          |       | 8-K                           |       | 000-31337  |   | 10.2 |   | 7/1/05 |   |   |
| 10.24*             |       | Employment offer letter, dated as of July 18,  2005, by and between the Company and Mark S. Knoch                                                                                                                                                                                                                                                                                                                                                                                                              |       | 8-K                           |       | 000-31337  |   | 10.1 |   | 8/4/05 |   |   |
| 10.25*             |       | Employment agreement,  dated October 19, 2005, by and between the Company and Haresh P. Patel                                                                                                                                                                                                                                                                                                                                                                                                                  |       | 8-K                           |       | 000-31337  |   | 10.1 |   | 10/28/05 |   |   |
|                    |            |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |            |                               |            |            |  |  |  |  |  |  |  |  |  |

 

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|              | ** ** | ** **                                                                                                                                                                | ** ** | **Incorporated   by Reference** | ** ** | ** ** |
|--------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|------------|
| **Exhibit**  | ** ** | ** **                                                                                                                                                                | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | **Filing** | ** ** | **Filed** |
| ** **   | **Number** | ** **                                                                                                                                                                | ** ** | **Exhibit Description**    | ** ** | **Form**   | ** ** | **File No** | ** ** | **Exhibit** | ** ** | **Date** | ** ** | **Herewith** |
| 10.26        |       | Amendment No. 4 to  Loan and Security Agreement by and between the Company and Comerica Bank  dated December 27, 2005                                           |       | 8-K                             |       | 000-31337  |   | 10.1 |   | 1/3/06 |   |   |
| 10.27*† |       | Employment Agreement,  dated as of December 21, 2005, by and between the Registrant and Mark S.  Knoch                                                          |       |                            |       |       |   |   |   |   |   | X |
| 10.28*       |       | Employment Agreement, dated as January 13,  2006, of by and between the Registrant and Morteza Saidi                                                                 |       |                            |       |       |   |   |   |   |   | X |
| 21.1         |       | Subsidiaries of the  registrant                                                                                                                                           |       |                            |       |       |   |   |   |   |   | X |
| 23.1         |       | Consent of  Deloitte & Touche, LLP, Independent Registered Public Accounting  Firm                                                                               |       |                            |       |       |   |   |   |   |   | X |
| 24.1         |       | Power of Attorney (see  signature page)                                                                                                                                   |       |                            |       |       |   |   |   |   |   | X |
| 31.1         |       | Certification of Bruce  W. Diamond, Chief Executive Officer (principal executive officer), pursuant  to Rule 13a-14 of the Securities Exchange Act of 1934.          |       |                            |       |       |   |   |   |   |   | X |
| 31.2         |       | Certification of Rainer  N. Growitz, Interim Chief Financial Officer (principal financial officer),  pursuant to Rule 13a-14 of the Securities Exchange Act of 1934. |       |                            |       |       |   |   |   |   |   | X |
| 32.1         |       | Certification of Bruce  W. Diamond, principal executive officer, Pursuant To 18 U.S.C. Section 1350.                                                                 |       |                            |       |       |   |   |   |   |   | X |
| 32.2         |       | Certification of Rainer N. Growitz, principal  financial officer, Pursuant To 18 U.S.C. Section 1350.                                                                |       |                            |       |       |   |   |   |   |   | X |
|              |            |                                                                                                                                                                           |            |                                 |            |            |  |  |  |  |  |  |  |  |  |

----

*                    Indicates acontract, compensatory plan or arrangement in which directors or executiveofficers are eligible to participate.

†                    Confidentialtreatment has been requested with respect to the redacted portions of thereferenced exhibit.

††             Confidentialtreatment has previously been granted by the SEC for certain portions of thereferenced exhibit pursuant to Rule 406 under the Securities Act.

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this Report to be signed on its behalf bythe undersigned, thereunto duly authorized, in the City of San Jose, State ofCalifornia, on the 30th day of March 2006.
|        |   |                |   |   |   | WJ  COMMUNICATIONS, INC.               |
|--------|--------|---------------------|--------|--------|--------|----------------------------------------|
|   |   |                |   |   |   | (Registrant)                           |
| Date   |   | March 30, 2006 |   | By:    |   | /s/  BRUCE W. DIAMOND                  |
|   |   |                |   |   |   | Bruce W. Diamond                       |
|   |   |                |   |   |   | President and  Chief Executive Officer |

 

**POWER OF ATTORNEY**

We, the undersigned officers and directors of WJCommunications, Inc., do hereby constitute and appoint Bruce W. Diamond,and Rainer N. Growitz, and each of them, our true and lawful attorneys-in-factand agents, each with full power of substitution and resubstitution, for himand in his name, place and stead, in any and all capacities, to sign any andall amendments to this Report, and to file the same, with exhibits thereto, andother documents in connection therewith, with the Securities and ExchangeCommission, granting unto said attorneys-in-fact and agents, and each of them,full power and authority to do and perform each and every act and thingrequisite or necessary to be done in and about the premises, as fully to allintents and purposes as he might or could do in person, hereby, ratifying andconfirming all that each of said attorneys-in-fact and agents, or hissubstitute or substitutes, may lawfully do or cause to be done by virtuehereof.

Pursuant to therequirements of the Securities Exchange Act of 1934, this Report has beensigned below by the following persons in the capacities and on the datesindicated:
| Signature                      | ** ** | **Title**                                         | ** ** | **Date**  |
|--------------------------------|------------|---------------------------------------------------|------------|-----------|
| /s/ BRUCE W.  DIAMOND          |       | President, Chief Executive  Officer               |       | 3/30/2006 |
| Bruce W. Diamond               |       | (principal executive officer) , Director          |       |      |
| /s/ RAINER N.  GROWITZ         |       | Interim Chief Financial  Officer                  |       | 3/30/2006 |
| Rainer N. Growitz              |       | Vice President of Finance and Corporate Secretary |       |      |
|                           |       | (principal financial officer)                     |       |      |
| /s/ DAVID R.  PULVINO          |       | Chief Accounting Officer                          |       | 3/30/2006 |
| David R. Pulvino               |       | (principal accounting officer)                    |       |      |
| /s/ W. DEXTER  PAINE, III |       | Chairman of the Board                             |       | 3/30/2006 |
| W. Dexter Paine, III      |       |                                              |       |      |
| /s/ MICHAEL E.  HOLMSTROM      |       | Director                                          |       | 3/30/2006 |
| Michael E. Holmstrom           |       |                                              |       |      |
| /s/ LIANE J.  PELLETIER        |       | Director                                          |       | 3/30/2006 |
| Liane J. Pelletier             |       |                                              |       |      |
| /s/ DAG F.  WITTUSEN           |       | Director                                          |       | 3/30/2006 |
| Dag F. Wittusen                |       |                                              |       |      |

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| /s/ JACK G. LEVIN      |   | Director |   | 3/30/2006 |
|------------------------|--------|----------|--------|-----------|
| Jack G. Levin          |   |     |   |      |
| /s/ CATHERINE  P. LEGO |   | Director |   | 3/30/2006 |
| Catherine P. Lego      |   |     |   |      |
| /s/ HERALD Y.  CHEN    |   | Director |   | 3/30/2006 |
| Herald Y. Chen         |   |     |   |      |
| /s/ ROBERT  WHELTON    |   | Director |   | 3/30/2006 |
| Robert Whelton         |   |     |   |      |

 

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**SCHEDULE II**

**WJCOMMUNICATIONS, INC. AND SUBSIDIARIESVALUATION AND QUALIFYING ACCOUNTS AND RESERVESFOR THE YEARS ENDED DECEMBER 31, 2005, 2004 and 2003**(inthousands)

| ** **                         | ** ** | **Balance at**   | ** ** | **Charged (Credits)** | ** ** | **Charged to** | ** ** | ** **       | ** ** | **Balance at** | ** ** |
|------------------------------------|------------|-----------------------|------------|----------------------------|------------|---------------------|------------|------------------|------------|---------------------|------------|
| ** **                         | ** ** | **Beginning of** | ** ** | **to Costs and** | ** ** | **Other**           | ** ** | **Recoveries/**  | ** ** | **End of**     | ** ** |
| **Description**                    | ** ** | **Period**            | ** ** | **Expenses**               | ** ** | **Accounts**        | ** ** | **(Write-offs)** | ** ** | **Period**          | ** ** |
| Year ended  December 31, 2005 |       |                  |       |                       |       |                |       |             |       |                |       |   |   |   |   |   |   |   |   |   |   |
| Deducted from  asset accounts:     |       |                  |       |                       |       |                |       |             |       |                |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts    |       |                  | $          | 79                         |       |                |       | $                | 32         |                |       |   | $ | — |   |   |   | $ | (96 | ) |   |   | $ | 15 |   |   |
| Sales return allowance             |       |                  | 74         |                       |       |                | 511        |             |       |                | —     |   |   |   | (512 | ) |   |   | 73 |   |   |
| Distributor stock rotation reserve |       |                  | 338        |                       |       |                | 26         |             |       |                | —     |   |   |   | (364 | ) |   |   | — |   |   |
| Ship & debit allowance    |       |                  | 5          |                       |       |                | 89         |             |       |                | —     |   |   |   | (60 | ) |   |   | 34 |   |   |
| Warranty reserve                   |       |                  | 54         |                       |       |                | 22         |             |       |                | —     |   |   |   | (36 | ) |   |   | 40 |   |   |
| Total                              |       |                  | $          | 550                        |       |                |       | $                | 680        |                |       |   | $ | — |   |   |   | $ | (1,068 | ) |   |   | $ | 162 |   |   |
| Year ended  December 31, 2004 |       |                  |       |                       |       |                |       |             |       |                |       |   |   |   |   |   |   |   |   |   |   |
| Deducted from  asset accounts:     |       |                  |       |                       |       |                |       |             |       |                |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts    |       |                  | $          | 21                         |       |                |       | $                | 51         |                |       |   | $ | — |   |   |   | $ | 7 |   |   |   | $ | 79 |   |   |
| Sales return allowance             |       |                  | 75         |                       |       |                | 760        |             |       |                | —     |   |   |   | (761 | ) |   |   | 74 |   |   |
| Distributor stock rotation reserve |       |                  | 196        |                       |       |                | 847        |             |       |                | —     |   |   |   | (705 | ) |   |   | 338 |   |   |
| Ship & debit allowance    |       |                  | 29         |                       |       |                | 35         |             |       |                | —     |   |   |   | (59 | ) |   |   | 5 |   |   |
| Warranty reserve                   |       |                  | 36         |                       |       |                | 76         |             |       |                | —     |   |   |   | (58 | ) |   |   | 54 |   |   |
| Total                              |       |                  | $          | 357                        |       |                |       | $                | 1,769      |                |       |   | $ | — |   |   |   | $ | (1,576 | ) |   |   | $ | 550 |   |   |
| Year ended  December 31, 2003 |       |                  |       |                       |       |                |       |             |       |                |       |   |   |   |   |   |   |   |   |   |   |
| Deducted from  asset accounts:     |       |                  |       |                       |       |                |       |             |       |                |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts    |       |                  | $          | 429                        |       |                |       | $                | (393       | )                   |       |   | $ | — |   |   |   | $ | (15 | ) |   |   | $ | 21 |   |   |
| Sales return allowance             |       |                  | 116        |                       |       |                | 481        |             |       |                | —     |   |   |   | (522 | ) |   |   | 75 |   |   |
| Distributor stock rotation reserve |       |                  | 247        |                       |       |                | 219        |             |       |                | —     |   |   |   | (270 | ) |   |   | 196 |   |   |
| Ship & debit allowance    |       |                  | —     |                       |       |                | 32         |             |       |                | —     |   |   |   | (3 | ) |   |   | 29 |   |   |
| Warranty reserve                   |       |                  | 54         |                       |       |                | 30         |             |       |                | —     |   |   |   | (48 | ) |   |   | 36 |   |   |
| Total                              |       |                  | $          | 846                        |       |                |       | $                | 369        |                |       |   | $ | — |   |   |   | $ | (858 | ) |   |   | $ | 357 |   |   |

 

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