Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 26, 2010

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission File No. 0-14225

 

 

EXAR CORPORATION

(Exact Name of Registrant as specified in its charter)

 

 

 

Delaware   94-1741481

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

48720 Kato Road, Fremont, CA 94538

(Address of principal executive offices, Zip Code)

(510) 668-7000

(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulations S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer   ¨    Accelerated filer   x
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

The number of shares outstanding of the Registrant’s Common Stock was 44,280,365 as of October 29, 2010, net of 19,924,369 treasury shares.

 

 

 


Table of Contents

 

EXAR CORPORATION AND SUBSIDIARIES

INDEX TO

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 26, 2010

 

          Page  
   PART I – FINANCIAL INFORMATION   
Item 1.    Financial Statements (Unaudited)      3   
   Condensed Consolidated Balance Sheets      3   
   Condensed Consolidated Statements of Operations      4   
   Condensed Consolidated Statements of Cash Flows      5   
   Notes to Condensed Consolidated Financial Statements      6   
Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations      26   
Item 3.    Quantitative and Qualitative Disclosures About Market Risk      36   
Item 4.    Controls and Procedures      36   
   PART II – OTHER INFORMATION   
Item 1.    Legal Proceedings      37   
Item 1A.    Risk Factors      37   
Item 6.    Exhibits      52   
   Signatures      53   
   Index to Exhibits      54   

 

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PART I – FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

EXAR CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share amounts)

(Unaudited)

 

     September 26,     March 28,  
     2010     2010  
ASSETS     

Current assets:

    

Cash and cash equivalents

   $ 14,086      $ 25,486   

Short-term marketable securities

     194,162        186,598   

Accounts receivable (net of allowances of $793 and $831)

     13,857        13,461   

Accounts receivable, related party (net of allowances of $342 and $605)

     3,963        4,323   

Inventories

     22,601        15,000   

Other current assets

     3,177        5,106   
                

Total current assets

     251,846        249,974   

Property, plant and equipment, net

     41,721        42,941   

Goodwill

     3,184        3,085   

Intangible assets, net

     26,009        31,957   

Other non-current assets

     5,048        5,357   
                

Total assets

   $ 327,808      $ 333,314   
                
LIABILITIES AND STOCKHOLDERS’ EQUITY     

Current liabilities:

    

Accounts payable

   $ 11,845      $ 9,828   

Accrued compensation and related benefits

     7,161        6,619   

Deferred income and allowances on sales to distributors

     5,712        4,227   

Deferred income and allowances on sales to distributors, related party

     11,018        10,650   

Short-term lease financing obligations

     3,764        3,540   

Other accrued expenses

     4,935        7,058   
                

Total current liabilities

     44,435        41,922   

Long-term lease financing obligations

     12,888        13,454   

Other non-current obligations

     3,838        3,806   
                

Total liabilities

   $ 61,161      $ 59,182   
                

Commitments and contingencies (Notes 15 and 16)

    

Stockholders’ equity:

    

Preferred stock, $.0001 par value; 2,250,000 shares authorized; no shares outstanding

   $ —        $ —     

Common stock, $.0001 par value; 100,000,000 shares authorized; 44,251,257 and 43,839,514 shares outstanding at September 26, 2010 and March 28, 2010, respectively

     4        4   

Additional paid-in capital

     724,899        720,455   

Accumulated other comprehensive income

     1,226        1,282   

Treasury stock at cost, 19,924,369 shares at September 26, 2010 and March 28, 2010

     (248,983     (248,983

Accumulated deficit

     (210,499     (198,626
                

Total stockholders’ equity

     266,647        274,132   
                

Total liabilities and stockholders’ equity

   $ 327,808      $ 333,314   
                

See accompanying Notes to Condensed Consolidated Financial Statements.

 

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EXAR CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

 

     Three Months Ended     Six Months Ended  
     September 26,     September 27,     September 26,     September 27,  
     2010     2009     2010     2009  

Sales:

        

Net sales

   $ 25,885      $ 23,118      $ 54,250      $ 46,228   

Net sales, related party

     11,348        8,470        22,619        16,222   
                                

Total net sales

     37,233        31,588        76,869        62,450   
                                

Cost of sales:

        

Cost of sales

     13,205        11,843        27,284        24,732   

Cost of sales, related party

     5,222        4,088        10,410        7,876   

Amortization of purchased intangible assets

     1,515        1,567        3,068        2,907   
                                

Total cost of sales

     19,942        17,498        40,762        35,515   
                                

Gross profit

     17,291        14,090        36,107        26,935   
                                

Operating expenses:

        

Research and development

     11,840        12,288        26,283        24,582   

Selling, general and administrative

     11,083        11,375        24,040        26,487   
                                

Total operating expenses

     22,923        23,663        50,323        51,069   

Loss from operations

     (5,632     (9,573     (14,216     (24,134

Other income and expense, net:

        

Interest income and other, net

     1,578        1,700        3,191        3,454   

Interest expense

     (316     (326     (634     (650

Impairment charges on investments

     (62     (245     (62     (317
                                

Total other income and expense, net

     1,200        1,129        2,495        2,487   

Loss before income taxes

     (4,432     (8,444     (11,721     (21,647

Provision for (benefit from) income taxes

     27        (281     152        (609
                                

Net loss

   $ (4,459   $ (8,163   $ (11,873   $ (21,038
                                

Loss per share:

        

Basic and diluted loss per share

   $ (0.10   $ (0.19   $ (0.27   $ (0.48
                                

Shares used in the computation of loss per share:

        

Basic and diluted

     44,173        43,550        44,035        43,432   
                                

See accompanying Notes to Condensed Consolidated Financial Statements.

 

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EXAR CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

     Six Months Ended  
     September 26,     September 27,  
     2010     2009  

Cash flows from operating activities:

    

Net loss

   $ (11,873   $ (21,038

Reconciliation of net loss to net cash provided by (used in) operating activities:

    

Depreciation and amortization

     10,690        10,935   

Deferred income taxes

     —          (203

Stock-based compensation expense

     4,836        2,975   

Provision for sales returns and allowances

     6,957        4,735   

Other than temporary loss on investments

     62        317   

Changes in operating assets and liabilities, net of effects of acquisitions:

    

Accounts receivable and accounts receivable, related party

     (6,993     (8,726

Inventories

     (7,601     7,623   

Other current assets

     544        1,325   

Accounts payable

     2,017        2,403   

Accrued compensation and related benefits

     (282     (647

Deferred income and allowance on sales to distributors and related parties

     1,853        191   

Other accrued expenses

     (176     (2,195
                

Net cash provided by (used in) operating activities

     34        (2,305
                

Cash flows from investing activities:

    

Purchases of property, plant and equipment and intellectual property, net

     (2,645     (3,313

Purchases of short-term marketable securities

     (82,269     (118,691

Proceeds from maturities of short-term marketable securities

     39,676        75,875   

Proceeds from sales of short-term marketable securities

     35,187        35,853   

Other investment activities

     (263     (25

Acquisition of Galazar, net of cash acquired

     —          (3,495

Acquisition of Hifn, net of cash acquired

     —          (40,349
                

Net cash used in investing activities

     (10,314     (54,145
                

Cash flows from financing activities:

    

Proceeds from issuance of common stock

     431        274   

Repayment of lease financing obligations

     (1,551     (792
                

Net cash used in financing activities

     (1,120     (518
                
Net decrease in cash and cash equivalents      (11,400     (56,968
Cash and cash equivalents at the beginning of period      25,486        89,002   
                
Cash and cash equivalents at the end of period    $ 14,086      $ 32,034   
                

Supplemental disclosure of non-cash investing and financial activities:

    

Property, plant and equipment acquired under capital lease

   $ 1,208      $ 710   

Issuance of common stock in connection with Hifn acquisition

     —          2,705   

See accompanying Notes to Condensed Consolidated Financial Statements.

 

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EXAR CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1. ORGANIZATION AND BASIS OF PRESENTATION

Description of Business—Exar Corporation was incorporated in California in 1971 and reincorporated in Delaware in 1991. Exar Corporation and its subsidiaries (“Exar” or “we”) is a fabless semiconductor company that designs, sub-contracts manufacturing and sells highly differentiated silicon, software and subsystem solutions for industrial, telecom, networking and storage applications.

Certain reclassifications have been made to the prior year consolidated financial statements to conform to the current year’s presentation. Such reclassification had no effect on previously reported results of operations or stockholders’ equity.

Our fiscal years consist of 52 or 53 weeks. In a 52-week year, each fiscal quarter consists of 13 weeks. The additional week in a 53-week year is added to the fourth fiscal quarter, making such quarter consist of 14 weeks. Fiscal year 2011 and fiscal year 2010 are comprised of a 52-week period. The second quarters of fiscal 2011 and fiscal 2010 each included 91 days from June 28, 2010 to September 26, 2010 and from June 29, 2009 to September 27, 2009, respectively. The first six months of fiscal 2011 and fiscal 2010 each included 182 days from March 29, 2010 to September 26, 2010 and from March 30, 2009 to September 27, 2009, respectively.

Basis of Presentation and Use of Management Estimates—The accompanying condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements and should be read in conjunction with the Financial Statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended March 28, 2010 as filed with the SEC. In the opinion of management, the accompanying condensed consolidated financial statements contain all adjustments, consisting only of normal recurring adjustments, that we believe are necessary for a fair statement of Exar’s financial position as of September 26, 2010 and our results of operations for the three and six months ended September 26, 2010 and September 27, 2009, respectively. These condensed consolidated financial statements are not necessarily indicative of the results to be expected for the entire year.

The financial statements include management’s estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and the reported amounts of sales and expenses during the reporting periods. Actual results could differ from those estimates, and material effects on operating results and financial position may result.

NOTE 2. RECENT ACCOUNTING PRONOUNCEMENTS

In January 2010, the Financial Accounting Standards Board’s (“FASB’s”) Emerging Issues Task Force issued new authoritative guidance addressing certain measurements and disclosures about purchases, sales, issuances, and settlements in Level 3 fair value measurements. We are currently evaluating the impact of implementing the disclosures about purchases, sales, issuances, and settlements in Level 3 fair value measurements on our financial position and result of operations, which are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. We currently do not have any purchases, sales, issuances, or settlements in Level 3 fair value measurements.

NOTE 3. BUSINESS COMBINATIONS

We periodically evaluate potential strategic acquisitions to build upon our existing library of intellectual property, human capital and engineering talent, in order to expand our capabilities in the areas in which we operate or to acquire complementary businesses.

We account for each business combination by applying the acquisition method, which requires (i) identifying the acquiree; (ii) determining the acquisition date; (iii) recognizing and measuring the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest of Exar in the acquiree at their acquisition date fair value; and (iv) recognizing and measuring goodwill or a gain from a bargain purchase.

Assets acquired and liabilities assumed in a business combination that arise from contingencies are recognized at fair value on the acquisition date if fair value can be determined during the measurement period. If fair value cannot be determined, we typically account for the acquired contingencies using existing guidance for a reasonable estimate.

To establish fair value, we measure the price that would be received to sell an asset or paid to transfer a liability in an ordinary transaction between market participants. The measurement assumes the highest and best use of the asset by the market participants that would maximize the value of the asset or the group of assets within which the asset would be used at the measurement date, even if the intended use of the asset is different.

 

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EXAR CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

Goodwill is measured and recorded as the amount by which the consideration transferred, generally at the acquisition date fair value, exceeds the acquisition date fair value of identifiable assets acquired, the liabilities assumed, and any noncontrolling interest of Exar in the acquiree. To the contrary, if the acquisition date fair value of identifiable assets acquired, the liabilities assumed, and any noncontrolling interest of Exar in the acquiree exceeds the consideration transferred, it is considered a bargain purchase and we would recognize the resulting gain in earnings on the acquisition date.

In-process research and development (“IPR&D”) assets are considered an indefinite-lived intangible asset and are not subject to amortization. IPR&D assets must be tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test consists of a comparison of the fair value of the IPR&D asset with its carrying amount. If the carrying amount of the IPR&D asset exceeds its fair value, an impairment loss must be recognized in an amount equal to that excess. After an impairment loss is recognized, the adjusted carrying amount of the IPR&D assets will be its new accounting basis. Subsequent reversal of a previously recognized impairment loss is prohibited. The initial determination and subsequent evaluation for impairment of the IPR&D asset requires management to make significant judgments and estimates. Once the IPR&D projects have been completed, the useful life of the IPR&D asset is determined and amortized accordingly. If the IPR&D asset is abandoned, the remaining carrying value is written off.

Acquisition-related costs, including finder’s fees, advisory, legal, accounting, valuation and other professional or consulting fees are accounted for as expenses in the periods in which the costs are incurred and the services are received, with the exception that the costs to issue debt or equity securities are recognized in accordance with other applicable generally accepted accounting principles (“GAAP”).

Acquisition of Neterion

On March 16, 2010, we completed the acquisition of Neterion, Inc. (“Neterion”), a supplier of 10 Gigabit Ethernet controller silicon and card solutions optimized for virtualized data centers located in Sunnyvale, California. Neterion’s results of operations and estimated fair value of assets acquired and liabilities assumed were included in our consolidated financial statements beginning March 17, 2010.

Consideration

We paid approximately $2.3 million in cash for Neterion, representing the fair value of total consideration transferred.

Acquisition-Related Costs

Acquisition-related costs, or deal costs, relating to Neterion which are included in the “Selling, general and administrative” line item on the condensed consolidated statement of operations for the six months ended September 26, 2010, were immaterial. No acquisition-related costs relating to Neterion were incurred during the three months ended September 26, 2010.

Restructuring Costs

For disclosure regarding restructuring costs, see “Note 8. Restructuring” contained herein.

Purchase Price Allocation

The allocation of the purchase price to Neterion’s tangible and identifiable intangible assets acquired and liabilities assumed was based on their estimated fair values at the date of acquisition. We will recognize additional assets or liabilities if new information is obtained about facts and circumstances that existed as of the acquisition date that, if known, would have resulted in the recognition of those assets and liabilities as of that date. The measurement period shall not exceed one year from the acquisition date. Further, any associated restructuring activities will be expensed in future periods. We have up to twelve months from the closing date of the acquisition to adjust pre-acquisition contingencies, if any. There were no severance costs relating to Neterion incurred during the three and six months ended September 26, 2010.

The excess of the purchase price over the tangible and identifiable intangible assets acquired and liabilities assumed has been allocated to goodwill. The $464,000 in goodwill resulted primarily from our expected synergies from the integration of Neterion’s technology into our product offerings. Goodwill is not deductible for tax purposes.

 

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EXAR CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

The fair value allocated to each of the major classes of tangible and identifiable intangible assets acquired and liabilities assumed in the Neterion acquisition was as follows (in thousands):

 

     As of
March 16,
2010
 

Identifiable tangible assets

  

Cash and cash equivalents

   $ 747   

Accounts receivable

     313   

Inventories

     617   

Other current assets

     311   

Other assets

     651   

Accounts payable and accruals

     (592

Other liabilities

     (2,920

Debt

     (6,963
        

Total identifiable tangible assets, net

     (7,836

Identifiable intangible assets

     9,700   
        

Total identifiable assets, net

     1,864   

Goodwill

     464   
        

Fair value of total consideration transferred

   $ 2,328   
        

Subsequent to the acquisition, there were no adjustments to the fair value allocated to each of the major classes of tangible and identifiable intangible assets acquired and liabilities assumed on March 16, 2010 in the Neterion acquisition.

Identifiable Intangible Assets

The following table sets forth the components of the identifiable intangible assets acquired in the Neterion acquisition, which are being amortized over their estimated useful lives, with a maximum amortization period of six years, on a straight-line basis with no residual value:

 

     Fair Value      Useful Life  
     (in thousands)      (in years)  

Existing technology

   $ 5,600         4.0   

Patents/Core technology

     900         6.0   

In-process research and development

     800         —     

Customer relationships

     2,100         6.0   

Tradenames/Trademarks

     100         2.0   

Non-Compete Agreements

     100         1.3   

Order backlog

     100         0.2   
           

Total acquired identifiable intangible assets

   $ 9,700      
           

We allocated the purchase price using the established valuation techniques described below.

Inventories — The value allocated to inventories reflects the estimated fair value of the acquired inventory based on the expected sales price of the inventory, less reasonable selling margin. The estimated fair value of raw materials is generally equal to their book value, due to the fact that raw materials have not been used to develop any finished goods or work-in-progress and therefore, there is no value added to the raw materials.

Intangible assets — The fair values of existing technology, patents/core technology, in-process research and development, customer relationships, tradenames/trademarks, non-compete agreements and order backlog were determined using the income approach, which discounted expected future cash flows to present value, taking into account multiple factors including, but not limited to, the stage of completion, estimated costs to complete, utilization of patents/core technology, the risks related to successful completion, and the markets served. The cash flows were discounted at rates ranging from 4% to 33%. The discount rate used to value the existing intangible assets was 20%.

Acquired In-Process Research and Development — The IPR&D project underway at Neterion at the acquisition date relates to the X3500 product series and as of such acquisition date had incurred approximately $2.9 million in expense. The total research and development expense expected to be incurred to complete the project is estimated at $17.5 million, based on the project development timeline and resource requirements, and is expected to be completed by December 2011. The percentage of completion for the project was estimated at 25% at the acquisition date.

 

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EXAR CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

Acquisition of Galazar

On June 17, 2009, we completed the acquisition of Galazar Networks, Inc. (“Galazar”), a fabless semiconductor company focused on carrier grade transport over telecom networks based in Ottawa, Ontario, Canada. Galazar’s product portfolio addressed transport of a wide range of datacom and telecom services including Ethernet, SAN, TDM and video over SONET/SDH, PDH and OTN networks. Galazar’s results of operations and estimated fair value of assets acquired and liabilities assumed were included in our consolidated financial statements beginning June 18, 2009.

Consideration

We paid approximately $5.0 million in cash for Galazar, representing the fair value of total consideration transferred. This amount included approximately $1.0 million contingent consideration that, for the purposes of valuation, was assigned a 95% probability or a fair value of $0.95 million. This payment was contingent on Galazar achieving a project milestone within a twelve-month period following the close of the transaction. This milestone was met during the three months ended December 27, 2009 and $1.0 million was paid in cash. The additional $50,000 was expensed and included in the “Research and development” line item on the consolidated statement of operations for the fiscal year ended March 28, 2010.

Acquisition-Related Costs

Acquisition-related costs, or deal costs, relating to Galazar are included in the “Selling, general and administrative” line item on the consolidated statement of operations. No acquisition-related costs relating to Galazar were incurred during the three and six months ended September 26, 2010.

Purchase Price Allocation

The allocation of the purchase price to Galazar’s tangible and identifiable intangible assets acquired and liabilities assumed was based on their estimated fair values at the date of acquisition. We will recognize additional assets or liabilities if new information is obtained about facts and circumstances that existed as of the acquisition date that, if known, would have resulted in the recognition of those assets and liabilities as of that date. The measurement period shall not exceed one year from the acquisition date and no additional assets or liabilities were recognized during this period. Further, any associated restructuring activities will be expensed in future periods. No severance costs relating to Galazar were incurred during the three and six months ended September 26, 2010.

The excess of the purchase price over the tangible and identifiable intangible assets acquired and liabilities assumed has been allocated to goodwill. The $372,000 in goodwill resulted primarily from our expected synergies from the integration of Galazar’s technology into our product offerings. Goodwill is not deductible for tax purposes.

The fair value allocated to each of the major classes of tangible and identifiable intangible assets acquired and liabilities assumed in the Galazar acquisition was as follows (in thousands):

 

     As of
June 17,
2009
 

Identifiable tangible assets

  

Cash and cash equivalents

   $ 506   

Other current assets

     909   

Other assets

     250   

Accounts payable and accruals

     (93

Accrued compensation and related benefits

     (230

Other obligations

     (224
        

Total identifiable tangible assets, net

     1,118   

Identifiable intangible assets

     3,460   
        

Total identifiable assets, net

     4,578   

Goodwill

     372   
        

Fair value of total consideration transferred

   $ 4,950   
        

Subsequent to the acquisition, there were no adjustments to the fair value allocated to each of the major classes of tangible and identifiable intangible assets acquired and liabilities assumed on June 17, 2009 in the Galazar acquisition.

 

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EXAR CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

Identifiable Intangible Assets

The following table sets forth the components of the identifiable intangible assets acquired in the Galazar acquisition, which are being amortized over their estimated useful lives, with a maximum amortization period of six years, on a straight-line basis with no residual value:

 

     Fair Value      Useful Life  
     (in thousands)      (in years)  

Existing technology

   $ 2,100         6.0   

Patents/Core technology

     400         6.0   

In-process research and development

     300         —     

Customer relationships

     500         6.0   

Tradenames/Trademarks

     100         3.0   

Order backlog

     60         0.3   
           

Total acquired identifiable intangible assets

   $ 3,460      
           

We allocated the purchase price using the established valuation techniques described below.

Intangible assets — The fair value of existing technology, patents/core technology, in-process research and development, customer relationships, order backlog and tradenames/trademarks were determined using the income approach, which discounted expected future cash flows to present value, taking into account multiple factors including, but not limited to, the stage of completion, estimated costs to complete, utilization of patents and core technology, the risks related to successful completion, and the markets served. The cash flows were discounted at rates ranging from 5% to 35%. The discount rate used to value the existing intangible assets was 28%.

Acquired In-Process Research and Development — The IPR&D project underway at Galazar at the acquisition date relates to the MXP2 product and as of such acquisition date had incurred approximately $2.3 million in expense. The total research and development expense expected to be incurred to complete the project is estimated at $7.6 million, based on the project development timeline and resource requirements, and is expected to be completed by October 2011. The percentage of completion for the project was estimated at 51% at the acquisition date.

Acquisition of Hifn

On April 3, 2009, we completed the acquisition of hi/fn, inc. (“Hifn”), a provider of network-and storage-security and data reduction products that simplify the way major network and storage OEMs, as well as small and medium enterprises, efficiently and securely share, retain, access and protect critical data. Hifn’s results of operations and estimated fair value of assets acquired and liabilities assumed were included in our consolidated financial statements beginning April 4, 2009.

Consideration

The following table summarizes the consideration paid for Hifn, representing the fair value of total consideration transferred (in thousands):

 

     Amounts  

Cash

   $ 56,825   

Equity instruments

     2,784   
        

Total consideration paid

   $ 59,609   
        

The $2.8 million estimated fair value for equity instruments represented approximately 429,600 shares of Exar’s common stock, valued at $6.48 per share, the closing price reported on The NASDAQ Global Market on April 3, 2009 (the acquisition date).

Acquisition-Related Costs

Acquisition-related costs, or deal costs, relating to Hifn are included in the “Selling, general and administrative” line item on the consolidated statement of operations. No acquisition-related costs relating to Hifn were incurred during the three and six months ended September 26, 2010.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

Purchase Price Allocation

The allocation of the purchase price to Hifn’s tangible and identifiable intangible assets acquired and liabilities assumed was based on their estimated fair values at the date of acquisition. We will recognize additional assets or liabilities if new information is obtained about facts and circumstances that existed as of the acquisition date that, if known, would have resulted in the recognition of those assets and liabilities as of that date. The measurement period shall not exceed one year from the acquisition date and no additional assets or liabilities were recognized during this period. Further, any associated restructuring activities will be expensed in future periods. Subsequent to the acquisition, we recorded $1.0 million in restructuring expenses relating to Hifn for the fiscal year ended March 28, 2010, relating to severance and a building lease obligation in Los Gatos, California. Severance costs relating to Hifn incurred during the six months ended September 26, 2010, were immaterial. No severance costs relating to Hifn were incurred during the three months ended September 26, 2010.

The excess of the purchase price over the tangible and identifiable intangible assets acquired and liabilities assumed has been allocated to goodwill. The $2.2 million in goodwill resulted primarily from our expected future product sales synergies from combining Hifn’s products with our product offerings. Goodwill is not deductible for tax purposes.

The fair value allocated to each of the major classes of tangible and identifiable intangible assets acquired and liabilities assumed on April 3, 2009 in the Hifn acquisition was as follows (in thousands):

 

     As of
April 3,
2009
 

Identifiable tangible assets

  

Cash and cash equivalents

   $ 16,468   

Short-term marketable securities

     14,133   

Accounts receivable

     2,982   

Inventories

     4,269   

Other current assets

     1,683   

Property, plant and equipment

     2,013   

Other assets

     1,721   

Accounts payable and accruals

     (586

Accrued compensation and related benefits

     (1,860

Other current liabilities

     (2,963
        

Total identifiable tangible assets, net

     37,860   

Identifiable intangible assets

     19,500   
        

Total identifiable assets, net

     57,360   

Goodwill

     2,249   
        

Fair value of total consideration transferred

   $ 59,609   
        

Subsequent to the acquisition, there were no adjustments to the fair value allocated to each of the major classes of tangible and identifiable intangible assets acquired and liabilities assumed on April 3, 2009 in the Hifn acquisition.

Identifiable Intangible Assets

The following table sets forth the components of the identifiable intangible assets acquired in the Hifn acquisition, which are being amortized over their estimated useful lives, with a maximum amortization period of seven years, on a straight-line basis with no residual value:

 

     Fair Value      Useful Life  
     (in thousands)      (in years)  

Existing technology

   $ 9,000         5.0   

Patents/Core technology

     1,500         5.0   

In-process research and development

     1,600         —     

Customer relationships

     1,300         7.0   

Tradenames/Trademarks

     700         3.0   

Order backlog

     900         0.5   

Research and development reimbursement contract

     4,500         1.5   
           

Total acquired identifiable intangible assets

   $ 19,500      
           

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

We allocated the purchase price using the established valuation techniques as described below.

Inventories – Inventories acquired in connection with the Hifn acquisition were finished goods. The value allocated to inventories reflects the estimated fair value of the acquired inventory based on the expected sales price of the inventory, less reasonable selling margin.

Property, plant and equipment – The basis used for our analysis is the fair value in continued use, which is expressed in terms of the price a willing and informed buyer would pay contemplating continued use as part of the assets in place for the purpose for which they were designed, engineered, installed, fabricated and erected.

Intangible assets – The fair value of existing technology, patents/core technology, in-process research and development, research and development reimbursement contract, customer relationships, order backlog and tradenames/trademarks were determined using the income approach, which discounted expected future cash flows to present value, taking into account multiple factors including, but not limited to, the stage of completion, estimated costs to complete, utilization of patents and core technology, the risks related to successful completion, and the markets served. The cash flows were discounted at rates ranging from 5% to 30%. The discount rate used to value the existing intangible assets was 14%.

Acquired In-Process Research and Development – The IPR&D projects underway at Hifn at the acquisition date were in the security processors and flow through product families, each consisting of one project, and as of such acquisition date Hifn had incurred approximately $2.6 million and $1.1 million in costs related to those projects, respectively. The percentage of completion for these projects, at the date of acquisition, was 90% and 30%, respectively. The total research and development expenditures expected to be incurred to complete the security processors and flow through projects were approximately $2.1 million and $0.7 million, respectively, based on project development timelines and resource requirements. The IPR&D projects for flow through and security processors were completed in January 2010 and July 2010, respectively, and are in production. The fair value, at date of acquisition, for both IPR&D projects, will be amortized over an estimated useful life of five years.

NOTE 4. CASH, CASH EQUIVALENTS AND SHORT-TERM MARKETABLE SECURITIES

Fair Value of Financial Instruments

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. GAAP describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value which are the following:

 

Level 1      Quoted prices in active markets for identical assets or liabilities.
Level 2      Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3      Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

Our investment assets, measured at fair value on a recurring basis, as of September 26, 2010 are as follows (in thousands):

 

     Level 1      Level 2      Total  

Assets:

        

Money market funds

   $ 8,552       $ —         $ 8,552   

U.S. Treasury securities

     19,323         —           19,323   

Asset-backed securities

     —           19,624         19,624   

Agency mortgage-backed securities

     —           41,901         41,901   

Agency pool mortgage-backed securities

     —           3,383         3,383   

Corporate bonds and notes

     —           80,819         80,819   

Government and agency bonds

     —           29,112         29,112   
                          

Total investment assets

   $ 27,875       $ 174,839       $ 202,714   
                          

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

Our investment assets, measured at fair value on a recurring basis, as of March 28, 2010 were as follows (in thousands):

 

     Level 1      Level 2      Total  

Assets:

        

Money market funds

   $ 19,616       $ —         $ 19,616   

U.S. Treasury securities

     15,839         —           15,839   

Asset-backed securities

     —           17,801         17,801   

Agency mortgage-backed securities

     —           42,514         42,514   

Agency pool mortgage-backed securities

     —           4,413         4,413   

Corporate bonds and notes

     —           62,122         62,122   

Government and agency bonds

     —           43,909         43,909   
                          

Total investment assets

   $ 35,455       $ 170,759       $ 206,214   
                          

Our cash, cash equivalents and short-term marketable securities as of September 26, 2010 and March 28, 2010 are as follows (in thousands):

 

     September 26,
2010
     March 28,
2010
 

Cash and cash equivalents

     

Cash at financial institutions

   $ 5,534       $ 5,870   

Cash equivalents

     

Money market funds

     8,552         19,616   
                 

Total cash and cash equivalents

   $ 14,086       $ 25,486   
                 

Available-for-sale securities

     

U.S. government and agency securities

   $ 48,435       $ 59,747   

Corporate bonds and commercial paper

     80,819         62,122   

Asset-backed securities

     19,624         17,801   

Mortgage-backed securities

     45,284         46,928   
                 

Total short-term marketable securities

   $ 194,162       $ 186,598   
                 

Our marketable securities include municipal securities, commercial paper, asset-backed and mortgage-backed securities, corporate bonds and U.S. government securities. We classify investments as available-for-sale at the time of purchase and re-evaluate such designation as of each balance sheet date. We amortize premiums and accrete discounts to interest income over the life of the investment. Our available-for-sale securities, which we intend to sell as necessary to meet our liquidity requirements, are classified as cash equivalents if the maturity date is 90 days or less from the date of purchase and as short-term marketable securities if the maturity date is greater than 90 days from the date of purchase.

All marketable securities are reported at fair value based on the estimated or quoted market prices as of each balance sheet date, with unrealized gains or losses, net of tax effect, recorded in accumulated other comprehensive income within stockholders’ equity except those unrealized losses that are deemed to be other than temporary which are reflected in the “Impairment charges on investments” line item on the condensed consolidated statements of operation.

Realized gains or losses on the sale of marketable securities are determined by the specific identification method and are reflected in the “Interest income and other, net” line item on the condensed consolidated statements of operation.

Net realized gains on marketable securities for the three months ended September 26, 2010 were $70,000. Net realized losses on marketable securities for the three months ended September 27, 2009 were $101,000, which included $48,000 in realized losses associated with marketable securities marked-up to fair value upon the acquisition of Hifn. Net realized gains on marketable securities for the six months ended September 26, 2010 and September 27, 2009 were $48,000 and $43,000, respectively.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

The following table summarizes our investments in marketable securities as of September 26, 2010 and March 28, 2010 (in thousands):

 

     September 26, 2010  
     Amortized
Cost
     Unrealized     Fair Value  
        Gross Gains      Gross Losses    

Money market funds

   $ 8,552       $ —         $ —        $ 8,552   

U.S. government and agency securities

     47,785         650         —          48,435   

Corporate bonds and commercial paper

     79,495         1,329         (5     80,819   

Asset and mortgage-backed securities

     64,852         293         (237     64,908   
                                  

Total investments

   $ 200,684       $ 2,272       $ (242   $ 202,714   
                                  

 

     March 28, 2010  
     Amortized
Cost
     Unrealized     Fair Value  
        Gross Gains      Gross Losses    

Money market funds

   $ 19,616       $ —         $ —        $ 19,616   

U.S. government and agency securities

     58,943         835         (31     59,747   

Corporate bonds and commercial paper

     61,240         900         (18     62,122   

Asset and mortgage-backed securities

     64,329         496         (96     64,729   
                                  

Total investments

   $ 204,128       $ 2,231       $ (145   $ 206,214   
                                  

As of September 26, 2010, asset-backed and mortgage-backed securities, accounted for 10% and 22%, respectively, of our total investments in marketable securities of $202.7 million. The asset-backed securities are comprised primarily of premium tranches of auto loans and credit card receivables, while our mortgage-backed securities are primarily from Federal agencies. We do not own auction rate securities nor do we own securities that are classified as subprime. As of the date of this Form 10-Q, we have sufficient liquidity and do not intend to sell these securities to fund normal operations nor realize any significant losses in the short term. As of September 26, 2010, the net unrealized gain of our asset-backed and mortgage-backed securities totaled $56,000.

As of September 26, 2010, for all of our marketable securities, including asset-backed and mortgage-back securities, there were approximately $1.3 million of net unrealized gains net of tax expense from our Level 1 and Level 2 investments.

We periodically review our investments in unrealized loss positions for other-than-temporary impairments. This evaluation includes, but is not limited to, significant quantitative and qualitative assessments and estimates regarding credit ratings, collateralized support, the length of time and significance of a security’s loss position, our intent to not sell the security, and whether it is more likely than not that we will not have to sell the security before recovery of its cost basis. Other-than-temporary declines in value of our investments are reported in the “Impairment charges on investments” line item in the condensed consolidated statements of operations. In the three months ended September 27, 2009, an investment in GSAA Home Equity with a cost of $425,000 was downgraded from an AAA rating to a CCC rating. As a result of the reduction in the rating, quantitative analysis showing an increase in the default rate and decrease in prepayment rate of the investment, we recorded an other-than-temporary impairment charge of $91,000 during the second quarter of fiscal 2010. In the three months ended September 26, 2010, due to further decline in the investment, we recorded an additional other-than-temporary impairment charge of $62,000.

The amortized cost and estimated fair value of cash equivalents and marketable securities classified as available-for-sale at September 26, 2010 and March 28, 2010 by expected maturity were as follows (in thousands):

 

     September 26, 2010      March 28, 2010  
     Amortized
Cost
     Fair Value      Amortized
Cost
     Fair Value  

Less than 1 year

   $ 92,784       $ 93,379       $ 108,813       $ 109,562   

Due in 1 to 5 years

     107,900         109,335         95,316         96,652   
                                   

Total

   $ 200,684       $ 202,714       $ 204,129       $ 206,214   
                                   

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

The following table summarizes the gross unrealized losses and fair values of our investments in an unrealized loss position as of September 26, 2010 and March 28, 2010, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position (in thousands):

 

     September 26, 2010  
     Less than 12 months     12 months or greater     Total  
     Fair
Value
     Gross
Unrealized
Losses
    Fair Value      Gross
Unrealized
Losses
    Fair Value      Gross
Unrealized
Losses
 

U.S. government and agency securities

   $ 501       $ (1   $ —         $ —        $ 501       $ (1

Corporate bonds and commercial paper

   $ 1,861       $ (5   $ —         $ —        $ 1,861       $ (5

Asset and mortgage-backed securities

     38,842         (220     533         (16     39,375         (236
                                                   

Total

   $ 41,204       $ (226   $ 533       $ (16   $ 41,737       $ (242
                                                   
     March 28, 2010  
     Less than 12 months     12 months or greater     Total  
     Fair
Value
     Gross
Unrealized
Losses
    Fair Value      Gross
Unrealized
Losses
    Fair Value      Gross
Unrealized
Losses
 

U.S. government and agency securities

   $ 5,399       $ (27   $ —         $ —        $ 5,399       $ (27

Corporate bonds and commercial paper

     12,981         (27     353         (31     13,334         (58

Asset and mortgage-backed securities

     19,672         (60     —           —          19,672         (60
                                                   

Total

   $ 38,052       $ (114   $ 353       $ (31   $ 38,405       $ (145
                                                   

NOTE 5. GOODWILL AND INTANGIBLE ASSETS

Goodwill

Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired in a business combination. We evaluate goodwill for impairment on an annual basis or whenever events and changes in circumstances suggest that the carrying amount may not be recoverable. We conduct our annual impairment analysis in the fourth quarter of each fiscal year. Impairment of goodwill is tested at the reporting unit level by comparing the reporting unit’s carrying amount, including goodwill, to the fair value of the reporting unit. If the carrying amount of the reporting unit exceeds its fair value, goodwill is considered impaired and a second step is performed to measure the amount of impairment loss. Because we have one reporting unit, we utilize an entity-wide approach to assess goodwill for impairment.

As of September 26, 2010, no events or changes in circumstances suggest that the carrying amount for goodwill may not be recoverable and therefore we did not perform an interim goodwill impairment analysis.

The changes in the carrying amount of goodwill for the six months ended September 26, 2010 are as follows (in thousands):

 

     Amount  

Balance as of March 28, 2010

   $ 3,085   

Goodwill additions, impairments and adjustments

     99   
        

Balance as of September 26, 2010

   $ 3,184   
        

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

Intangible Assets

Our purchased intangible assets at September 26, 2010 and March 28, 2010 are as follows (in thousands):

 

     September 26, 2010      March 28, 2010  
     Carrying
Amount
     Accumulated
Amortization
    Net Carrying
Amount
     Carrying
Amount
     Accumulated
Amortization
    Net Carrying
Amount
 

Existing technology

   $ 36,971       $ (18,927   $ 18,044       $ 35,621       $ (15,734   $ 19,887   

Patents/Core technology

     4,492         (2,020     2,472         4,492         (1,688     2,804   

In-process research and development

     1,100         —          1,100         2,200         —          2,200   

Research and development reimbursement contract

     4,500         (4,500     —           4,500         (2,496     2,004   

Customer backlog

     1,400         (1,400     —           1,400         (1,325     75   

Distributor relationships

     1,264         (969     295         1,264         (919     345   

Customer relationships

     4,670         (1,115     3,555         4,670         (777     3,893   

Non-compete agreement

     100         (43     57         100         (3     97   

Tradenames/Trademarks

     1,077         (591     486         1,077         (425     652   
                                                   

Total

   $ 55,574       $ (29,565   $ 26,009       $ 55,324       $ (23,367   $ 31,957   
                                                   

Long-lived assets are evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We compare the carrying value of long-lived assets to our projection of future undiscounted cash flows attributable to such assets and, in the event that the carrying value exceeds the future undiscounted cash flows, we record an impairment charge equal to the excess of the carrying value over the asset’s fair value.

As of September 26, 2010, there were no indicators that required us to perform an intangible assets impairment review, therefore, we did not record an impairment charge during the six months ended September 26, 2010.

The aggregate amortization expenses for our purchased intangible assets for periods presented below are as follows:

 

            Three Months Ended      Six Months Ended  
     Weighted
Average  Lives
     September 26,
2010
     September 27,
2009
     September 26,
2010
     September 27,
2009
 
     (in months)      (in thousands)  

Existing technology

     65       $ 1,615       $ 1,002       $ 3,193       $ 2,074   

Patents/Core technology

     61         166         129         332         235   

Research and development reimbursement contracts

     24         1,002         562         2,004         1,078   

Customer backlog

     6         —           502         75         918   

Distributor relationships

     72         25         25         50         50   

Customer relationships

     80         169         82         338         140   

Non-compete agreements

     15         20         —           40         —     

Tradenames/Trademarks

     35         82         71         166         130   
                                      

Total

      $ 3,079       $ 2,373       $ 6,198       $ 4,625   
                                      

The estimated future amortization expenses for our purchased intangible assets are summarized below (in thousands):

 

Amortization Expense (by fiscal year)

 

2011 (6 months remaining)

   $ 4,047   

2012

     6,919   

2013

     6,313   

2014

     5,667   

2015

     1,875   

2016 and thereafter

     1,188   
        

Total estimated amortization

   $ 26,009   
        

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

NOTE 6. LONG-TERM INVESTMENT

Our long-term investment consists of our investment in Skypoint Telecom Fund II (US), L.P. (“Skypoint Fund”). Skypoint Fund is a venture capital fund that invests primarily in private companies in the telecommunications and/or networking industries. We account for this non-marketable equity investment under the cost method. We have periodically reviewed and determined whether the investment is other-than-temporarily impaired, in which case the investment is written down to its impaired value.

As of September 26, 2010 and March 28, 2010, our long-term investment balance, which is included in the “Other non-current assets” line item on the condensed consolidated balance sheet, was as follows (in thousands):

 

Long-term investment

   September 26,
2010
     March 28,
2010
 

Skypoint Fund

   $ 1,541       $ 1,440   
                 

We have made approximately $4.7 million in capital contributions to Skypoint Fund since we became a limited partner in July 2001. Our total capital commitment is $5.0 million. We contributed $165,000 to the fund during the six months ended September 26, 2010. As of September 26, 2010, we have a remaining obligation of approximately $0.3 million should the general partner decide to request it on or before July 27, 2011.

The carrying amount of $1.5 million reflects the net of capital contributions, cumulative impairment charges and capital distributions. We received capital distributions of $63,000 and $36,000 during the six months ended September 26, 2010 and fiscal year 2010, respectively.

Impairment

In the three and six months ended September 26, 2010, we analyzed the fair value of the underlying investments of Skypoint Fund and concluded that there was no other-than-temporary impairment and therefore we did not record an impairment charge for Skypoint Fund in either period. In the three months ended September 27, 2009, we analyzed the fair value of the underlying investments of Skypoint Fund and concluded a portion of the carrying value was other-than-temporarily impaired and recorded an impairment charge of $154,000 in addition to the $72,000 recorded in the first quarter of fiscal 2010.

NOTE 7. RELATED PARTY TRANSACTION

Affiliates of Future Electronics Inc. (“Future”), Alonim Investments Inc. and two of its affiliates (collectively “Alonim”), own approximately 7.6 million shares, or approximately 17%, of our outstanding common stock as of September 26, 2010. As such, Alonim is our largest stockholder.

Our sales to Future are made under an agreement that provides protection against price reduction for its inventory of our products and other sales allowances. We recognize revenue on sales to Future under a distribution agreement when Future sells the products to its end customers. Future has historically accounted for a significant portion of our net sales. Future is our largest distributor worldwide and accounted for 30% and 27% of our total net sales for the second quarters of fiscal 2011 and fiscal 2010, respectively. Future accounted for 29% and 26% of our total net sales for the six months ended September 26, 2010 and September 27, 2009, respectively.

We reimbursed Future $10,000 and $8,000 of expenses for marketing promotional materials for the second quarters of fiscal 2011 and fiscal 2010, respectively. We reimbursed Future $16,000 and $20,000 of expenses for marketing promotional materials for each of the six months ended September 26, 2010 and September 27, 2009, respectively.

NOTE 8. RESTRUCTURING

In connection with the Neterion acquisition in March 2010, we assumed a lease obligation for a facility in Sunnyvale, California. Subsequent to the acquisition, we vacated the facility in May 2010 and recorded a restructuring reserve of approximately $234,000, during the three months ended June 27, 2010, to reflect the remaining payments owed under this lease. The majority of this balance is expected to be paid by August 2011, when the lease expires.

In connection with the acquisition of Sipex Corporation (“Sipex”) in August 2007, our management approved and initiated plans to restructure the operations of the combined company to eliminate certain duplicative activities, reduce costs and better align product and operating expenses with then-current economic conditions. The Sipex restructuring costs were accounted for as liabilities assumed as part of the business combination and are expected to be paid over the remaining term of the Sipex lease, which is for office space in Belgium and expires in March 2012.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

Our restructuring liabilities were included in the “Other accrued expenses” line item in our condensed consolidated balance sheets, and the activities affecting the liabilities for the three and six months ended September 26, 2010 are summarized as follows (in thousands):

 

     Facility
Costs
 

Balance at March 28, 2010

   $ 239   

Payments

     (96

Additional accruals

     234   
        

Balance at September 26, 2010

   $ 377   
        

NOTE 9. BALANCE SHEET DETAIL

Our property, plant and equipment consisted of the following as of the dates indicated (in thousands):

 

     September 26,
2010
    March 28,
2010
 

Land

   $ 11,960      $ 11,960   

Building and leasehold improvements

     24,398        24,022   

Machinery and equipment

     46,232        45,932   

Software and licenses

     37,708        35,651   
                

Property, plant and equipment, total

     120,298        117,565   

Accumulated depreciation and amortization

     (78,577     (74,624
                

Property, plant and equipment, net

   $ 41,721      $ 42,941   
                

Our inventories consisted of the following as of the dates indicated (in thousands):

 

     September 26,
2010
     March 28,
2010
 

Work-in-process

   $ 13,670       $ 9,318   

Finished goods

     8,931         5,682   
                 

Total Inventories

   $ 22,601       $ 15,000   
                 

Our other accrued expenses consisted of the following as of the dates indicated (in thousands):

 

     September 26,
2010
     March 28,
2010
 

Accrued legal and professional services

   $ 2,318       $ 4,053   

Accrued sales and marketing expenses

     764         676   

Accrued manufacturing expenses, royalties and licenses

     691         1,308   

Accrued restructuring expenses

     377         239   

Other

     785         782   
                 

Total other accrued expenses

   $ 4,935       $ 7,058   
                 

NOTE 10. EARNINGS (LOSS) PER SHARE

Basic earnings (loss) per share excludes dilution and is computed by dividing net income (loss) by the weighted average number of common shares outstanding for the periods. Diluted earnings per share (“EPS”) reflects the potential dilution that would occur if outstanding stock options or warrants to issue common stock were exercised for common stock, using the treasury stock method, and the common stock underlying restricted stock units (“RSUs”) were issued.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

A summary of our loss per share for the periods presented is as follows (in thousands, except per share amounts):

 

     Three Months Ended     Six Months Ended  
     September 26,
2010
    September 27,
2009
    September 26,
2010
    September 27,
2009
 

Net loss

   $ (4,459   $ (8,163   $ (11,873   $ (21,038
                                

Shares used in computation:

        

Weighted average shares of common stock outstanding used in computation of basic loss per share

     44,173        43,550        44,035        43,432   

Dilutive effect of stock options and restricted stock units

     —          —          —          —     
                                

Shares used in computation of diluted loss per share

   $ 44,173      $ 43,550      $ 44,035      $ 43,432   
                                

Loss per share - basic and diluted

   $ (0.10   $ (0.19   $ (0.27   $ (0.48
                                

For the three and six months ended September 26, 2010, as we incurred a net loss, the weighted average number of shares of common stock outstanding equaled the weighted average number of shares of common stock and common stock equivalents assuming dilution. Options to purchase shares of common stock and unvested restricted stock units (“RSUs”) for shares of common stock in the aggregate amount of approximately 261,000 and 330,000 shares of common stock for the three and six months ended September 26, 2010, respectively, were excluded from our loss per share calculation under the treasury stock method. Had we had income for these periods, our diluted shares would have increased by the aforementioned amount.

For the three and six months ended September 26, 2010, options to purchase approximately 6.0 million shares of common stock, at exercise prices ranging from approximately $5.84 to $23.99 and $5.84 to $86.10, respectively, were outstanding but were not included in the computation of diluted loss per share because they were anti-dilutive under the treasury stock method. Warrants to purchase approximately 280,000 shares of common stock with an exercise price of $9.63 were also excluded from the computation of diluted loss per share because they were anti-dilutive under the treasury stock method. There were no unvested RSUs at September 26, 2010 that were considered anti-dilutive under the treasury method.

For the three and six months ended September 27, 2009, as we incurred a net loss, the weighted average number of shares of common stock outstanding equaled the weighted average number of shares of common stock and common stock equivalent assuming dilution. Options to purchase shares of common stock and unvested restricted stock units (“RSUs”) for shares of common stock in the aggregate amount of approximately 335,000 and 301,000 shares of common stock for the three and six months ended September 27, 2009, respectively, were excluded from our loss per share calculation under the treasury stock method. Had we had income for these periods, our diluted shares would have increased by the aforementioned amount.

For the three and six months ended September 27, 2009, options to purchase approximately 5.3 million and 4.6 million shares of common stock, respectively, at exercise prices ranging from $6.16 to $86.10 and $6.22 to $86.10, respectively, were outstanding but were not included in the computation of diluted loss per share because they were anti-dilutive under the treasury stock method. Warrants to purchase approximately 280,000 shares of common stock with an exercise price of $9.63 were also excluded from the computation of diluted loss per share because they were anti-dilutive under the treasury stock method. There were no unvested RSUs at September 27, 2009 that were considered anti-dilutive under the treasury method.

Our application of the treasury stock method in determining the dilutive effect of stock options and RSUs includes assumed cash proceeds from option exercises, the average unamortized stock-based compensation expense for the period, and the estimated deferred tax benefit or detriment associated with stock-based compensation expense.

NOTE 11. COMMON STOCK REPURCHASES

From time to time, we acquire outstanding common stock in the open market to partially offset dilution from our equity award programs, to increase our return on our invested capital and to bring our cash to a more appropriate level for our company.

On August 28, 2007, we announced the approval of a share repurchase plan (“2007 SRP”) and authorized the repurchase of up to $100 million of our common stock.

During the three and six months ended September 26, 2010 and the three and six months ended September 27, 2009, we did not repurchase any shares under the 2007 SRP. As of September 26, 2010, the remaining authorized amount for the stock repurchase under the 2007 SRP was $11.8 million. The 2007 SRP does not have a termination date. We may continue to utilize our share repurchase plan, which would reduce our cash, cash equivalents and/or short-term marketable securities available to fund future operations and to meet other liquidity requirements.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

NOTE 12. STOCK-BASED COMPENSATION

Employee Stock Participation Plan (“ESPP”)

Our ESPP permits employees to purchase common stock through payroll deductions at a purchase price that is equal to 95% of our common stock price on the last trading day of each three-calendar-month offering period. Our ESPP is non-compensatory.

We are authorized to issue 4.5 million shares of common stock under our ESPP. There were 1,515,858 shares of common stock reserved for future issuance under our ESPP at September 26, 2010.

In the six months ended September 26, 2010, we issued 33,304 shares of our common stock at a weighted average price of $6.71 to the participating employees under our ESPP.

Equity Incentive Plans

We currently have four equity incentive plans including the Exar Corporation 2006 Equity Incentive Plan (the “2006 Plan”) and three other equity plans assumed upon our August 2007 acquisition of Sipex: the Sipex Corporation 2000 Non-Qualified Stock Option Plan, the Sipex Corporation Amended and Restated 2002 Non-Statutory Stock Option Plan and the Sipex Corporation 2006 Equity Incentive Plan (collectively, the “Sipex Plans”).

The 2006 Plan authorizes the issuance of stock options, stock appreciation rights, restricted stock, stock bonuses and other forms of awards granted or denominated in common stock or units of common stock, as well as cash bonus awards. RSUs granted under the 2006 Plan are counted against authorized shares available for future issuance on a basis of two shares for every RSU issued. The 2006 Plan allows for performance-based vesting and partial vesting based upon level of performance. Grants under the Sipex Plans are only available to former Sipex employees or employees of Exar hired after the Sipex acquisition. At our annual meeting, on September 15, 2010, our stockholders approved the proposed amendment to increase the aggregate share limit for the 2006 Plan by an additional 5,500,000 shares to 8,300,000 shares. At September 26, 2010, there were approximately 5.9 million shares available for future grant under all our equity incentive plans.

Stock Option Activities

Our stock option transactions during the six months ended September 26, 2010 are summarized as follows:

 

     Outstanding     Weighted
Average
Exercise
Price per
Share
     Weighted
Average
Remaining
Contractual
Term
     Aggregate
Intrinsic Value  (1)
 
                  (in years)         

Balance at March 28, 2010

     5,345,504      $ 8.01         5.38       $ 1,882,286   

Options granted

     1,150,800        7.09         

Options exercised

     (34,436     6.04         

Options expired

     (123,271     12.69         

Options forfeited

     (263,768     8.94         
                                  

Balance at September 26, 2010

     6,074,829      $ 7.79         5.15       $ 39,829   
                                  

Vested and expected to vest, September 26, 2010

     5,762,027      $ 7.82         5.11       $ 39,517   
                                  

Vested and exercisable, September 26, 2010

     2,144,901      $ 8.85         4.20       $ 33,773   
                                  

 

(1) The aggregate intrinsic values in the table above represent the total pre-tax intrinsic value, which is based on the closing price of our common stock of $5.76 and $7.32 as of September 26, 2010 and March 28, 2010, respectively. These are the values which would have been received by option holders if all option holders exercised their options on that date.

The total number of in-the-money options vested and exercisable was 0.1 million and 0.2 million as of September 26, 2010 and March 28, 2010, respectively.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

Total unrecognized stock-based compensation cost was $8.8 million at September 26, 2010, which is expected to be recognized over a weighted average period of 2.65 years.

RSU Activities

Our RSU transactions during the six months ended September 26, 2010 are summarized as follows:

 

     Shares     Weighted
Average
Grant-Date

Fair Value
     Weighted
Average
Remaining
Contractual
Term in Years
     Aggregate
Intrinsic
Value (1)

(in millions)
     Unrecognized
Stock-based
Compensation
Cost (2)

(in millions)
 

Unvested at March 28, 2010

     834,204      $ 8.20         1.04       $ 6.1       $ 4.2   

Granted

     275,108        7.10            

Issued and released

     (459,147     7.00            

Forfeited

     (18,490     7.66            
                                           

Unvested at September 26, 2010

     631,675      $ 7.34         1.03       $ 3.7       $ 3.8   
                                           

Vested and expected to vest at September 26, 2010

     599,752      $ 7.34         0.99       $ 3.5      
                                     

 

(1) The aggregate intrinsic value of RSUs represents the closing price per share of our stock at the end of the periods presented, multiplied by the number of unvested RSUs or the number of vested and expected to vest RSUs, as applicable, at the end of each period.
(2) For RSUs, stock-based compensation expense was calculated based on our stock price on the date of grant, multiplied by the number of RSUs granted. The grant date fair value of RSUs, less estimated forfeitures, is recognized on a straight-line basis over the vesting period.

In July 2009, we granted performance-based RSUs covering 99,000 shares to certain executives, issuable upon meeting certain performance targets in our fiscal year 2010 and vesting annually over a three year period beginning July 1, 2010. The annual vesting requires continued service through each annual vesting date. In the three and six months ended September 26, 2010, we recognized approximately $61,000 and $108,000, respectively, of compensation expense related to these awards.

In April 2010, we granted performance-based RSUs covering 56,000 shares to our CEO, issuable upon meeting certain performance targets in our fiscal year 2011 and vesting annually over a three year period beginning May 3, 2010. The annual vesting requires continued service through each annual vesting date. In the three and six months ended September 26, 2010, we recognized approximately $60,000 and $120,000, respectively, of compensation expense related to these awards.

In the three months ended June 27, 2010, we granted approximately 210,000 shares as stock based awards to certain employees that resulted in $1.5 million in stock-based compensation expense. These grants were discretionary in nature and fully vested upon issuance. There were no awards of this nature granted in the three months ended September 26, 2010.

Stock-Based Compensation Expense

The following table summarizes stock-based compensation expense related to stock options and RSUs during the fiscal periods presented (in thousands):

 

     Three Months Ended      Six Months Ended  
     September 26,
2010
     September 27,
2009
     September 26,
2010
     September 27,
2009
 

Cost of sales

   $ 98       $ 151       $ 318       $ 267   

Research and development

     665         748         2,221         1,234   

Selling, general and administrative

     751         767         2,297         1,474   
                                   

Total Stock-based compensation expense

   $ 1,514       $ 1,666       $ 4,836       $ 2,975   
                                   

Stock-based compensation expense for the three and six months ended September 26, 2010 includes approximately $119,000 and $252,000, respectively, of incremental stock-based compensation expense associated with RSU awards covering an aggregate of 344,020 shares of our common stock issued in exchange for the options surrendered pursuant to the October 23, 2008 option exchange program. Stock-based compensation expense for the three and six months ended September 27, 2009, includes $140,000 and $288,000, respectively, of incremental stock-based compensation expense, associated with the same RSU awards.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

Valuation Assumptions

We estimate the fair value of stock options on the date of grant using the Black-Scholes option-pricing model. The assumptions used in calculating the fair value of stock-based compensation represent our estimates, but these estimates involve inherent uncertainties and the application of management judgments which include the expected term of the share-based awards, stock price volatility and forfeiture rates. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future.

We used the following weighted average assumptions to calculate the fair values of options granted during the fiscal periods presented:

 

     Three Months Ended     Six Months Ended  
     September 26,
2010
    September 27,
2009
    September 26,
2010
    September 27,
2009
 

Expected term of options (years)

     4.4        4.7 – 4.9        4.4        4.7 – 4.9   

Risk-free interest rate

     1.3     2.4 – 2.5     1.3 – 2.1     2.1 – 2.5

Expected volatility

     39     38     39     38

Expected dividend yield

     —          —          —          —     

Weighted average estimated fair value

   $ 2.31      $ 2.64      $ 2.46      $ 2.40   

NOTE 13. COMPREHENSIVE INCOME (LOSS)

Our comprehensive loss for the periods indicated below was as follows (in thousands):

 

     Three Months Ended     Six Months Ended  
     September 26,
2010
    September 27,
2009
    September 26,
2010
    September 27,
2009
 

Net loss

   $ (4,459   $ (8,163   $ (11,873   $ (21,038

Other comprehensive loss:

        

Change in unrealized income (loss), on marketable securities, net of tax

     442        500        (56     912   
                                

Total other comprehensive income (loss)

     442        500        (56     912   
                                

Comprehensive loss

     (4,017     (7,663     (11,929     (20,126
                                

NOTE 14. LEASE FINANCING OBLIGATION

In connection with the Sipex acquisition, we assumed a lease financing obligation related to a facility located in Milpitas, California (the “Hillview Facility”). The lease term expires in March, 2011 with average lease payments of approximately $1.4 million per year.

The fair value of the Hillview Facility was estimated at $13.4 million at the time of the acquisition and was included in the “Property, plant and equipment, net” line item on the condensed consolidated balance sheet. In connection with purchase accounting, we have accounted for this sale and leaseback transaction as a financing transaction which was included in the “Long-term lease financing obligations” line item on our condensed consolidated balance sheet. The effective interest rate is 8.2%. Depreciation for the Hillview Facility was recorded over the straight-line method for the remaining useful life and was $88,000 and $176,000, respectively, for the three and six months ended on September 26, 2010.

In April 2008 we entered into a sublease agreement for the Hillview Facility. The sublease expires in March, 2011 and we expect annual sublease income of approximately $1.5 million for the duration of the sublease term. The sublease income for the three and six months ended September 26, 2010 was $393,000 and $786,000, respectively, and was recorded in the “Other income and expense, net” line item in our condensed consolidated statements of operations. The sublease income for the three and six months ended September 27, 2009 was $353,000 and $706,000, respectively.

We have also acquired engineering design tools (“design tools”) under capital leases. We acquired $5.2 million of design tools in December 2007 under a four-year license, $3.7 million of design tools in November 2008 under a three-year license, and $1.3 million of design tools in February and June 2010 under a two-year and a three-year license, respectively, which were accounted for as capital leases and recorded in the “Property, plant and equipment, net” line item on the condensed consolidated balance sheets. The related design tool obligations were included in the lease financing obligation in our condensed consolidated balance sheets. Amortization of the design tools is recorded using the straight-line method over the remaining useful life and was $894,000 and $1,737,000 in the three and six months ended September 26, 2010, respectively.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

Future minimum lease and sublease income payments for the lease financing obligations as of September 26, 2010 are as follows (in thousands):

 

Fiscal Years

   Hillview
Facility (1)
    Design
Tools
    Total     Expected
Sublease
Income
 

2011 (6 months remaining)

   $ 12,896      $ 2,658      $ 15,554      $ 786   

2012

     —          1,838        1,838        —     

2013

     —          390        390        —     
                                

Total minimum lease payments

     12,896        4,886        17,782        786   

Less: amount representing interest

     (506     (315     (821  

Less: amount representing maintenance

     —          (309     (309  
                                

Present value of minimum lease payments

     12,390        4,262        16,652        786   

Less: current portion of lease financing obligation

     (222     (3,542     (3,764     —     
                                

Long-term lease financing obligation

   $ 12,168      $ 720      $ 12,888      $ 786   
                                

 

(1) At the end of the lease term, the estimated final lease obligation is approximately $12.2 million, which we will settle in a noncash transaction by returning the Hillview Facility to the lessor.

For the three and six months ended September 26, 2010, interest expense totaled $321,000 and $639,000, respectively, for the Hillview Facility lease financing obligation and design tools. For the three and six months ended September 27, 2009, interest expense totaled $322,000 and $646,000 for the Hillview Facility lease financing obligation and design tools, respectively.

NOTE 15. COMMITMENTS AND CONTINGENCIES

In 1986, Micro Power Systems Inc. (“MPSI”), a subsidiary that we acquired in June 1994, identified low-level groundwater contamination at its principal manufacturing site. The area and extent of the contamination appear to have been defined. MPSI previously reached an agreement with a prior tenant to share in the cost of ongoing site investigations and the operation of remedial systems to remove subsurface chemicals. The frequency and number of wells monitored at the site was reduced with prior regulatory approval for a plume stability analysis as an initial step towards site closure. No significant rebound concentrations have been observed. The groundwater treatment system remains shut down. In July 2008, we evaluated the effectiveness of the plume stability and decided to initiate an alternative treatment program to pursue a no further action order for the site. The program was approved by the state and implementation started in October 2009. As such, we accrued an additional $58,000, increasing our liability to $250,000. This accrual included approximately $200,000 for various remediation options under consideration and $50,000 for future annual monitoring. As of September 26, 2010 the remaining liability was $128,000, net of payments of $9,000 and $113,000, during the six months ended September 26, 2010 and the fiscal year 2010, respectively.

Sipex, which we acquired in August 2007, entered into a definitive Master Agreement with Hangzhou Silan Microelectronics Co. Ltd. and Hangzhou Silan Integrated Circuit Co. Ltd. (collectively “Silan”) in China. Silan is a China-based semiconductor foundry. This transaction was related to the closing of Sipex wafer fabrication operations located in Milpitas, California. Under this agreement, Sipex and Silan would work together to enable Silan to manufacture semiconductor wafers using Sipex process technology. The Master Agreement includes a Process Technology Transfer and License Agreement which contemplates the transfer of eight of our processes and related product manufacturing to Silan. Subject to our option to suspend in whole or in part, there is a purchase commitment under the Wafer Supply Agreement obligating us to purchase from Silan an average of at least one thousand equivalent wafers per week, calculated on a quarterly basis, for five years beginning February 2006. There were open purchase orders for approximately $3.1 million outstanding as of September 26, 2010.

Generally, we warrant all custom products and application specific products, including cards and boards, against defects in materials and workmanship for a period of 12 months and occasionally we may provide an extended warranty of up to three years from the delivery date. We warrant all of our standard products against defects in materials and workmanship for a period of 90 days from the date of delivery. Reserve requirements are recorded in the period of sale and are based on an assessment of the products sold with warranty and historical warranty costs incurred. Our liability is generally limited to replacing, repairing or issuing credit, at our option, for the product if it has been paid for. The warranty does not cover damage which results from accident, misuse, abuse, improper line voltage, fire, flood, lightning or other damage resulting from modifications, repairs or alterations performed other than by us, or resulting from failure to comply with our written operating and maintenance instructions. Warranty expense has historically been immaterial for our products. The warranty liabilities related to our products as of September 26, 2010 was immaterial.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

In the ordinary course of business, we may provide indemnification of varying scope and terms to customers, vendors, lessors and business partners, purchasers of assets or subsidiaries, and other parties with respect to certain matters, including, but not limited to, losses arising out of our breach of agreements or representations and warranties made by us, services to be provided by us, intellectual property infringement claims made by third parties or, with respect to the sale of assets or a subsidiary, matters related to our conduct of the business and tax matters prior to the sale. In addition, we have entered into indemnification agreements with our directors and certain of our executive officers that will require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors or executive officers. We maintain director and officer insurance, which may cover certain liabilities arising from our obligation to indemnify our directors and officers, and former directors and officers of acquired companies, in certain circumstances. It is not possible to determine the aggregate maximum potential loss under these indemnification agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each particular agreement. Such indemnification agreements might not be subject to maximum loss clauses. Historically, we have not incurred material costs as a result of obligations under these agreements and we have not accrued any liabilities related to such indemnification obligations in our condensed consolidated financial statements.

NOTE 16. LEGAL PROCEEDINGS

From time to time, we are involved in various claims, legal actions and complaints arising in the normal course of business. We are not a named party to any lawsuit or formal proceeding that, in the opinion of our management, is likely to have a material adverse effect on our financial position, results of operations or cash flows.

NOTE 17. INCOME TAXES

During the three and six months ended September 26, 2010, we recorded income tax expense of approximately $27,000 and $152,000, respectively. During the second quarter and first six months of fiscal 2010, we recorded income tax benefit of $281,000 and $609,000, respectively. The income tax expense was primarily due to expenses recorded during the second quarter of fiscal 2011 for foreign taxable income.

During the second quarter and first six months of fiscal 2011 the unrecognized tax benefits increased by $119,000 and $238,000, respectively, to $16.1 million as of September 26, 2010. The increase was primarily related to our research tax credits. If recognized, $13.6 million of these unrecognized tax benefits (net of federal benefit) would be recorded as a reduction of future income tax provision before consideration of changes in valuation allowance.

Estimated interest and penalties related to the income taxes are classified as a component of the provision for income taxes in the condensed consolidated statement of operations. Accrued interest and penalties were $379,000 and $356,000 as of September 26, 2010 and September 27, 2009, respectively.

Our only major tax jurisdictions are the United States federal and various U.S. states. The fiscal years 2002 through 2010 remain open and subject to examinations by the appropriate governmental agencies in the United States and in certain of our U.S. state jurisdictions.

NOTE 18. SEGMENT AND GEOGRAPHIC INFORMATION

We operate in one reportable segment. We design, develop and market high-performance, analog and mixed-signal silicon solutions and software and subsystem solutions for a variety of markets including communications, datacom and storage, interface and power management. The nature of our products and production processes and the type of customers and distribution methods are consistent among all of our products.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

Our net sales by product line are summarized as follows (in thousands):

 

     Three Months Ended      Six Months Ended  
     September 26,
2010
     September 27,
2009
     September 26,
2010
     September 27,
2009
 

Communications

   $ 4,966       $ 4,463       $ 11,815       $ 12,108   

Datacom and storage

     4,438         6,718         9,398         12,056   

Interface

     20,208         14,852         39,884         27,874   

Power Management

     7,621         5,555         15,772         10,412   
                                   

Total net sales

   $ 37,233       $ 31,588       $ 76,869       $ 62,450   
                                   

 

* Incremental revenues from Hifn, Galazar and Neterion have been included in our condensed consolidated financial statements since April 4, 2009, June 18, 2009 and March 17, 2010, respectively.

Our foreign operations are conducted primarily through our wholly-owned subsidiaries in Canada, China, France, Germany, Italy, Japan, Malaysia, Singapore, South Korea, Taiwan and the United Kingdom. Our principal markets include North America, Europe and the Asia Pacific region. Net sales by geographic areas represent sales to unaffiliated customers.

Our net sales by geographic area are summarized as follows (in thousands):

 

     Three Months Ended      Six Months Ended  
     September 26,
2010
     September 27,
2009
     September 26,
2010
     September 27,
2009
 

United States

   $ 7,317       $ 8,494       $ 15,655       $ 15,678   

China

     13,424         11,632         27,248         22,896   

Singapore

     3,650         3,593         7,432         6,623   

Japan

     1,884         1,397         5,162         3,366   

Germany

     4,328         420         5,207         837   

Europe (excluding Germany)

     1,618         3,462         6,474         7,929   

Rest of world

     5,012         2,590         9,691         5,121   
                                   

Total net sales

   $ 37,233       $ 31,588       $ 76,869       $ 62,450   
                                   

 

* Incremental revenues from Hifn, Galazar and Neterion have been included in our consolidated financial statements since April 4, 2009, June 18, 2009 and March 17, 2010, respectively.

Substantially all of our long-lived assets at each of September 26, 2010 and March 28, 2010 were located in the United States.

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations, as well as information contained in “Part II, Item 1A. Risk Factors” below and elsewhere in this Quarterly Report on Form 10-Q, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements are generally written in the future tense and/or may generally be identified by words such as “will,” “may,” “should,” “could,” “expect,” “suggest,” “believe,” “anticipate,” “intend,” “plan,” or other similar words. Forward-looking statements contained in this Quarterly Report include, among others, statements regarding (1) our revenue growth, (2) our future gross profits and margins, (3) our future research and development efforts and related expenses, (4) our future selling, general and administrative expenses, (5) our cash and cash equivalents, short-term marketable securities and cash flows from operations being sufficient to satisfy working capital requirements and capital equipment needs for at least the next 12 months, (6) our ability to continue to finance operations with cash flows from operations, existing cash and investment balances, and some combination of long-term debt and/or lease financing and sales of equity securities, (7) the possibility of future acquisitions and investments, (8) our ability to accurately estimate our assumptions used in valuing stock-based compensation, (9) our ability to estimate and reconcile distributors’ reported inventories to their activities, (10) our ability to estimate future cash flows associated with long-lived assets, (11) the volatile global economic and financial market conditions, and (12) anticipated results in connection with the acquisitions of hi/fn, inc. (“Hifn”), Galazar Networks, Inc. (“Galazar”) and Neterion, Inc. (“Neterion”). These statements reflect our current views with respect to future events and our potential financial performance and are subject to risks and uncertainties that could cause our business, operating results and financial condition to differ materially and adversely from what is projected or implied by any forward looking statement included in this Form 10-Q. Factors that could cause actual results to differ materially from those stated herein include, but are not limited to: the information contained under the captions “Part I, Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Part II, Item 1A. Risk Factors”, as well as those risks discussed in our Annual Report on Form 10-K for the fiscal year ended March 28, 2010. We disclaim any obligation to update information in any forward-looking statement.

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the condensed consolidated financial statements and notes thereto, included in this Quarterly Report on Form 10-Q, and our audited consolidated financial statements for the fiscal year ended March 28, 2010 included in our Annual Report on Form 10-K, as filed with the Securities and Exchange Commission (“SEC”). Our results of operations for the three and six months ended September 26, 2010 are not necessarily indicative of results to be expected for any future period.

BUSINESS OVERVIEW

Exar Corporation and its subsidiaries (“Exar” or “we”) is a fabless semiconductor company that designs, sub-contracts manufacturing and sells highly differentiated silicon, software and subsystem solutions for industrial, telecom, networking and storage applications. Our core expertise in silicon integration, system architecture and software has enabled the development of innovative solutions designed to meet the needs of the evolving connected world. Our product portfolio includes power management and interface components, datacom products, storage optimization solutions, network security and applied service processors. Applying both analog and digital technologies, our products are deployed in a wide array of applications such as portable electronic devices, set top boxes, digital video recorders, telecommunication systems, servers, enterprise storage systems and industrial automation equipment. We provide customers with a breadth of component products and subsystem solutions based on advanced silicon integration.

We market our products worldwide with sales offices and personnel located throughout the Americas, Europe, and Asia. Our products are sold in the United States through a number of manufacturers’ representatives and distributors. Internationally, our products are sold through various regional and country specific distributors with locations around the globe. In addition to our sales offices, we also employ a worldwide team of field application engineers to work directly with our customers.

Our international sales consist of sales that are denominated in U.S. dollars. Our international related operations expenses expose us to fluctuations in currency exchange rates because our foreign operating expenses are denominated in foreign currency while our sales are denominated in U.S. dollars. Although foreign sales within certain countries or foreign sales comprised of certain products may subject us to tariffs, our gross profit margin on international sales, adjusted for differences in product mix, is not significantly different from that realized on our sales to domestic customers. Our operating results are subject to quarterly and annual fluctuations as a result of several factors that could materially and adversely affect our future profitability as described in “Part II, Item 1A. Risk Factors—Our Financial Results May Fluctuate Significantly Because Of A Number Of Factors, Many Of Which Are Beyond Our Control.”

Our fiscal years consist of 52 or 53 weeks. In a 52-week year, each fiscal quarter consists of 13 weeks. The additional week in a 53-week year is added to the fourth quarter, making such quarter consist of 14 weeks. Fiscal year 2011 and fiscal year 2010 are comprised of a 52-week period. The second quarter of fiscal 2011 and fiscal 2010 included 91 days from June 28, 2010 to September 26, 2010 and from June 29, 2009 to September 27, 2009, respectively. The first six months of fiscal 2011 and fiscal 2010 each included 182 days from March 29, 2010 to September 26, 2010 and from March 30, 2009 to September 27, 2009, respectively.

Business Outlook

We experienced a sequential quarterly decrease in our net sales in the second quarter of fiscal 2011 as compared to the first quarter of fiscal 2011. The major factors affecting our decrease in net sales were inventory corrections at our end customers as their inventory was built in excess of their end demand and a slower than expected increase in sales of our new products. We expect our net sales for our third quarter of fiscal 2011 to be slightly down to marginally up when compared to the current quarter as we believe our end customer inventory correction will continue through our third fiscal quarter. As we exit fiscal year 2011, we believe, with our limited visibility, that sales of our new products will increase and net sales of certain of our other products will rebound. We continue to manage our operating expenses but will experience some upward fluctuation in the near term as we invest in some intellectual property and mask tooling costs for our key, next generation products.

 

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CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of our financial statements and accompanying disclosures in conformity with GAAP requires estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the condensed consolidated financial statements and the accompanying notes. The SEC has defined a company’s critical accounting policies as policies that are most important to the portrayal of a company’s financial condition and results of operations, and which require a company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified our most critical accounting policies and estimates to be as follows: (1) revenue recognition; (2) valuation of inventories; (3) income taxes; (4) stock-based compensation; (5) goodwill; (6) long-lived assets; and (7) valuation of business combinations. Although we believe that our estimates, assumptions and judgments are reasonable, they are based upon information presently available. Actual results may differ significantly from these estimates if the assumptions, judgments and conditions upon which they are based turn out to be inaccurate. A further discussion of our critical accounting policies can be found in “Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the fiscal year ended March 28, 2010.

RESULTS OF OPERATIONS

Net Sales by Product Line

Our net sales by product line in dollars and as a percentage of net sales were as follows for the periods presented (in thousands, except percentages):

 

     Three Months Ended     Change     Six Months Ended     Change  
     September 26,
2010
    September 27,
2009
      September 26,
2010
    September 27,
2009
   

Net Sales:

                        

Communication

   $ 4,966         13   $ 4,463         14     11   $ 11,815         15   $ 12,108         19     (2 %) 

Datacom and storage

     4,438         12     6,718         21     (34 %)      9,398         12     12,056         19     (22 %) 

Interface

     20,208         54     14,852         47     36     39,884         52     27,874         45     43

Power Management

     7,621         21     5,555         18     37     15,772         21     10,412         17     51
                                                                        

Total

   $ 37,233         100   $ 31,588         100     $ 76,869         100   $ 62,450         100  
                                                                        

 

* Net sales from Hifn, Galazar and Neterion have been included in our consolidated financial statements since April 4, 2009, June 18, 2009 and March 17, 2010, respectively. Software net sales have not been a significant part of our total net sales.

Communication

Net sales of communication products include network access, transport and transmission products as well as optical products. Net sales of communications products for the three months ended September 26, 2010 increased $0.5 million as compared to the same period a year ago. The increase is primarily due to higher shipments of our SDH/SONET Framer products partially offset by price erosion on certain framer products and a decrease in our Ethernet over SONET/SDH products.

Net sales of communications products for the six months ended September 26, 2010 decreased $0.3 million as compared to the same period a year ago. The decrease is primarily due to lower shipments of our Ethernet over SDH/SONET products.

Datacom and Storage

Net sales of datacom and storage products include network access, transmission and storage products, as well as encryption, data reduction and packet processing products and 10 Gigabit Ethernet controller silicon and card solutions. Net sales of datacom and storage products for the three months ended September 26, 2010 decreased $2.3 million as compared to the same period a year ago and included $1.2 million of additional sales of Neterion products. Excluding the additional Neterion sales, datacom and storage decreased $3.5 million primarily due to slower demand with an inventory correction at certain OEM customers and a discontinuation of a platform at a storage OEM.

Net sales of datacom and storage products for the six months ended September 26, 2010 decreased $2.7 million as compared to the same period a year ago and included $1.8 million of additional sales of Neterion products. Excluding the additional Neterion sales, datacom and storage decreased $4.4 million primarily due to slower demand with an inventory correction at certain OEM customers and a discontinuation of a platform at a storage OEM.

 

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Interface

Net sales of interface products include UARTs, video, imaging and other products as well as transceiver products. Net sales of interface products for the three months ended September 26, 2010 increased $5.4 million as compared to the same period a year ago, primarily due to higher shipments of our serial transceiver and UART products.

Net sales of interface products for the six months ended September 26, 2010 increased $12.0 million as compared to the same period a year ago, primarily due to higher shipments of our serial transceiver and UART products.

Power Management

Power management products include DC-DC regulators and LED drivers. Net sales of power management products for the three months ended September 26, 2010 increased $2.1 million as compared to the same period a year ago primarily due to higher shipments of our analog power solutions.

Net sales of power management products for the six months ended September 26, 2010 increased $5.4 million as compared to the same period a year ago primarily due to higher shipments of our analog power solutions.

Net Sales by Channel

Our net sales by channel in dollars and as a percentage of net sales were as follows for the periods presented (in thousands, except percentages):

 

     Three Months Ended     Change     Six Months Ended        
     September 26,
2010
    September 27,
2009
      September 26,
2010
    September 27,
2009
    Change  

Net Sales:

                        

Sell-through distributors

   $ 21,297         57   $ 15,562         49     37   $ 43,317         56   $ 30,859         49     40

Direct and others

     15,936         43     16,026         51     (1 %)      33,552         44     31,591         51     6
                                                                        

Total

   $ 37,233         100   $ 31,588         100     $ 76,869         100   $ 62,450         100  
                                                                        

 

* Net sales from Hifn, Galazar and Neterion have been included in our consolidated financial statements since April 4, 2009, June 18, 2009 and March 17, 2010, respectively. Software net sales have not been a significant part of our total net sales.

For the three months ended September 26, 2010, net sales to our distributors for which we recognize revenue on the sell-through method increased as a percentage of total net sales as compared to the same period a year ago primarily due to the strength in our serial and power products, which are products primarily sold through distributors.

For the three months ended September 26, 2010, net sales to our direct and other distributors included $0.3 million of sales of our Neterion products.

For the six months ended September 26, 2010, net sales increased as a percentage of total net sales as compared to the same period a year ago primarily due to the strength in our serial and power products, which are products primarily sold through distributors.

For the six months ended September 26, 2010, net sales to our direct and other distributors included $0.9 million of sales of our Neterion products.

 

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Net Sales by Geography

Our net sales by geography in dollars and as a percentage of net sales were as follows for the periods presented (in thousands, except percentages):

 

     Three Months Ended     Change     Six Months Ended     Change  
     September 26,
2010
    September 27,
2009
      September 26,
2010
    September 27,
2009
   

Net Sales:

                        

Americas

   $ 8,357         22   $ 8,567         27     (2 %)    $ 17,019         22   $ 15,883         25     7

Asia

     22,930         62     19,139         61     20     48,169         63     37,801         61     27

Europe

     5,946         16     3,882         12     53     11,681         15     8,766         14     33
                                                                        

Total

   $ 37,233         100   $ 31,588         100     $ 76,869         100   $ 62,450         100  
                                                                        

 

* Net sales from Hifn, Galazar and Neterion have been included in our consolidated financial statements since April 4, 2009, June 18, 2009 and March 17, 2010, respectively. Software net sales have not been a significant part of our total net sales.

For the three and six months ended September 26, 2010, net sales in the Americas included $0.9 million and $1.2 million of Neterion sales, respectively.

For the three and six months ended September 26, 2010, net sales in Asia included $0.2 million and $0.5 million of Neterion sales, respectively.

Gross Profit

Our gross profit in dollars and as a percentage of net sales was as follows for the periods indicated (in thousands, except percentages):

 

     Three Months Ended     Change     Six Months Ended     Change  
     September  26,
2010
    September  27,
2009
      September  26,
2010
    September  27,
2009
   

Net Sales

   $ 37,233         $ 31,588           $ 76,869         $ 62,450        

Cost of sales:

                        

Cost of sales

     18,427         50     15,484         49     19     37,652         49     30,374         49     24

Fair value adjustment of acquired inventories

     —           —       447         1     (100 %)      42         —       2,234         3     (98 %) 

Amortization of acquired intangible assets

     1,515         4     1,567         5     (3 %)      3,068         4     2,907         5     6
                                                                        

Gross profit

   $ 17,291         46   $ 14,090         45     $ 36,107         47   $ 26,935         43  
                                                                        

Gross profit represents net sales less cost of sales. Cost of sales includes:

 

   

the cost of purchasing finished silicon wafers manufactured by independent foundries;

 

   

the costs associated with assembly, packaging, test, quality assurance and product yields;

 

   

the cost of personnel and equipment associated with manufacturing support and engineering;

 

   

the cost of stock-based compensation associated with manufacturing engineering and support personnel;

 

   

the amortization of purchased intangible assets, acquired intellectual property and capitalized IPR&D;

 

   

the fair value adjustment of acquired inventories;

 

   

the provision for excess and obsolete inventory; and

 

   

the sale of previously reserved inventory.

 

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The increase in gross profit, as a percentage of net sales, for the three and six months ended September 26, 2010, as compared to the same periods a year ago, was primarily due to improved manufacturing absorption and yields and the exclusion of fair value adjustment of acquired inventories partially offset by a change in the product mix.

We believe that gross margin will fluctuate as a percentage of sales and in absolute dollars due to, among other factors, sales mix, including the release of our new products which are designed to have better margins, subcontract manufacturing costs, our ability to leverage fixed operational costs across increased shipment volumes and competitive pricing pressure on our products.

Other Costs and Expenses

 

(in thousands, except percentages)    Three Months Ended     Change     Six Months Ended     Change  
     September 26,
2010
    September 27,
2009
      September 26,
2010
    September 27,
2009
   

Net Sales

   $ 37,233         $ 31,588           $ 76,869         $ 62,450        

R&D expense:

                        

R&D - base

   $ 10,101         27   $ 10,713         34     (6 %)    $ 21,914         28   $ 21,376         34     3

Stock-based compensation

     665         2     748         2     (11 %)      2,221         3     1,234         2     80

Amortization expense – acquired intangibles

     1,074         3     635         2     69     2,148         3     1,223         2     76

Accelerated depreciation and other

     —           —       192         1     (100 %)      —           —       749         1     (100 %) 
                                                

Total R&D expense

   $ 11,840         32   $ 12,288         39     (4 %)    $ 26,283         34   $ 24,582         39     7
                                                

SG&A expense:

                        

SG&A - base

   $ 10,035         27   $ 9,809         31     2   $ 20,820         27   $ 20,146         32     3

Stock-based compensation

     751         2     767         2     (2 %)      2,297         3     1,474         2     56

Amortization expense – acquired intangibles

     297         1     179         1     66     595         1     321         1     85

Acquisition related costs

     —           —       620         2     (100 %)      328         —       4,546         7     (93 %) 
                                                

Total SG&A expense

   $ 11,083         30   $ 11,375         36     (3 %)    $ 24,040         31   $ 26,487         42     (9 %) 
                                                

 

* Incremental revenues and operating expenses from Hifn, Galazar and Neterion have been included in our consolidated financial statements since April 4, 2009, June 18, 2009 and March 17, 2010, respectively.

Research and Development (“R&D”)

Our R&D costs consist primarily of:

 

   

the salaries, stock-based compensation, and related expenses of employees engaged in product research, design and development activities;

 

   

costs related to engineering design tools, mask tooling costs, software amortization, test hardware, and engineering supplies and services;

 

   

amortization of acquired intangible assets; and

 

   

facilities expenses.

The $0.6 million decrease in base R&D expenses for the three months ended September 26, 2010 as compared to the same period a year ago was primarily a result of decreased mask sets and outside design offset by incremental labor-related expenses due to the acquisition of Neterion. The $0.5 million increase in base R&D expenses for the six months ended September 26, 2010 as compared to the same period a year ago was primarily a result of incremental labor-related costs due to the Galazar and Neterion acquisitions partially offset by lower mask sets, outside services and tool maintenance costs. Included in the base R&D expenses are costs offsets as discussed below.

 

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In connection with the Hifn acquisition, we assumed a contractual agreement under which certain of our research and development costs are eligible for reimbursement. Amounts collected under this arrangement are offset against R&D expenses. For the second quarters of fiscal 2011 and 2010, we offset $2.0 million and $1.7 million, respectively, of R&D expenses in connection with this agreement. For the first six months of fiscal 2011 and 2010, we offset $3.5 million and $2.4 million, respectively, of R&D expenses in connection with the same agreement.

Stock-based compensation expense recorded in R&D expenses was $0.7 million for both of the second quarter of fiscal 2011 and 2010. The $1.0 million increase in stock-based compensation for the six months ended September 26, 2010 as compared to the same period a year ago reflects the increase in grants of options and RSUs to employees in connection with our acquisitions and award based incentives to certain individuals.

The growth in amortization expense – acquired intangibles relates to the shortening of the useful life of the R&D reimbursement contract associated with the Hifn acquisition that resulted in higher amortization expense.

Accelerated depreciation and other costs in the six months ended September 27, 2009 are primarily associated with the accelerated depreciation relating to shortened remaining lives of equipment of $0.5 million acquired from Hifn and employee severance costs.

We believe that development R&D expenses will fluctuate as a percentage of sales and in absolute dollars due to, among other factors, higher mask costs in connection with advanced process geometries, development for our 10 Gigabit Ethernet products, increased investment in software development, higher salaries due to additional employees from acquired companies, annual merit increases and fluctuations in reimbursements under the research and development contract.

Selling, General and Administrative (“SG&A”)

SG&A expenses consist primarily of:

 

   

salaries, stock-based compensation and related expenses;

 

   

sales commissions;

 

   

professional and legal fees;

 

   

amortization of acquired intangible assets such as distributor relationships, tradenames/trademarks and customer relationships; and

 

   

acquisition related costs.

The $0.2 million increase in base SG&A expenses for the three months ended September 26, 2010 as compared to the same period a year ago was primarily a result of incremental business taxes as well as an accrual for a loss contingency. The $0.7 million increase in base SG&A expenses for the six months ended September 26, 2010 as compared to the same period a year ago was primarily a result of incremental labor-related costs, an accrual for a loss contingency, incentives and trade show and advertising costs.

Stock-based compensation expense recorded in SG&A expenses was $0.8 million for both of the second fiscal periods of 2011 and 2010. The $0.8 million increase in stock-based compensation for the six months ended September 26, 2010 as compared to the same period a year ago reflects the increase in grants of options and RSUs to employees in connection with our acquisitions, award based incentives to certain individuals and performance based RSU grants to our executive officers.

Acquisition related costs in the six months ended September 26, 2010 primarily reflects remaining payments on a vacated Neterion facility located in Sunnyvale, California. Acquisition related costs for the six months ended September 27, 2009 are primarily associated with $2.2 million in investment banker, printing, legal and other professional fees that are recorded as expenses under business combinations accounting and the accelerated depreciation relating to shortened remaining lives of equipment of $0.8 million acquired from Hifn, employee severance of $0.6 million, and building exit and moving costs of $0.3 million related to the Hifn Los Gatos facility.

We believe that SG&A expenses will fluctuate as a percentage of sales and in absolute dollars due to, among other factors, salaries of employees from acquired companies, variable commissions, legal costs and annual merit increases.

 

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Other Income and Expenses

 

(in thousands, except percentages)    Three Months Ended     Change     Six Months Ended     Change  
     September  26,
2010
    September  27,
2009
      September  26,
2010
    September  27,
2009
   

Net Sales

   $ 37,233        $ 31,588          $ 76,869        $ 62,450       

Interest income and other, net

     1,578        4     1,700        5     (7 %)      3,191        4     3,454        6     (8 %) 

Interest expense

     (316     (1 %)      (326     (1 %)      (3 %)      (634     (1 %)      (650     (1 %)      (2 %) 

Impairment charges on investments

     (62     —       (245     (1 %)      (75 %)      (62     —       (317     (1 %)      (80 %) 

Interest Income and Other, Net

Interest income and other, net primarily consists of:

 

   

interest income;

 

   

sublease income;

 

   

foreign exchange gains or losses;

 

   

realized gains or losses on marketable securities; and

 

   

gains or losses on the sale or disposal of equipment.

The decrease in interest income and other, net during the three and six months ended September 26, 2010 as compared to the same periods a year ago was primarily attributable to a decrease in interest income as a result of lower invested interest earning balances and lower interest rates.

Our Hillview Facility, which we originally leased from Mission West Properties, L.P., was sublet in April 2008. The sublease expires on March 31, 2011 with average annual rent of approximately $1.5 million. The sublease also requires the subtenant to pay certain operating costs associated with subleasing the facility. The sublease income for the three and six months ended September 26, 2010 was approximately $0.4 million and $0.8 million, respectively. See “Part I, Item 1, Notes to Condensed Consolidated Financial Statements, Note 14 – Lease Financing Obligation.” The sublease income is derived from a tenant who is a venture backed, private company. If the subtenant were to experience financial difficulties, our sublease would be impacted and costs to maintain and return the lease facility to the landlord could increase.

Interest Expense

In fiscal year 2008, in connection with the acquisition of Sipex, we assumed a lease financing obligation related to the Hillview Facility. We have accounted for this sale and leaseback transaction as a financing transaction which is included in the “Long-term lease financing obligation” line item on the condensed consolidated balance sheet. The effective interest rate is 8.2%.

We have also acquired engineering design tools (“design tools”) under capital leases. We acquired $5.2 million of design tools in December 2007 under a four-year license, $3.7 million of design tools in November 2008 under a three-year license, and $1.3 million of design tools in February and June 2010 under two-year and three-year licenses, which were accounted for as capital leases and recorded in the “Property, plant and equipment, net” line item on the condensed consolidated balance sheets. The related design tool obligations were included in the “Long-term lease financing obligations” line on our condensed consolidated balance sheets. The effective interest rates for the design tools range from 4.0% to 7.25%.

Interest expense for the Hillview Facility lease financing and the design tools lease obligations was approximately $0.3 million and $0.6 million for the three and six months ended September 26, 2010, respectively.

 

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Impairment Charges on Investments

We periodically review and determine whether our investments with unrealized loss positions are other-than-temporarily impaired. We regularly review our investments in unrealized loss positions for other-than-temporary impairments. This evaluation includes, but is not limited to, significant quantitative and qualitative assessments and estimates regarding credit ratings, collateralized support, the length of time and significance of a security’s loss position, our intent to not sell the security and whether it is more likely than not that we will not have to sell the security before recovery of its cost basis. Realized gains and losses and declines in value of our investments, both marketable and non-marketable, judged to be other-than-temporary are reported in the “Impairment charges on investments” line item in the condensed consolidated statements of operations.

Our long-term investment consists of our investment in Skypoint Telecom Fund II (US), L.P. (“Skypoint Fund”). Skypoint Fund is a venture capital fund that invested primarily in private companies in the telecommunications and/or networking industries. We account for this non-marketable equity investment under the cost method. We periodically review and determine whether the investment is other-than-temporarily impaired, in which case the investment is written down to its impaired value.

In the second quarter of fiscal 2010, we analyzed the fair value of the underlying investments of Skypoint Fund and concluded a portion of the carrying value was other-than-temporarily impaired and recorded an impairment charge of $154,000 in addition to the $72,000 recorded in the first quarter of fiscal 2010.

In the second quarter of fiscal 2010 an investment in GSAA Home Equity with a cost of $425,000 was downgraded from an AAA rating to a CCC rating. As a result of the reduction in the rating and quantitative analysis showing an increase in the default rate and decrease in prepayment rate of the investment, we recorded an other-than-temporary impairment charge of $91,000 during the second quarter of fiscal 2010. In the second quarter of fiscal 2011, this investment continued to deteriorate and we recorded an additional charge of $62,000.

Provision for (Benefit from) Income Taxes

During the three and six months ended September 26, 2010, we recorded an income tax expense of approximately $27,000 and $152,000, respectively. During the three and six months ended September 27, 2009, we recorded an income tax benefit of $281,000 and $609,000, respectively. The increase in income tax expense was primarily due to expenses recorded during the first six months of fiscal 2011 for foreign taxable income.

LIQUIDITY AND CAPITAL RESOURCES

 

     Six Months Ended  
     September 26,
2010
    September 27,
2009
 
     (dollars in thousands)  

Cash and cash equivalents

   $ 14,086      $ 32,034   

Short-term investments

     194,162        189,411   
                

Total cash, cash equivalents, and short-term investments

   $ 208,248      $ 221,445   
                

Percentage of total assets

     64     67

Net cash provided by (used in) operating activities

   $ 34      $ (2,305

Net cash used in investing activities

     (10,314     (54,145

Net cash used in financing activities

     (1,120     (518
                

Net decrease in cash and cash equivalents

   $ (11,400   $ (56,968
                

Our net loss was approximately $11.9 million for the six months ended September 26, 2010. After adjustments for non-cash items and changes in working capital, we provided $34,000 of cash through operating activities.

Significant non-cash charges included:

 

   

depreciation and amortization expenses of $10.7 million;

 

   

stock-based compensation expense of $4.8 million; and

 

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provision for sales returns and allowances of $7.0 million.

Working capital changes included:

 

   

a $7.0 million increase in accounts receivable primarily due to excluding the noncash provision for sales returns and allowances line item of the consolidated statements of cash flow;

 

   

a $7.6 million increase in inventories primarily due to higher material receipts for our datacom and storage and power products in anticipation of higher future shipments of our new products;

 

   

a $2.0 million increase in accounts payable primarily due to higher inventory receipts; and

 

   

a $1.9 million increase in deferred income and allowances on sales to distributors and related party as our distributors and related party have increased their inventories.

In the six months ended September 26, 2010, net cash used in investing activities reflects net purchases of short-term marketable securities of $7.4 million and $2.6 million in purchases of property, plant and equipment and intellectual property.

From time to time, we acquire outstanding shares of our common stock in the open market to partially offset dilution from our equity awards, to increase our return on our invested capital and to bring our cash to a more appropriate level for our company. On August 28, 2007, we established a share repurchase plan (“2007 SRP”) and authorized the repurchase of up to $100 million of our common stock. During the three and six months ended September 26, 2010 and the three and six months ended September 27, 2009, we did not repurchase any shares under the 2007 SRP. As of September 26, 2010, the remaining authorized amount for the stock repurchase under the 2007 SRP was $11.8 million. We may continue to utilize our share repurchase plan, which would reduce our cash, cash equivalents and/or short-term investments available to fund future operations and to meet other liquidity requirements.

To date, inflation has not had a significant impact on our operating results.

We anticipate that we will continue to finance our operations with cash flows from operations, existing cash and investment balances, and some combination of long-term debt and/or lease financing and additional sales of equity securities. The combination and sources of capital will be determined by management based on our needs and prevailing market conditions.

The following table summarizes our investments in marketable securities (in thousands):

 

     September 26, 2010  
     Amortized
Cost
     Unrealized     Fair Value  
        Gross Gains      Gross Losses    

Money market funds

   $ 8,552       $ —         $ —        $ 8,552   

U.S. government and agency securities

     47,785         650         —          48,435   

Corporate bonds and commercial paper

     79,495         1,329         (5     80,819   

Asset and mortgage-backed securities

     64,852         293         (237     64,908   
                                  

Total investments

   $ 200,684       $ 2,272       $ (242   $ 202,714   
                                  
     March 28, 2010  
     Amortized
Cost
     Unrealized     Fair Value  
        Gross Gains      Gross Losses    

Money market funds

   $ 19,616       $ —         $ —        $ 19,616   

U.S. government and agency securities

     58,943         835         (31     59,747   

Corporate bonds and commercial paper

     61,240         900         (18     62,122   

Asset and mortgage-backed securities

     64,329         496         (96     64,729   
                                  

Total investments

   $ 204,128       $ 2,231       $ (145   $ 206,214   
                                  

As of September 26, 2010, asset-backed and mortgage-backed securities, accounted for 10% and 22%, respectively, of our total investments in marketable securities of $202.7 million. The asset-backed securities are comprised primarily of premium tranches of auto loans and credit card receivables, while our mortgage-backed securities are primarily from Federal agencies. We do not own auction rate securities nor do we own securities that are classified as sub-prime. As of the date of this Form 10-Q, we have sufficient liquidity and do not expect the need to sell these securities to fund normal operations nor realize any significant losses in the short term. As of September 26, 2010, the net unrealized gain of our asset-backed and mortgage-backed securities totaled $56,000.

 

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We believe that our cash and cash equivalents, short-term marketable securities and expected cash flows from operations will be sufficient to satisfy working capital requirements, capital equipment and intellectual property needs for at least the next 12 months. However, should the demand for our products decrease in the future, the availability of cash flows from operations may be limited, thus having a material adverse effect on our financial condition or results of operations. From time to time, we evaluate potential acquisitions, strategic arrangements and equity investments complementary to our design expertise and market strategy, which may include investments in wafer fabrication foundries. To the extent that we pursue or position ourselves to pursue these transactions, we could consume a significant portion of our capital resources or choose to seek additional equity or debt financing. Additional financing may not be available on terms acceptable to us or at all. The sale of additional equity or convertible debt could result in dilution to our stockholders.

RECENT ACCOUNTING PRONOUNCEMENTS

Please refer to “Part I, Item 1. Financial Statements” and “Notes to Condensed Consolidated Financial Statements, Note 2 – Recent Accounting Pronouncements.”

OFF-BALANCE SHEET ARRANGEMENTS

As of September 26, 2010, the Company has not utilized special purpose entities to facilitate off-balance sheet financing arrangements. However, we have, in the normal course of business, entered into agreements which impose warranty obligations with respect to our products or which obligate us to provide indemnification of varying scope and terms to customers, vendors, lessors and business partners, our directors and executive officers, purchasers of assets or subsidiaries, and other parties with respect to certain matters. These arrangements may constitute “off-balance sheet transactions” as defined in Section 303(a)(4) of Regulation S-K. Please see “Note 15. Commitments and Contingencies” to the Condensed Consolidated Financial Statements for further discussion of our product warranty liabilities and indemnification obligations.

As discussed in “Note 15. Commitments and Contingencies”, during the normal course of business, we make certain indemnities and commitments under which we may be required to make payments in relation to certain transactions. These indemnities include non-infringement of patents and intellectual property, indemnities to our customers in connection with the delivery, design, manufacture and sale of our products, indemnities to our directors and officers in connection with legal proceedings, indemnities to various lessors in connection with facility leases for certain claims arising from such facility or lease, and indemnities to other parties to certain acquisition agreements. The duration of these indemnities and commitments varies, and in certain cases, is indefinite. We believe that substantially all of our indemnities and commitments provide for limitations on the maximum potential future payments we could be obligated to make. However, we are unable to estimate the maximum amount of liability related to our indemnities and commitments because such liabilities are contingent upon the occurrence of events which are not reasonably determinable. Management believes that any liability for these indemnities and commitments would not be material to our accompanying condensed consolidated financial statements.

CONTRACTUAL OBLIGATIONS AND COMMITMENTS

Our contractual obligations and commitments at September 26, 2010 were as follows (in thousands):

 

     Payments due by period  

Contractual Obligations

   Total      Less than
1 year
     1-3
years
     3-5
years
     More than
5 years
 

Purchase commitments (1)

   $ 22,080       $ 22,080       $ —         $ —         $ —     

Long-term lease financing obligations (2)

     5,613         4,861         752         —           —     

Lease obligations (3)

     1,948         1,453         495         —           —     

Long-term investment commitments (Skypoint Fund) (4)

     304         304         —           —           —     

Remediation commitment (5)

     128         78         10         40         —     
                                            

Total

   $ 30,073       $ 28,776       $ 1,257       $ 40       $ —     
                                            

 

Note: The table above excludes the liability for unrecognized income tax benefit of approximately $3.6 million at September 26, 2010 since we cannot predict with reasonable reliability the timing of cash settlements with the respective taxing authorities.

 

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(1) We place purchase orders with wafer foundries and other vendors as part of our normal course of business. We expect to receive and pay for wafers, capital equipment and various service contracts over the next 12 to 18 months from our existing cash balances.
(2) Includes licensing agreements related to engineering design software of $4.9 million. Also includes $0.7 million related to the Hillview Facility, but excludes approximately $12.2 million estimated final obligation settlement with the lessor by returning the Hillview Facility at the end of the lease term due on the Hillview Facility in Milpitas, California under a 5-year Standard Form Lease agreement that we signed with Mission West Properties, L.P. on March 9, 2006, as amended on August 25, 2007. The lease term expires on March 31, 2011.
(3) Includes lease payments related to worldwide offices and buildings.
(4) The commitment related to the Skypoint Fund does not have a set payment schedule and thus will become payable upon the request from the Funds General Partner.
(5) The commitment relates to the environmental remediation activities of Micro Power Systems, Inc.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Foreign Currency Fluctuations. We are exposed to foreign currency fluctuations primarily through our foreign operations. This exposure is the result of foreign operating expenses being denominated in foreign currency. Operational currency requirements are typically forecasted for a one-month period. If there is a need to hedge this risk, we may enter into transactions to purchase currency in the open market or enter into forward currency exchange contracts.

If our foreign operations forecasts are overstated or understated during periods of currency volatility, we could experience unanticipated currency gains or losses. At September 26, 2010, we did not have significant foreign currency denominated net assets or net liabilities positions, and had no foreign currency contracts outstanding.

Investment Risk and Interest Rate Sensitivity. We maintain investment portfolio holdings of various issuers, types, and maturity dates with two professional money management institutions. The market value of these investments on any given day during the investment term may vary as a result of market interest rate fluctuations. Our investment portfolio consisted of cash equivalents, money market funds and fixed income securities of $202.7 million as of September 26, 2010 and $206.2 million as of March 28, 2010. These securities, like all fixed income instruments, are subject to interest rate risk and will vary in value as market interest rates fluctuate. If market interest rates were to increase or decline immediately and uniformly by less than 10% from levels as of September 26, 2010, the increase or decline in the fair value of the portfolio would not be material. At September 26, 2010, the difference between the fair market value and the underlying cost of the investments portfolio was a net unrealized gain of $2.0 million.

Our short-term investments are classified as “available-for-sale” securities and the cost of securities sold is based on the specific identification method. At September 26, 2010, short-term investments consisted of asset and mortgage-backed securities, corporate bonds and government agency securities of $194.2 million.

 

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures (“Disclosure Controls”)

Disclosure Controls, as defined in Rule 13a-15(e) and 15d-15(e) of the Exchange Act, are controls and procedures designed to ensure that information required to be disclosed in the reports filed or submitted under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods as specified in the SEC’s rules and forms. In addition, Disclosure Controls are designed to ensure the accumulation and communications of information required to be disclosed in reports filed or submitted under the Securities Exchange Act of 1934, as amended, to our management, including the Chief Executive Officer (the “CEO”) and Chief Financial Officer (the “CFO”), to allow timely decisions regarding required disclosure.

We evaluated the effectiveness of the design and operation of our Disclosure Controls, as defined by the rules and regulations of the SEC (the “Evaluation”), as of the end of the period covered by this Quarterly Report on Form 10-Q. This Evaluation was performed under the supervision and with the participation of management, including our CEO, as principal executive officer, and CFO, as principal financial officer.

Attached as Exhibits 31.1 and 31.2 of this Quarterly Report on Form 10-Q are the certifications of the CEO and the CFO, respectively, in compliance with Section 302 of the Sarbanes-Oxley Act of 2002 (the “Certifications”). This section of the Quarterly Report on Form 10-Q provides information concerning the Evaluation referred to in the Certifications and should be read in conjunction with the Certifications.

Based on the Evaluation, our CEO and CFO have concluded that our Disclosure Controls are effective at the reasonable assurance level as of September 26, 2010.

Inherent Limitations on the Effectiveness of Disclosure Controls

Our management, including the CEO and CFO, does not expect that our Disclosure Controls will prevent all errors and all fraud. Disclosure Controls, no matter how well conceived, managed, utilized and monitored, can provide only reasonable assurance that the objectives of such controls are met. Therefore, because of the inherent limitation of Disclosure Controls, no evaluation of such controls can provide absolute assurance that all control issues and instances of fraud, if any, within us have been detected.

Changes in Internal Control over Financial Reporting

There has been no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II – OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

The disclosure in “Notes to Condensed Consolidated Financial Statements, Note 16 – Legal Proceedings” contained in “Part I, Item 1. Financial Statements” is hereby incorporated by reference.

 

ITEM 1A. RISK FACTORS

We are subject to the following risks that could materially adversely affect our business, results of operations and financial condition. The following risk factors and other information included in this Quarterly Report, in our Quarterly Report on Form 10-Q for the fiscal quarter ended June 27, 2010 and in our Annual Report on Form 10-K for our fiscal year ended March 28, 2010 should be carefully considered. The risks and uncertainties described below, in the Quarterly Report on Form 10-Q for the fiscal quarter ended June 27, 2010 and in our Annual Report on Form 10-K for our fiscal year ended March 28, 2010 are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations. If any of the following risks occur, our business, financial condition, operating results and cash flows could be materially adversely affected.

Global capital, credit market, employment, and general economic conditions, and resulting declines in consumer confidence and spending, could have a material adverse effect on our business, operating results, and financial condition.

Periodic declines or fluctuations in the U.S. dollar, corporate results of operations, interest rates, inflation or deflation, the global impact of sovereign debt, economic trends, actual or feared economic recessions, lower spending, the impact of conflicts throughout the world, terrorist acts, natural disasters, volatile energy costs, the outbreak of communicable diseases and other geopolitical factors, have had, and may continue to have, a negative impact on the U.S. and global economies. Volatility and disruption in the global capital and credit markets have led to a tightening of business credit and liquidity, a contraction of consumer credit, business failures, higher unemployment, and declines in consumer confidence and spending in the U.S. and internationally. If global economic and financial market conditions, currently showing signs of recovery, deteriorate or remain weak for an extended period of time, many related factors could have a material adverse effect on our business, operating results, and financial condition, including the following:

 

   

slower spending by consumers and market fluctuations may result in reduced demand for our products, reduced orders for our products, order cancellations, lower revenues, increased inventories, and lower gross margins;

 

   

if we undertake restructuring activities due to economical pressure, we cannot guarantee that any of our restructuring efforts will be successful, or that we will be able to realize the cost savings and other anticipated benefits from our previous or future restructuring plans, in addition, if we reduce our workforce, it may adversely impact our ability to respond rapidly to new growth opportunities;

 

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we may be unable to predict the strength or duration of market conditions or the effects of consolidation of our customers in their industries, which may result in project delays or cancellations;

 

   

we may be unable to find suitable investments that are safe, liquid, and provide a reasonable return resulting in lower interest income or longer investment horizons, and disruptions to capital markets or the banking system may also impair the value of investments or bank deposits we currently consider safe or liquid;

 

   

the failure of financial institution counterparties to honor their obligations to us under credit instruments could jeopardize our ability to rely on and benefit from those instruments, and our ability to replace those instruments on the same or similar terms may be limited under poor market conditions;

 

   

continued volatility in the markets and prices for commodities and raw materials we use in our products and in our supply chain could have a material adverse effect on our costs, gross margins, and profitability;

 

   

if distributors of our products experience declining revenues, or experience difficulty obtaining financing in the capital and credit markets to purchase our products, or experience severe financial difficulty, it could result in insolvency, reduced orders for our products, order cancellations, inability to timely meet payment obligations to us, extended payment terms, higher accounts receivable, reduced cash flows, greater expenses associated with collection efforts, and increased bad debt expenses;

 

   

if contract manufacturers or foundries of our products or other participants in our supply chain experience difficulty obtaining financing in the capital and credit markets to purchase raw materials or to finance general working capital needs, it may result in delays or non-delivery of shipments of our products;

 

   

potential shutdowns or over capacity constraints by our third-party foundry, assembly and test subcontractors could result in longer lead-times, higher buffer inventory levels and degraded on-time delivery performance; and

 

   

the current macroeconomic environment also limits our visibility into future purchases by our customers and renewals of existing agreements, which may necessitate changes to our business model.

Our financial results may fluctuate significantly because of a number of factors, many of which are beyond our control.

Our financial results may fluctuate significantly as a result of a number of factors, many of which are difficult or impossible to control or predict, which include:

 

   

the continuing effects of the recent economic downturn;

 

   

the cyclical nature of the semiconductor industry;

 

   

difficulty in predicting revenues and ordering the correct mix of products from suppliers due to limited visibility provided by customers and channel partners;

 

   

fluctuations of our revenue and gross profits due to the mix of product sales as our margins vary by product;

 

   

the impact of our revenue recognition policies on reported results; and

 

   

the reduction, rescheduling, cancellation or timing of orders by our customers, distributors and channel partners due to, among others, the following factors:

 

   

management of customer, subcontractor and/or channel inventory;

 

   

delays in shipments from our subcontractors causing supply shortages;

 

   

inability of our subcontractors to provide quality products, in adequate quantities and in a timely manner;

 

   

dependency on a single product with a single customer and/or distributor;

 

   

volatility of demand for equipment sold by our large customers, which in turn, introduces demand volatility for our products;

 

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disruption in customer demand as customers change or modify their complex subcontract manufacturing supply chain;

 

   

disruption in customer demand due to technical or quality issues with our devices or components in their system;

 

   

the inability of our customers to obtain components from their other suppliers;

 

   

disruption in sales or distribution channels;

 

   

our ability to maintain and expand distributor relationships;

 

   

changes in sales and implementation cycles for our products;

 

   

the ability of our suppliers and customers to remain solvent, obtain financing or fund capital expenditures as a result of the recent global economic slowdown;

 

   

risks associated with entering new markets;

 

   

the announcement or introduction of products by our existing competitors or new competitors;

 

   

loss of market share by our customers;

 

   

competitive pressures on selling prices or product availability;

 

   

pressures on selling prices overseas due to foreign currency exchange fluctuations;

 

   

erosion of average selling prices coupled with the inability to sell newer products with higher average selling prices, resulting in lower overall revenue and margins;

 

   

delays in product design releases;

 

   

market and/or customer acceptance of our products;

 

   

consolidation among our competitors, our customers and/or our customers’ customers;

 

   

changes in our customers’ end user concentration or requirements;

 

   

loss of one or more major customers;

 

   

significant changes in ordering pattern by major customers;

 

   

our or our channel partners’ ability to maintain and manage appropriate inventory levels;

 

   

the availability and cost of materials and services, including foundry, assembly and test capacity, needed by us from our foundries and other manufacturing suppliers;

 

   

disruptions in our or our customers’ supply chain due to natural disasters, fire, outbreak of communicable diseases, labor disputes, civil unrest or other reasons;

 

   

delays in successful transfer of manufacturing processes to our subcontractors;

 

   

fluctuations in the manufacturing output, yields, and capacity of our suppliers;

 

   

fluctuation in suppliers’ capacity due to reorganization, relocation or shift in business focus, financial constraints, or other reasons;

 

   

problems, costs, or delays that we may face in shifting our products to smaller geometry process technologies and in achieving higher levels of design and device integration;

 

   

our ability to successfully introduce and transfer into production new products and/or integrate new technologies;

 

   

increased manufacturing costs;

 

   

higher mask tooling costs associated with advanced technologies; and

 

   

the amount and timing of our investment in research and development;

 

   

costs and business disruptions associated with stockholder or regulatory issues;

 

   

the timing and amount of employer payroll tax to be paid on our employees’ gains on stock options exercised;

 

   

inability to generate profits to utilize net operating losses;

 

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increased costs and time associated with compliance with new accounting rules or new regulatory requirements;

 

   

changes in accounting or other regulatory rules, such as the requirement to record assets and liabilities at fair value;

 

   

write-off of some or all of our goodwill and other intangible assets;

 

   

fluctuations in interest rates and/or market values of our marketable securities;

 

   

litigation costs associated with the defense of suits brought or complaints made against us; and

 

   

change in or continuation of certain tax provisions.

Our expense levels are based, in part, on expectations of future revenues and are, to a large extent, fixed in the short-term. Our revenues are difficult to predict and at times we have failed to achieve revenue expectations. We may be unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall. If revenue levels are below expectations for any reason, our business, financial condition and results of operations could be materially and adversely impacted.

If we fail to develop, introduce or enhance products that meet evolving market needs or which are necessitated by technological advances, or we are unable to grow revenues, then our business, financial condition and results of operations could be materially and adversely impacted.

The markets for our products are characterized by a number of factors, some of which are listed below:

 

   

changing or disruptive technologies;

 

   

evolving and competing industry standards;

 

   

changing customer requirements;

 

   

increasing price pressure;

 

   

increasing product development costs;

 

   

long design-to-production cycles;

 

   

competitive solutions;

 

   

fluctuations in capital equipment spending levels and/or deployment;

 

   

rapid adjustments in customer demand and inventory;

 

   

increasing functional integration;

 

   

moderate to slow growth;

 

   

frequent product introductions and enhancements;

 

   

changing competitive landscape (consolidation, financial viability); and

 

   

finite market windows for product introductions.

Our growth depends in part on our successful continued development and customer acceptance of new products for our core markets. We must: (i) anticipate customer and market requirements and changes in technology and industry standards; (ii) properly define and develop new products on a timely basis; (iii) gain access to and use technologies in a cost-effective manner; (iv) have suppliers produce quality products; (v) continue to expand our technical and design expertise; (vi) introduce and cost-effectively manufacture new products on a timely basis; (vii) differentiate our products from our competitors’ offerings; and (viii) gain customer acceptance of our products. In addition, we must continue to have our products designed into our customers’ future products and maintain close working relationships with key customers to define and develop new products that meet their evolving needs. Moreover, we must respond in a rapid and cost-effective manner to shifts in market demands, the trend towards increasing functional integration and other changes. Migration from older products to newer products may result in volatility of earnings as revenues from older products decline and revenues from newer products begin to grow.

 

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Products for our customers’ applications are subject to continually evolving industry standards and new technologies. Our ability to compete will depend in part on our ability to identify and ensure compliance with these industry standards. The emergence of new standards could render our products incompatible. We could be required to invest significant time, effort and expenses to develop and qualify new products to ensure compliance with industry standards.

The process of developing and supporting new products is complex, expensive and uncertain, and if we fail to accurately predict and understand our customers’ changing needs and emerging technological trends, our business, financial condition and results of operations may be harmed. In addition, we may make significant investments to modify new products according to input from our customers who may choose a competitor’s or an internal solution, or cancel their projects. We may not be able to identify new product opportunities successfully, develop and bring to market new products, achieve design wins, ensure when and which design wins actually get released to production, or respond effectively to technological changes or product announcements by our competitors. In addition, we may not be successful in developing or using new technologies or may incorrectly anticipate market demand and develop products that achieve little or no market acceptance. Our pursuit of technological advances may require substantial time and expense and may ultimately prove unsuccessful. Failure in any of these areas may materially and adversely harm our business, financial condition and results of operations.

We have made and in the future may make acquisitions and significant strategic equity investments, which may involve a number of risks. If we are unable to address these risks successfully, such acquisitions and investments could have a materially adverse effect on our business, financial condition and results of operations.

We have recently undertaken a number of strategic acquisitions, have made strategic investments in the past, and may make further strategic acquisitions and investments from time to time in the future. The risks involved with these acquisitions and investments include:

 

   

the possibility that we may not receive a favorable return on our investment or incur losses from our investment or the original investment may become impaired;

 

   

revenues or synergies could fall below projections or fail to materialize as assumed;

 

   

failure to satisfy or set effective strategic objectives;

 

   

the opportunity cost associated with committing capital in such transactions;

 

   

the possibility of litigation arising from these transactions;

 

   

our assumption of known or unknown liabilities or other unanticipated events or circumstances; and

 

   

the diversion of management’s attention from day-to-day operations of the business and the resulting potential disruptions to the ongoing business.

Additional risks involved with acquisitions include:

 

   

difficulties in integrating and managing various functional areas such as sales, engineering, marketing, and operations;

 

   

difficulties in incorporating or leveraging acquired technologies and intellectual property rights in new products;

 

   

difficulties or delays in the transfer of manufacturing flows and supply chains of products of acquired businesses;

 

   

failure to retain and integrate key personnel;

 

   

failure to retain and maintain relationships with existing customers, distributors, channel partners and other parties;

 

   

failure to manage and operate multiple geographic locations both effectively and efficiently;

 

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failure to coordinate research and development activities to enhance and develop new products and services in a timely manner that optimize the assets and resources of the combined company;

 

   

difficulties in creating uniform standards, controls (including internal control over financial reporting), procedures, policies and information systems;

 

   

unexpected capital equipment outlays and continuing expenses related to technical and operational integration;

 

   

difficulties in entering markets or retaining current markets in which we have limited or no direct prior experience and where competitors in such markets may have stronger market positions;

 

   

insufficient revenues to offset increased expenses associated with acquisitions;

 

   

under-performance problems with an acquired company;

 

   

issuance of common stock that would dilute our current stockholders’ percentage ownership;

 

   

reduction in liquidity and interest income on lower cash balances;

 

   

recording of goodwill and intangible assets that will be subject to periodic impairment testing and potential impairment charges against our future earnings;

 

   

incurring amortization expenses related to certain intangible assets; and

 

   

incurring large and immediate write-offs.

Strategic equity investments also include risks associated with third parties managing the funds and the risk of poor strategic choices or execution of strategic and operating plans.

We may not address these risks successfully without substantial expense, delay or other operational or financial problems, or at all. Any delays or other such operations or financial problems could materially and adversely impact our business, financial condition and results of operations.

If we are unable to convert a significant portion of our design wins into revenue, our business, financial condition and results of operations could be materially and adversely impacted.

We continue to secure design wins for new and existing products. Such design wins are necessary for revenue growth. However, many of our design wins may never generate revenues if their end-customer projects are unsuccessful in the market place or the end-customer terminates the project, which may occur for a variety of reasons. Mergers, consolidations or cost reduction activities among our customers may lead to termination of certain projects before the associated design win generates revenue. If design wins do generate revenue, the time lag between the design win and meaningful revenue is typically between six months to greater than eighteen months. If we fail to convert a significant portion of our design wins into substantial revenue, our business, financial condition and results of operations could be materially and adversely impacted. Under recent deteriorating global economic conditions, our design wins could be delayed even longer than the typical lag period and our eventual revenue could be less than anticipated from products that were introduced within the last eighteen to thirty-six months, which would likely materially and adversely affect our business, financial condition and results of operations.

The complexity of our products may lead to errors, defects and bugs, which could subject us to significant costs or damages and adversely affect market acceptance of our products.

Although we, our customers and our suppliers rigorously test our products, they may contain undetected errors, performance weaknesses, defects or bugs when first introduced or as new versions are released. If any of our products contain production defects or reliability, quality or compatibility problems that are significant to our customers, our reputation may be damaged and customers may be reluctant to continue to buy our products, which could adversely affect our ability to retain and attract new customers. In addition, these defects or bugs could interrupt or delay sales of affected products, which could materially and adversely affect our business, financial condition and results of operations.

 

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If defects or bugs are discovered after commencement of commercial production, we may be required to make significant expenditures of capital and other resources to resolve the problems. This could result in significant additional development costs and the diversion of technical and other resources from our other development efforts. We could also incur significant costs to repair or replace defective products or may agree to be liable for certain damages incurred. These costs or damages could have a material adverse effect on our business, financial condition and results of operations.

We derive a substantial portion of our revenues from distributors, especially from our two primary distributors, Future Electronics Inc. (“Future”), a related party, and Nu Horizons Electronics Corp. (“Nu Horizons”). Our revenues would likely decline significantly if our primary distributors elected not to promote or sell our products or if they elected to cancel, reduce or defer purchases of our products.

Future and Nu Horizons have historically accounted for a significant portion of our revenues, and they are our two primary distributors worldwide. We anticipate that sales of our products to these distributors will continue to account for a significant portion of our revenues. The loss of either Future or Nu Horizons as a distributor, for any reason, or a significant reduction in orders from either of them would materially and adversely affect our business, financial condition and results of operations.

Sales to Future and Nu Horizons are made under agreements that provide protection against price reduction for their inventory of our products. As such, we could be exposed to significant liability if the inventory value of the products held by Future and Nu Horizons declined dramatically. Our distributor agreements with Future and Nu Horizons do not contain minimum purchase commitments. As a result, Future and Nu Horizons could cease purchasing our products with short notice or cease distributing these products. In addition, they may defer or cancel orders without penalty, which would likely cause our revenues to decline and materially and adversely impact our business, financial condition and results of operations.

On September 20, 2010, Arrow Electronics, Inc. announced a definitive agreement to acquire Nu Horizons in an all cash transaction for $7.00 per share. The acquisition has been approved by the Boards of Directors of both companies and is subject to the approval of Nu Horizons' shareholders as well as customary regulatory approvals. The transaction is expected to close during the fourth quarter of 2010. It is uncertain at this point what effect, if any, the acquisition may have on our relationship with the combined company going forward. As Nu Horizons is currently one of our two primary distributors, if the relationship were to be terminated or altered in an unfavorable fashion, it could result in a material and adverse effect on our business, financial condition and/or results of operations.

If we are unable to accurately forecast demand for our products, we may be unable to efficiently manage our inventory.

Due to the absence of substantial non-cancelable backlog, we typically plan our production and inventory levels based on customer forecasts, internal evaluation of customer demand and current backlog, which can fluctuate substantially. As a consequence of inaccuracies inherent in forecasting, inventory imbalances periodically occur that result in surplus amounts of some of our products and shortages of others. Such shortages can adversely impact customer relations and surpluses can result in larger-than-desired inventory levels, which can materially and adversely impact our business, financial condition and results of operations. Due to the unpredictability of global economic conditions and increased difficulty in forecasting demand for our products, we could experience an increase in inventory levels.

If our distributors or sales representatives stop selling or fail to successfully promote our products, our business, financial condition and results of operations could be materially and adversely impacted.

We sell many of our products through sales representatives and distributors, many of which sell directly to OEMs, contract manufacturers and end customers. Our non-exclusive distributors and sales representatives may carry our competitors’ products, which could adversely impact or limit sales of our products. Additionally, they could reduce or discontinue sales of our products or may not devote the resources necessary to sell our products in the volumes and within the time frames that we expect. Our agreements with distributors contain limited provisions for return of our products, including stock rotations whereby distributors may return a percentage of their purchases from us based upon a percentage of their most recent three or six months of shipments. In addition, in certain circumstances upon termination of the distributor relationship, distributors may return some portion of their prior purchases. The loss of business from any of our significant distributors or the delay of significant orders from any of them, even if only temporary, could materially and adversely harm our business, financial conditions and results of operations.

Moreover, we depend on the continued viability and financial resources of these distributors and sales representatives, some of which are small organizations with limited working capital. In turn, these distributors and sales representatives are subject to general economic and semiconductor industry conditions. We believe that our success will continue to depend on these distributors and sales representatives. If some or all of our distributors and sales representatives experience financial difficulties, or otherwise become unable or unwilling to promote and sell our products, our business, financial condition and results of operations could be materially and adversely impacted.

 

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Our distributors rely heavily on the availability of short-term capital at reasonable rates to fund their ongoing operations. If this capital is not available, or is only available on onerous terms, certain distributors may not be able to pay for inventory received or we may experience a reduction in orders from these distributors, which would likely cause our revenue to decline and materially and adversely impact our business, financial condition and results of operations.

We depend in part on the continued service of our key engineering and management personnel and our ability to identify, hire, incentivize and retain qualified personnel. If we lose key employees or fail to identify, hire, incentivize and retain these individuals, our business, financial condition and results of operations could be materially and adversely impacted.

Our future success depends, in part, on the continued service of our key design engineering, technical, sales, marketing and executive personnel and our ability to identify, hire, motivate and retain other qualified personnel.

Under certain circumstances, including a company acquisition or business downturn, current and prospective employees may experience uncertainty about their future roles with us. Volatility or lack of positive performance in our stock price and the ability to offer equity compensation to as many key employees or in amounts consistent with market practices, as a result of regulations regarding the expensing of equity awards, may also adversely affect our ability to retain key employees, all of whom have been granted equity awards. In addition, competitors may recruit employees, as is common in the high tech sector. If we are unable to retain personnel that are critical to our future operations, we could face disruptions in operations, loss of existing customers, loss of key information, expertise or know-how, and unanticipated additional recruitment and training costs.

Competition for skilled employees having specialized technical capabilities and industry-specific expertise is intense and continues to be a considerable risk inherent in the markets in which we compete. At times, competition for such employees has been particularly notable in California and the People’s Republic of China (“PRC”). Further, the PRC historically has different managing principles from Western style management and financial reporting concepts and practices, as well as in modern banking, computer and other control systems, making the successful identification and employment of qualified personnel particularly important, and hiring and retaining a sufficient number of such qualified employees may be difficult. As a result of these factors, we may experience difficulty in establishing management, legal and financial controls, collecting financial data, books of account and records and instituting business practices that meet Western standards, which could materially and adversely impact our business, financial condition and results of operations.

Our employees are employed at-will, which means that they can terminate their employment at any time. Our international locations are subject to local labor laws, which are often significantly different from U.S. labor laws and which may under certain conditions result in large separation costs upon termination. The failure to recruit and retain, as necessary, key design engineers and technical, sales, marketing and executive personnel could materially and adversely impact our business, financial condition and results of operations.

Stock-based awards are critical to our ability to recruit, retain and motivate highly skilled talent. In making employment decisions, particularly in the semiconductor industry and the geographies where our employees are located, a key consideration of current and potential employees is the value of the equity awards they receive in connection with their employment. If we are unable to offer employment packages with competitive equity award component, our ability to attract highly skilled employees would be harmed. In addition, volatility in our stock price could result in a stock option’s exercise price exceeding the market value of our common stock or a deterioration in the value of restricted stock units granted, thus lessening the effectiveness of stock-based awards for retaining and motivating employees. Similarly, decreases in the number of unvested in-the-money stock options held by existing employees, whether because our stock price has declined, options have vested, or because the size of follow-on option grants has declined, may make it more difficult to retain and motivate employees. Consequently, we may not continue to successfully attract and retain key employees, which could have an adverse effect on our business, financial condition and results of operations.

Occasionally, we enter into agreements that expose us to potential damages that exceed the value of the agreement.

We have given certain customers increased indemnification for product deficiencies or intellectual property infringement that is in excess of our standard limited warranty and indemnification provision and could possibly result in greater costs, in excess of the original contract value. In an attempt to limit this liability, we have purchased an errors and omissions insurance policy to partially offset these potential additional costs; however, our insurance coverage could be insufficient in terms of amount and/or coverage language to prevent us from suffering material losses if the indemnification amounts are large enough or if there are coverage issues.

We may be exposed to additional credit risk as a result of the addition of significant direct customers through recent acquisitions.

From time to time one of our customers has contributed more than 10% of our quarterly net sales. A number of our customers are OEMs, or the manufacturing subcontractors of OEMs, which might result in an increase in concentrated credit risk with respect to our trade receivables and therefore, if a large customer were to be unable to pay, it could materially and adversely impact our business, financial condition and results of operations.

 

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Any error in our sell-through revenue recognition judgment or estimates could lead to inaccurate reporting of our net sales, gross profit, deferred income and allowances on sales to distributors and net income.

Sell-through revenue recognition is highly dependent on receiving pertinent and accurate data from our distributors in a timely fashion. Distributors provide us periodic data regarding the product, price, quantity, and end customer when products are resold as well as the quantities of our products they still have in stock. We must use estimates and apply judgment to reconcile distributors’ reported inventories to their activities. Any error in our judgment could lead to inaccurate reporting of our net sales, gross profit, deferred income and allowances on sales to distributors and net income.

Because a significant portion of our total assets were, and may again be with future potential acquisitions, represented by goodwill and other intangible assets, which are subject to mandatory annual impairment evaluations, we could be required to write-off some or all of our goodwill and other intangible assets, which may materially and adversely impact our business, financial condition and results of operations.

A significant portion of the purchase price for any business combination may be allocated to identifiable tangible and intangible assets and assumed liabilities based on estimated fair values at the date of consummation. As required by GAAP, the excess purchase price, if any, over the fair value of these assets less liabilities typically would be allocated to goodwill. We evaluate goodwill for impairment on an annual basis or whenever events and changes in circumstances suggest that the carrying amount may not be recoverable. We typically conduct our annual analysis of our goodwill in the fourth quarter of our fiscal year. In-process research and development (“IPR&D”) asset is considered an indefinite-lived intangible asset and is not subject to amortization until the conclusion of development. IPR&D must be tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test consists of a comparison of the fair value of the IPR&D with its carrying amount. If the carrying amount of the IPR&D exceeds its fair value, an impairment loss must be recognized in an amount equal to that excess. After an impairment loss is recognized, the adjusted carrying amount of the IPR&D will be its new accounting basis. If the fair value of the IPR&D exceeds the carrying amount, no adjustment is recorded. Subsequent reversal of a previously recognized impairment loss is prohibited. Once the IPR&D projects have been completed, the useful life of the IPR&D asset is determined and amortized accordingly. Intangible assets that are subject to amortization are reviewed for impairment on an annual basis or whenever events and changes in circumstances suggest that the carrying amount may not be recoverable.

The assessment of goodwill and other intangible assets impairment is a subjective process. Estimations and assumptions regarding future performance, results of our operations and comparability of our market capitalization and its net book value will be used. Changes in estimates and assumptions could impact fair value resulting in an impairment which could materially and adversely impact on our business, financial condition and results of operations.

Our business may be materially and adversely impacted if we fail to effectively utilize and incorporate acquired technology.

We have acquired and may in the future acquire intellectual property in order to accelerate our time to market for new products. Acquisitions of intellectual property may involve risks such as successful technical integration into new products, market acceptance of new products and achievement of planned return on investment. Successful technical integration in particular requires a variety of factors which we may not currently have, such as available technical staff with sufficient time to devote to integration, the requisite skill sets to understand the acquired technology and the necessary support tools to effectively utilize the technology. The timely and efficient integration of acquired technology may be adversely impacted by inherent design deficiencies or application requirements. The potential failure of or delay in product introduction utilizing acquired intellectual property could lead to an impairment of capitalized intellectual property acquisition costs.

If we are unable to compete effectively with existing or new competitors, we will experience fewer customer orders, reduced revenues, reduced gross margins and lost market share.

We compete in markets that are intensely competitive, and which are subject to both rapid technological change, continued price erosion and changing business terms with regard to risk allocation. Our competitors include many large domestic and foreign companies that have substantially greater financial, technical and management resources, name recognition and leverage than we have. As a result, they may be able to adapt more quickly to new or emerging technologies and changes in customer requirements or to devote greater resources to promote the sale of their products.

 

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We have experienced increased competition at the design stage, where customers evaluate alternative solutions based on a number of factors, including price, performance, product features, technologies, and availability of long-term product supply and/or roadmap guarantee. Additionally, we experience, in some cases, severe pressure on pricing from some of our competitors or on-going cost reduction expectations from customers. Such circumstances may make some of our products unattractive due to price or performance measures and result in losing our design opportunities or causing a decrease in our revenue and margins. Also, competition from new companies in emerging economy countries with significantly lower costs could affect our selling price and gross margins. In addition, if competitors in Asia reduce prices on commodity products, it would adversely affect our ability to compete effectively in that region. Specifically, we have licensed rights to Hangzhou Silan Microelectronics Co. Ltd. and Hangzhou Silan Integrated Circuit Co. Ltd. (collectively “Silan”) in China to market our commodity interface products that could reduce our sales in the future should they become a meaningful competitor. Loss of competitive position could result in price reductions, fewer customer orders, reduced revenues, reduced gross margins and loss of market share, any of which would affect our operating results and financial condition. To the extent that our competitors offer distributors or sales representatives more favorable terms, these distributors and sales representatives may decline to carry, or discontinue carrying, our products. Our business, financial condition and results of operations could be harmed by any failure to maintain and expand our distribution network. Furthermore, many of our existing and potential customers internally develop solutions which attempt to perform all or a portion of the functions performed by our products. To remain competitive, we continue to evaluate our manufacturing operations for opportunities for additional cost savings and technological improvements. If we or our contract partners are unable to successfully implement new process technologies and to achieve volume production of new products at acceptable yields, our business, financial condition and results of operations may be materially and adversely affected. Our future competitive performance depends on a number of factors, including our ability to:

 

   

increase device performance and improve manufacturing yields;

 

   

accurately identify emerging technological trends and demand for product features and performance characteristics;

 

   

develop and maintain competitive and reliable products;

 

   

enhance our products by adding innovative features that differentiate our products from those of our competitors;

 

   

bring products to market on a timely basis at competitive prices;

 

   

respond effectively to new technological changes or new product announcements by others;

 

   

adapt products and processes to technological changes;

 

   

adopt or set emerging industry standards;

 

   

meet changing customer requirements; and

 

   

provide adequate technical service and support.

Our design, development and introduction schedules for new products or enhancements to our existing and future products may not be met. In addition, these products or enhancements may not achieve market acceptance, or we may not be able to sell these products at prices that are favorable which could materially and adversely affect on our business, financial condition and results of operations.

Soros Fund Management LLC, as principal investment manager for Quantum Partners LP (“Soros”), beneficially owns approximately 14.5% of our common stock, and affiliates of Future, Alonim Investments Inc. and two of its affiliates (collectively “Alonim”), beneficially own approximately 17% of our common stock. As such, Alonim and Soros are our largest stockholders. These substantial ownership positions allow Alonim and Soros to significantly influence matters requiring shareholder approval, which may or may not be in our best interests or the interest of the other holders of common stock. In addition, Alonim is an affiliate of Future and an executive officer of Future is on our board of directors, which could lead to actual or perceived influence from Future.

Alonim and Soros each own a significant percentage of our outstanding shares. Due to such ownership, Alonim and Soros, acting independently or jointly, may be able to exert strong influence over actions requiring the approval of our stockholders, including the election of directors, many types of change of control transactions and amendments to our charter documents. Further, if one of these stockholders were to sell or even propose to sell a large number of their shares, the market price of our common stock could decline significantly.

Although we have no reason to believe it to be the case, the interests of these significant stockholders could conflict with our best interests or the interests of the other stockholders. For example, the significant ownership percentages of these two stockholders could have the effect of delaying or preventing a change of control or otherwise discouraging a potential acquirer from obtaining control of us, regardless of whether the change of control is supported by us and the other stockholders. Conversely, by virtue of their percentage ownership of our stock, Alonim and/or Soros could facilitate a takeover transaction that our board of directors and/or the other stockholders did not approve.

 

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Further, Alonim is an affiliate of Future, our largest distributor, and Pierre Guilbault, the chief financial officer of Future, is a member of our board of directors. These relationships could also result in actual or perceived attempts to influence management and/or our stockholders to take actions beneficial to Future which may or may not be beneficial to us or in our best interests. Future could attempt to obtain terms and conditions more favorable than those we would typically provide our distributors because of its relationship with us. Any such actual or perceived preferential treatment could materially and adversely affect our business, financial condition and results of operations.

We depend on third-party subcontractors to manufacture our products. We utilize wafer foundries for processing our wafers and assembly and test subcontractors for manufacturing and testing our packaged products. Any disruption in or loss of subcontractors’ capacity to manufacture our products subjects us to a number of risks, including the potential for an inadequate supply of products and higher materials costs. These risks may lead to delayed product delivery or increased costs, which could materially and adversely impact our business, financial condition and results of operations.

We do not own or operate a semiconductor fabrication facility or a foundry. We utilize various foundries for different processes. Our products are based on Complementary Metal Oxide Semiconductor (“CMOS”) processes, bipolar processes and bipolar-CMOS (“BiCMOS”) processes. Globalfoundries Singapore Pte. Ltd. (f.k.a. Chartered Semiconductor Manufacturing Ltd.) (“Globalfoundries”) manufactures the majority of the CMOS wafers from which the majority of our communications and UART products are produced. Episil Technologies, Inc. (“Episil”), located in Taiwan, and Silan, located in China, manufacture the majority of the CMOS and bipolar wafers from which our power and serial products are produced. High Voltage BiCMOS power products are supplied by Polar Semiconductor (MN, USA) and Jazz Semiconductor (CA, USA). All of these foundries produce semiconductors for many other companies (many of which have greater requirements than us), and therefore, we may not have access on a timely basis to sufficient capacity or certain process technologies and we do, from time to time, experience extended lead times on some products. In addition, we rely on our foundries’ continued financial health and ability to continue to invest in smaller geometry manufacturing processes and additional wafer processing capacity.

Many of our new products are designed to take advantage of smaller geometry manufacturing processes. Due to the complexity and increased cost of migrating to smaller geometries as well as process changes, we could experience interruptions in production or significantly reduced yields causing product introduction or delivery delays. If such delays occur, our products may have delayed market acceptance or customers may select our competitors’ products during the design process.

New process technologies or new products can be subject to especially wide variations in manufacturing yields and efficiency. There can be no assurance that our foundries or the foundries of our suppliers will not experience unfavorable yield variances or other manufacturing problems that result in delayed product introduction or delivery delays.

We do not have long-term wafer supply agreements with Globalfoundries that would guarantee wafer quantities, prices, and delivery or lead times, but we do provide minimum purchase commitments to Silan and Episil in accordance with our supply agreements. Subject to any such minimum purchase commitments, these foundries manufacture our products on a purchase order basis. We provide our foundries with rolling forecasts of our production requirements. However, the ability of our foundries to provide wafers is limited by the foundries’ available capacity. There can be no assurance that our third-party foundries will allocate sufficient capacity to satisfy our requirements.

Furthermore, any sudden reduction or elimination of any primary source or sources of fully processed wafers could result in a material delay in the shipment of our products. Any delays or shortages will materially and adversely impact our business, financial condition and results of operations.

In addition, we may not continue to do business with our foundries on terms as favorable as our current terms. Significant risks associated with our reliance on third-party foundries include:

 

   

consolidation in the industry leading to a change in control at key wafer suppliers;

 

   

the lack of assured process technology and wafer supply;

 

   

limited control over quality assurance, manufacturing yields and production costs;

 

   

financial and operating stability of the foundries;

 

   

limited control over delivery schedules;

 

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limited manufacturing capacity of the foundries; and

 

   

potential misappropriation of our intellectual property.