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 December 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 44,514,421 as of January 26, 2011, 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 DECEMBER 26, 2010

 

          Page  
  PART I – FINANCIAL INFORMATION   
Item 1.   Financial Statements      3   
  Condensed Consolidated Balance Sheets (Unaudited)      3   
  Condensed Consolidated Statements of Operations (Unaudited)      4   
  Condensed Consolidated Statements of Cash Flows (Unaudited)      5   
  Notes to Condensed Consolidated Financial Statements (Unaudited)      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      37   
Item 4.   Controls and Procedures      38   
  PART II – OTHER INFORMATION   
Item 1.   Legal Proceedings      38   
Item 1A.   Risk Factors      38   
Item 6.   Exhibits      54   
  Signatures      55   
  Index to Exhibits      56   

 

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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)

 

     December 26,
2010
    March 28,
2010
 
ASSETS     

Current assets:

    

Cash and cash equivalents

   $ 14,097      $ 25,486   

Short-term marketable securities

     188,024        186,598   

Accounts receivable (net of allowances of $607 and $831)

     10,128        13,461   

Accounts receivable, related party (net of allowances of $314 and $605)

     2,805        4,323   

Inventories

     27,292        15,000   

Other current assets

     3,947        5,106   
                

Total current assets

     246,293        249,974   

Property, plant and equipment, net

     39,819        42,941   

Goodwill

     3,184        3,085   

Intangible assets, net

     24,847        31,957   

Other non-current assets

     5,856        5,357   
                

Total assets

   $ 319,999      $ 333,314   
                
LIABILITIES AND STOCKHOLDERS’ EQUITY     

Current liabilities:

    

Accounts payable

   $ 12,726      $ 9,828   

Accrued compensation and related benefits

     6,042        6,619   

Deferred income and allowances on sales to distributors

     5,371        4,227   

Deferred income and allowances on sales to distributors, related party

     9,734        10,650   

Short-term lease financing obligations

     2,785        3,540   

Other accrued expenses

     5,084        7,058   
                

Total current liabilities

     41,742        41,922   

Long-term lease financing obligations

     12,558        13,454   

Other non-current obligations

     3,679        3,806   
                

Total liabilities

     57,979        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; 44,448,348 and 43,839,514 shares outstanding at December 26, 2010 and March 28, 2010, respectively

     4        4   

Additional paid-in capital

     726,493        720,455   

Accumulated other comprehensive income (loss)

     (36     1,282   

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

     (248,983     (248,983

Accumulated deficit

     (215,458     (198,626
                

Total stockholders’ equity

     262,020        274,132   
                

Total liabilities and stockholders’ equity

   $ 319,999      $ 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     Nine Months Ended  
     December 26,
2010
    December 27,
2009
    December 26,
2010
    December 27,
2009
 

Sales:

        

Net sales

   $ 24,892      $ 24,458      $ 79,142      $ 70,686   

Net sales, related party

     10,473        9,473        33,092        25,695   
                                

Total net sales

     35,365        33,931        112,234        96,381   
                                

Cost of sales:

        

Cost of sales

     12,742        11,273        40,026        36,005   

Cost of sales, related party

     5,007        4,505        15,417        12,381   

Amortization of purchased intangible assets

     1,533        1,108        4,601        4,015   
                                

Total cost of sales

     19,282        16,886        60,044        52,401   
                                

Gross profit

     16,083        17,045        52,190        43,980   
                                

Operating expenses:

        

Research and development

     12,071        11,674        38,354        36,256   

Selling, general and administrative

     10,298        10,688        34,338        37,175   
                                

Total operating expenses

     22,369        22,362        72,692        73,431   

Loss from operations

     (6,286     (5,317     (20,502     (29,451

Other income and expense, net:

        

Interest income and other, net

     1,577        1,835        4,768        5,289   

Interest expense

     (313     (323     (947     (973

Impairment charges on investments

     —          —          (62     (317
                                

Total other income and expense, net

     1,264        1,512        3,759        3,999   

Loss before income taxes

     (5,022     (3,805     (16,743     (25,452

Provision for (benefit from) income taxes

     (63     (43     89        (652
                                

Net loss

   $ (4,959   $ (3,762   $ (16,832   $ (24,800
                                

Loss per share:

        

Basic and diluted loss per share

   $ (0.11   $ (0.09   $ (0.38   $ (0.57
                                

Shares used in the computation of loss per share:

        

Basic and diluted

     44,300        43,648        44,123        43,504   
                                

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)

 

     Nine Months Ended  
     December 26,
2010
    December 27,
2009
 

Cash flows from operating activities:

    

Net loss

   $ (16,832   $ (24,800

Reconciliation of net loss to net cash used in operating activities:

    

Depreciation and amortization

     14,838        15,644   

Deferred income taxes

     —          373   

Stock-based compensation expense

     6,144        4,311   

Provision for sales returns and allowances

     10,108        7,917   

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

     (5,257     (13,203

Inventories

     (12,292     7,016   

Other assets

     (1,065     (2,201

Accounts payable

     2,898        1,435   

Accrued compensation and related benefits

     (1,534     (1,633

Deferred income and allowance on sales to distributors, including related parties

     228        2,413   

Other accrued expenses

     (732     1,019   
                

Net cash used in operating activities

     (3,434     (1,392
                

Cash flows from investing activities:

    

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

     (3,248     (4,690

Purchases of short-term marketable securities

     (129,639     (149,019

Proceeds from maturities of short-term marketable securities

     56,763        78,675   

Proceeds from sales of short-term marketable securities

     70,488        56,064   

Other investment activities

     (272     (1

Acquisition of Galazar, net of cash acquired

     —          (4,445

Acquisition of Hifn, net of cash acquired

     —          (40,345
                

Net cash used in investing activities

     (5,908     (63,761
                

Cash flows from financing activities:

    

Proceeds from issuance of common stock

     811        367   

Repayment of lease financing obligations

     (2,858     (2,050
                

Net cash used in financing activities

     (2,047     (1,683
                

Net decrease in cash and cash equivalents

     (11,389     (66,836

Cash and cash equivalents at the beginning of period

     25,486        89,002   
                

Cash and cash equivalents at the end of period

   $ 14,097      $ 22,166   
                

Supplemental disclosure of non-cash investing and financial activities:

    

Property, plant and equipment acquired under capital lease

   $ 1,808      $ 2,012   

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. Fiscal year 2011 and fiscal year 2010 each consist of 52-weeks. Fiscal year 2012 will consist of 53 weeks.

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 December 26, 2010 and our results of operations for the three and nine months ended December 26, 2010 and December 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”) 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.

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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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 until its useful life is determined to be no longer indefinite. 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 nine months ended December 26, 2010, were immaterial. No acquisition-related costs relating to Neterion were incurred during the three months ended December 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 nine months ended December 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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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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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 condensed consolidated statement of operations. No acquisition-related costs relating to Galazar were incurred during the three and nine months ended December 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 nine months ended December 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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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, tradenames/trademarks 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 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 $8.3 million, based on the project development timeline and resource requirements, and is expected to be completed by February 2012. 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 located in Los Gatos, California. 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 condensed consolidated statement of operations. No acquisition-related costs relating to Hifn were incurred during the three and nine months ended December 26, 2010.

 

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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 nine months ended December 26, 2010, were immaterial. No severance costs relating to Hifn were incurred during the three months ended December 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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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, tradenames/trademarks 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 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, is being 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 as follows:

 

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 December 26, 2010 are as follows (in thousands, except for percentages):

 

     Level 1      Level 2      Total         

Assets:

           

Money market funds

   $ 8,284       $ —         $ 8,284         4

U.S. Treasury securities

     23,585         —           23,585         12

Asset-backed securities

     —           19,067         19,067         10

Agency mortgage-backed securities

     —           35,860         35,860         18

Agency pool mortgage-backed securities

     —           4,443         4,443         2

Corporate bonds and notes

     —           77,371         77,371         40

Government and agency bonds

     —           27,698         27,698         14
                             

Total investment assets

   $ 31,869       $ 164,439       $ 196,308         100
                             

 

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

 

     Level 1      Level 2      Total         

Assets:

           

Money market funds

   $ 19,616       $ —         $ 19,616         9

U.S. Treasury securities

     15,839         —           15,839         8

Asset-backed securities

     —           17,801         17,801         9

Agency mortgage-backed securities

     —           42,514         42,514         21

Agency pool mortgage-backed securities

     —           4,413         4,413         2

Corporate bonds and notes

     —           62,122         62,122         30

Government and agency bonds

     —           43,909         43,909         21
                             

Total investment assets

   $ 35,455       $ 170,759       $ 206,214         100
                             

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

 

     December 26,
2010
     March 28,
2010
 

Cash and cash equivalents

     

Cash at financial institutions

   $ 5,813       $ 5,870   

Cash equivalents

     

Money market funds

     8,284         19,616   
                 

Total cash and cash equivalents

   $ 14,097       $ 25,486   
                 

Available-for-sale securities

     

U.S. government and agency securities

   $ 51,283       $ 59,747   

Corporate bonds and commercial paper

     77,371         62,122   

Asset-backed securities

     19,067         17,801   

Mortgage-backed securities

     40,303         46,928   
                 

Total short-term marketable securities

   $ 188,024       $ 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 (loss) 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 operations.

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 operations.

Our net realized gains (losses) on marketable securities were as follows for the periods indicated (in thousands):

 

     Three Months Ended     Nine Months Ended  
     December 26,
2010
    December 27,
2009
    December 26,
2010
    December 27,
2009
 

Gross realized gains

   $ 491      $ 198      $ 1,007      $ 432   

Gross realized losses

     (348     (140     (816     (332
                                

Net realized gains

   $ 143      $ 58      $ 191      $ 100   

 

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

 

     December 26, 2010  
            Unrealized         
     Amortized
Cost
     Gross
Gains  (1)
     Gross
Losses  (1)
    Net Gain
(Loss) (1)
     Fair Value  

Money market funds

   $ 8,284       $ —         $ —        $ —         $ 8,284   

U.S. government and agency securities

     51,228         293         (238     55         51,283   

Corporate bonds and commercial paper

     76,687         797         (113     684         77,371   

Asset and mortgage-backed securities

     59,342         232         (204     28         59,370   
                                           

Total investments

   $ 195,541       $ 1,322       $ (555   $ 767       $ 196,308   
                                           

 

     March 28, 2010  
            Unrealized         
     Amortized
Cost
     Gross
Gains  (1)
     Gross
Losses  (1)
    Net Gain
(Loss) (1)
     Fair Value  

Money market funds

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

U.S. government and agency securities

     58,943         835         (31     804         59,747   

Corporate bonds and commercial paper

     61,240         900         (18     882         62,122   

Asset and mortgage-backed securities

     64,329         496         (96     400         64,729   
                                           

Total investments

   $ 204,128       $ 2,231       $ (145   $ 2,086       $ 206,214   
                                           

 

(1) Gross of tax impact

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.

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 December 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. During the third quarter of fiscal 2011, we sold our investment in GSAA Home Equity for $255,000 resulting in a realized loss of $17,000.

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

 

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

Less than 1 year

   $ 88,463       $ 88,847       $ 108,813       $ 109,562   

Due in 1 to 5 years

     107,078         107,461         95,316         96,652   
                                   

Total

   $ 195,541       $ 196,308       $ 204,129       $ 206,214   
                                   

 

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

 

     December 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

   $ 31,251       $ (238   $ —         $ —        $ 31,251       $ (238

Corporate bonds and commercial paper

     15,794         (112     125         (1     15,919         (113

Asset and mortgage-backed securities

     38,212         (195     365         (9     38,577         (204
                                                   

Total

   $ 85,257       $ (545   $ 490       $ (10   $ 85,747       $ (555
                                                   

 

     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       $ (31   $ —         $ —        $ 5,399       $ (31

Corporate bonds and commercial paper

     8,851         (18     —           —          8,851         (18

Asset and mortgage-backed securities

     23,802         (69     353         (27     24,155         (96
                                                   

Total

   $ 38,052       $ (118   $ 353       $ (27   $ 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 December 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 nine months ended December 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 December 26, 2010

   $ 3,184   
        

 

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Intangible Assets

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

 

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

Existing technology

   $ 37,871       $ (20,530   $ 17,341       $ 35,621       $ (15,734   $ 19,887   

Patents/Core technology

     4,492         (2,186     2,306         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         (994     270         1,264         (919     345   

Customer relationships

     4,670         (1,284     3,386         4,670         (777     3,893   

Non-compete agreement

     100         (63     37         100         (3     97   

Tradenames/Trademarks

     1,077         (670     407         1,077         (425     652   
                                                   

Total

   $ 56,474       $ (31,627   $ 24,847       $ 55,324       $ (23,367   $ 31,957   
                                                   

Long-lived assets are amortized on a straight-line basis over their respective estimated useful lives. We evaluate the remaining useful life of our long-lived assets that are being amortized each reporting period to determine whether events and circumstances warrant a revision to the remaining period of amortization. If the estimate of an intangible asset’s remaining useful life is changed, the remaining carrying amount of the long-lived asset is amortized prospectively over the remaining useful life. 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. IPR&D assets are considered an indefinite-lived intangible asset and are not subject to amortization until its useful life is determined to be no longer indefinite. IPR&D assets are evaluated for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired.

As of December 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 nine months ended December 26, 2010.

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

 

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

Existing technology

     65       $ 1,603       $ 1,216       $ 4,796       $ 3,490   

Patents/Core technology

     61         166         129         498         364   

Research and development reimbursement contract

     24         —           563         2,004         1,641   

Customer backlog

     6         —           42         75         960   

Distributor relationships

     72         25         25         75         75   

Customer relationships

     80         169         82         507         222   

Non-compete agreements

     15         20         —           60         —     

Tradenames/Trademarks

     35         79         71         245         201   
                                      

Total

      $ 2,062       $ 2,128       $ 8,260       $ 6,953   
                                      

 

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

 

Amortization Expense (by fiscal year)

 

2011 (3 months remaining)

   $ 2,076   

2012

     7,060   

2013

     6,533   

2014

     5,888   

2015

     2,023   

2016 and thereafter

     1,267   
        

Total estimated amortization

   $ 24,847   
        

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 periodically review and determine whether the investment is other-than-temporarily impaired, in which case the investment is written down to its impaired value.

As of December 26, 2010 and March 28, 2010, respectively, 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    December 26,
2010
     March 28,
2010
 

Skypoint Fund

   $ 1,553       $ 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 $176,000 to the fund during the nine months ended December 26, 2010. As of December 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 $1.6 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 nine months ended December 26, 2010 and fiscal year 2010, respectively.

Impairment

In the three and nine months ended December 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 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 an impairment charge of $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 December 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.

 

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Related party contributions to our total net sales were as follows for the periods indicated:

 

     Three Months Ended     Nine Months Ended  
     December 26,
2010
    December 27,
2009
    December 26,
2010
    December 27,
2009
 

Future

     30     28     29     27

Related party expenses for marketing promotional materials reimbursed were as follows for the periods indicated (in thousands):

 

     Three Months Ended      Nine Months Ended  
     December 26,
2010
     December 27,
2009
     December 26,
2010
     December 27,
2009
 

Future

   $ 8       $ 7       $ 24       $ 27   

NOTE 8. RESTRUCTURING

During the three months ended December 26, 2010, we vacated our facility in Framingham, Massachusetts, which is under lease until November 2011. As of December 26, 2010, a reserve of $134,000 was recorded for the remaining lease obligations.

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 which expires in March 2012.

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 nine months ended December 26, 2010 are summarized as follows (in thousands):

 

     Facility
Costs
 

Balance at March 28, 2010

   $ 239   

Payments

     (175

Additional accruals

     368   
        

Balance at December 26, 2010

   $ 432   
        

NOTE 9. BALANCE SHEET DETAIL

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

 

     December 26,
2010
    March 28,
2010
 

Land

   $ 11,960      $ 11,960   

Building and leasehold improvements

     24,450        24,022   

Machinery and equipment

     46,412        45,932   

Software and licenses

     37,783        35,651   
                

Property, plant and equipment, total

     120,605        117,565   

Accumulated depreciation and amortization

     (80,786     (74,624
                

Property, plant and equipment, net

   $ 39,819      $ 42,941   
                

 

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

 

     December 26,
2010
     March 28,
2010
 

Work-in-process and raw materials

   $ 15,511       $ 9,318   

Finished goods

     11,781         5,682   
                 

Total Inventories

   $ 27,292       $ 15,000   
                 

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

 

     December 26,
2010
     March 28,
2010
 

Accrued legal and professional services

   $ 1,912       $ 4,053   

Accrued sales and marketing expenses

     836         676   

Accrued manufacturing expenses, royalties and licenses

     1,232         1,308   

Accrued restructuring expenses

     432         239   

Other

     672         782   
                 

Total other accrued expenses

   $ 5,084       $ 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 purchase common stock were exercised for common stock, using the treasury stock method, and the common stock underlying outstanding restricted stock units (“RSUs”) was issued.

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

 

     Three Months Ended     Nine Months Ended  
     December 26,
2010
    December 27,
2009
    December 26,
2010
    December 27,
2009
 

Net loss

   $ (4,959   $ (3,762   $ (16,832   $ (24,800
                                

Shares used in computation:

        

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

     44,300        43,648        44,123        43,504   

Dilutive effect of stock options and restricted stock units

     —          —          —          —     
                                

Shares used in computation of diluted loss per share

   $ 44,300      $ 43,648      $ 44,123      $ 43,504   
                                

Loss per share - basic and diluted

   $ (0.11   $ (0.09   $ (0.38   $ (0.57
                                

Options to purchase shares of common stock and unvested restricted stock units for shares of common stock were excluded from our loss per share calculation under the treasury stock method for the periods presented and are as follows (in thousands):

 

     Three Months Ended      Nine Months Ended  
     December 26,
2010 (1)
     December 27,
2009 (1)
     December 26,
2010 (1)
     December 27,
2009 (1)
 

Options and RSUs

     207         314         330         321   

 

(1) As we incurred a net loss, we did not consider the impact of potentially dilutive instruments in the weighted average number of shares calculation as their inclusion would have been anti-dilutive. Had we had income for these periods, our diluted shares would have increased by the aforementioned amount.

 

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The following were not included in the computation of diluted shares outstanding because they were anti-dilutive under the treasury stock method (in thousands, except per share amounts):

 

     Three Months Ended      Nine Months Ended  
     December 26,
2010
     December 27,
2009
     December 26,
2010
     December 27,
2009
 
     Shares      Prices      Shares      Prices      Shares      Prices      Shares      Prices  

Options

     6,577         $5.74 - $23.99         5,100         $7.11 - $86.10         6,203         $5.44 - $86.10         4,800         $6.97 - $86.10   

Warrants

     280         9.63         280         9.63         280         9.63         280         9.63   

RSUs

     —           —           —           —           —           —           —           —     
                                               

Total

     6,857            5,380            6,483            5,080      
                                               

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 nine months ended December 26, 2010 and the three and nine months ended December 27, 2009, we did not repurchase any shares under the 2007 SRP. As of December 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.

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.

The following table summarizes our ESPP transactions during the fiscal periods presented (in thousands, except per share amounts):

 

     As of
December 26,
2010
     Nine Months Ended
December 26,
2010
 
     Shares of
Common Stock
     Shares of
Common Stock
     Weighted
Average
Price
 

Authorized to issue

     4,500         

Reserved for future issuance

     1,497         

Issued

        52,386       $ 6.34   

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”).

 

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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 an amendment to the 2006 Plan to increase the aggregate share limit under the 2006 Plan by an additional 5.5 million shares to 8.3 million shares. At December 26, 2010, there were approximately 5.7 million shares available for future grant under all our equity incentive plans.

Stock Option Activities

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

 

     Outstanding     Weighted
Average
Exercise
Price per
Share
     Weighted
Average
Remaining
Contractual
Term
(in years)
     Aggregate
Intrinsic
Value (1)
(in thousands)
     In-the-money
Options
Vested and
Exercisable

(in thousands)
 

Balance at March 28, 2010

     5,345,504      $ 8.01         5.38       $ 1,882         235   

Options granted

     2,056,590        6.61            

Options exercised

     (79,781     6.01            

Options expired

     (157,971     11.60            

Options forfeited

     (512,389     7.08            
                                     

Balance at December 26, 2010

     6,651,953      $ 7.59         5.03       $ 1,795         560   
                                     

Vested and expected to vest, December 26, 2010

     6,303,799      $ 7.63         4.99       $ 1,664      
                                     

Vested and exercisable, December 26, 2010

     2,215,256      $ 8.85         3.87       $ 375      
                                     

 

(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 $6.96 and $7.32 as of December 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.

RSU Activities

Our RSU transactions during the nine months ended December 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 thousands)
 

Unvested at March 28, 2010

     834,204      $ 8.20         1.04       $ 6,106   

Granted

     399,183        6.76         

Issued and released

     (613,080     6.90         

Forfeited

     (51,962     7.52         
                                  

Unvested at December 26, 2010

     568,345      $ 6.96         1.33       $ 3,956   
                                  

Vested and expected to vest at December 26, 2010

     531,792      $ 6.96         1.27       $ 3,701   
                                  

 

(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.

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 nine months ended December 26, 2010, we recognized approximately $54,000 and $162,000, respectively, of compensation expense related to these awards.

 

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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.

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      Nine Months Ended  
     December 26,
2010
     December 27,
2009
     December 26,
2010
     December 27,
2009
 

Cost of sales

   $ 78       $ 117       $ 396       $ 384   

Research and development

     645         467         2,866         1,701   

Selling, general and administrative

     585         752         2,882         2,226   
                                   

Total Stock-based compensation expense

   $ 1,308       $ 1,336       $ 6,144       $ 4,311   
                                   

Stock-based compensation expense for the three and nine months ended December 26, 2010 includes approximately $75,000 and $327,000, 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 nine months ended December 27, 2009, includes $138,000 and $426,000, respectively, of incremental stock-based compensation expense, associated with the same RSU awards.

Unrecognized Stock-based Compensation Expense

The following table summarizes unrecognized stock-based compensation expense related to stock options and RSUs for the periods indicated below as follows:

 

     December 26, 2010      March 28, 2010  
     Amount
(in thousands)
     Weighted Average
Expected
Remaining

Period (in years)
     Amount
(in thousands)
     Weighted Average
Expected
Remaining

Period (in years)
 

Options

   $ 8,017         2.7       $ 8,139         2.9   

RSUs (1)

     2,419         2.1         4,168         1.0   
                       

Total Stock-based compensation expense

   $ 10,436          $ 12,307      
                       

 

(1) 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.

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     Nine Months Ended  
     December 26,
2010
    December 27,
2009
    December 26,
2010
    December 27,
2009
 

Expected term of options (years)

     4.4        4.7 – 4.9        4.4        4.7 – 4.9   

Risk-free interest rate

     1.4     2.2 – 2.3      1.6     2.1 – 2.5 

Expected volatility

     40     37 – 38      39     37 – 38 

Expected dividend yield

     —          —          —          —     

Weighted average estimated fair value

   $ 2.05      $ 2.47      $ 2.28      $ 2.40   

 

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NOTE 13. COMPREHENSIVE LOSS

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

 

     Three Months Ended     Nine Months Ended  
     December 26,
2010
    December 27,
2009
    December 26,
2010
    December 27,
2009
 

Net loss

   $ (4,959   $ (3,762   $ (16,832   $ (24,800

Other comprehensive income (loss):

        

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

     (1,262     (223     (1,318     689   
                                

Total other comprehensive income (loss)

     (1,262     (223     (1,318     689   
                                

Comprehensive loss

   $ (6,221   $ (3,985   $ (18,150   $ (24,111
                                

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 recorded over the straight-line method for the remaining useful life for the periods indicated below was as follows (in thousands):

 

     Three Months Ended      Nine Months Ended  
     December 26,
2010
     December 27,
2009
     December 26,
2010
     December 27,
2009
 

Depreciation expense

   $ 88       $ 88       $ 264       $ 264   

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 recorded in the “Other income and expense, net” line item in our condensed consolidated statements of operations for the periods indicated below was as follows (in thousands):

 

     Three Months Ended      Nine Months Ended  
     December 26,
2010
     December 27,
2009
     December 26,
2010
     December 27,
2009
 

Sublease income

   $ 354       $ 353       $ 1,059       $ 1,059   

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.

 

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Amortization of the design tools recorded using the straight-line method over the remaining useful life for the periods indicated below was as follows (in thousands):

 

     Three Months Ended      Nine Months Ended  
     December 26,
2010
     December 27,
2009
     December 26,
2010
     December 27,
2009
 

Amortization expense

   $ 894       $ 669       $ 2,631       $ 1,765   

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

 

Fiscal Years

   Hillview
Facility  (1)
    Design
Tools
    Total     Expected
Sublease
Income
 

2011 (3 months remaining)

   $ 12,532      $ 1,044      $ 13,576      $ 354   

2012

     —          1,838        1,838        —     

2013

     —          390        390        —     
                                

Total minimum lease payments

     12,532        3,272        15,804        354   

Less: amount representing interest

     (252     (209     (461     —     

Less: amount representing maintenance

     —          —          —          —     
                                

Present value of minimum lease payments

     12,280        3,063        15,343        354   

Less: current portion of lease financing obligation

     (112     (2,673     (2,785     —     
                                

Long-term lease financing obligation

   $ 12,168      $ 390      $ 12,558      $ 354   
                                

 

(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 in March 2011.

Interest expense for the Hillview Facility lease financing obligation and design tools for the periods indicated below was as follows (in thousands):

 

     Three Months Ended      Nine Months Ended  
     December 26,
2010
     December 27,
2009
     December 26,
2010
     December 27,
2009
 

Interest expense

   $ 254       $ 320       $ 768       $ 966   

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 December 26, 2010 the remaining liability was $121,000, net of payments of $16,000 and $113,000, during the nine months ended December 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 $2.9 million outstanding as of December 26, 2010.

 

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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 December 26, 2010 was immaterial.

In the ordinary course of business, we may provide for 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 liability 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 currently ongoing 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 months ended December 26, 2010, we recorded an income tax benefit of approximately $63,000. During the nine months ended December 26, 2010, we recorded an income tax expense of approximately $89,000. During the three and nine months ended December 27, 2009, we recorded an income tax benefit of $43,000 and $652,000, respectively. The income tax expense for the nine months ended December 26, 2010 was primarily due to expenses recorded for foreign taxable income.

During the three and nine months ended December 26, 2010, the unrecognized tax benefits increased by $168,000 and $406,000, respectively, to $16.3 million as of December 26, 2010. The increase was primarily as a result of increased unrecognized tax benefit on R&D tax credits offset by a decrease in unrecognized tax benefit due to the release of a FIN 48 reserve of $96,000 and $37,000, respectively, during the three and nine months ended December 26, 2010, due to the expiration of the applicable statute of limitations. If recognized, $13.8 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 $392,000 and $320,000 as of December 26, 2010 and December 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.

 

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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.

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

 

     Three Months Ended      Nine Months Ended  
     December 26,
2010
     December 27,
2009 (1)
     December 26,
2010
     December 27,
2009 (1)
 

Communications

   $ 5,655       $ 5,764       $ 17,470       $ 17,872   

Datacom and storage

     4,251         6,652         13,649         18,708   

Interface

     19,156         15,655         59,040         43,529   

Power Management

     6,303         5,860         22,075         16,272   
                                   

Total net sales

   $ 35,365       $ 33,931       $ 112,234       $ 96,381   
                                   

 

(1) 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      Nine Months Ended  
     December 26,
2010
     December 27,
2009 (1)
     December 26,
2010
     December 27,
2009 (1)
 

United States

   $ 8,410       $ 9,079       $ 24,065       $ 24,757   

China

     11,837         10,904         39,085         33,800   

Singapore

     3,425         3,907         10,857         10,530   

Japan

     2,102         2,080         7,264         5,446   

Germany

     3,881         408         9,088         1,245   

Europe (excluding Germany)

     1,539         4,494         8,013         12,423   

Rest of world

     4,171         3,059         13,862         8,180   
                                   

Total net sales

   $ 35,365       $ 33,931       $ 112,234       $ 96,381   
                                   

 

(1) 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 December 26, 2010 and March 28, 2010 were located in the United States.

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

 

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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 included in our Annual Report on Form 10-K for the fiscal year ended March 28, 2010, as filed with the Securities and Exchange Commission (“SEC”). Our results of operations for the three and nine months ended December 26, 2010 or for any other period 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. Fiscal year 2011 and fiscal year 2010 each consist of 52-weeks. Fiscal year 2012 will consist of 53 weeks.

Business Outlook

We experienced a sequential quarterly decrease of 5% in our net sales in the third quarter of fiscal 2011 as compared to the second quarter of fiscal 2011. We continue to be impacted by what we believe to be an industry-wide inventory correction and the delay in orders for our new products. We believe that the inventory correction will continue to impact us in the fourth quarter of fiscal 2011 and expect our net sales to be flat to down when compared to our third quarter net sales. The reduction in net sales will negatively impact our gross margins as absorption of manufacturing costs will be limited and result in higher period expenses. We will continue to monitor operating expenses but expect our expenses to be slightly up due to higher payroll taxes in the first quarter of calendar 2011.

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

 

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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           Nine Months Ended        
     December 26,
2010
    December 27,
2009
    Change     December 26,
2010
    December 27,
2009
    Change  

Net Sales:

                        

Communication

   $ 5,655         16   $ 5,764         17     (2 %)    $ 17,470         15   $ 17,872         19     (2 %) 

Datacom and storage

     4,251         12     6,652         20     (36 %)      13,649         12     18,708         19     (27 %) 

Interface

     19,156         54     15,655         46     22     59,040         53     43,529         45     36

Power management

     6,303         18      5,860         17      8     22,075         20      16,272         17      36 
                                                                        

Total

   $ 35,365         100    $ 33,931         100      $ 112,234         100    $ 96,381         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 net sales of network access, transport and transmission products as well as optical products. Net sales of communications products for the three months ended December 26, 2010 decreased $0.1 million as compared to the same period a year ago.

Net sales of communications products for the nine months ended December 26, 2010 decreased $0.4 million as compared to the same period a year ago. The decreases in net sales of these products are primarily due to price erosion on certain SDH/SONET Framer products partially offset by higher shipments of the same product.

Datacom and Storage

Net sales of datacom and storage products include net sales of encryption, data reduction and packet processing products, as well as 10 Gigabit Ethernet controller silicon and card solutions. Net sales of datacom and storage products for the three months ended December 26, 2010 decreased $2.4 million as compared to the same period a year ago and included $0.7 million of additional sales of Neterion products. Excluding the additional Neterion sales, datacom and storage decreased $3.1 million primarily due to lower demand as a result of an inventory correction at certain OEM customers and discontinued programs at a certain customer.

Net sales of datacom and storage products for the nine months ended December 26, 2010 decreased $5.1 million as compared to the same period a year ago and included $2.5 million of additional sales of Neterion products. Excluding the additional Neterion sales, datacom and storage decreased $7.5 million primarily due to slower demand with an inventory correction at certain OEM customers and discontinued programs at a certain customer.

Interface

Net sales of interface products include net sales of UARTs as well as transceiver products. Net sales of interface products for the three months ended December 26, 2010 increased $3.5 million as compared to the same period a year ago. Net sales of interface products for the nine months ended December 26, 2010 increased $15.5 million as compared to the same period a year ago. The increases in net sales of these products were primarily due to higher shipments of our serial transceiver and, to a lesser extent, our UART products.

 

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Power Management

Power management products include DC-DC regulators and LED drivers. Net sales of power management products for the three months ended December 26, 2010 increased $0.4 million as compared to the same period a year ago primarily due to higher shipments of our analog DC/DC power solutions partially offset by price erosion on certain analog DC-DC products.

Net sales of power management products for the nine months ended December 26, 2010 increased $5.8 million as compared to the same period a year ago primarily due to higher shipments of our analog DC-DC 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           Nine Months Ended        
     December 26,
2010
    December 27,
2009
    Change     December 26,
2010
    December 27,
2009
    Change  

Net Sales:

                        

Sell-through distributors

   $ 20,880         59   $ 17,105         50     22   $ 64,197         57   $ 47,964         50     34

Direct and others

     14,485         41     16,826         50     (14 %)      48,037         43     48,417         50     (1 %) 
                                                                        

Total

   $ 35,365         100    $ 33,931         100      $ 112,234         100    $ 96,381         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 December 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 increased sales of our serial products, which are products primarily sold through these distributors.

For the three months ended December 26, 2010, net sales to our direct customers and other distributors included $0.5 million of sales of our Neterion products, which was reported in our datacom and storage product line.

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

For the nine months ended December 26, 2010, net sales to our direct customers and other distributors included $1.4 million of sales of our Neterion products, which was reported in our datacom and storage product line.

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           Nine Months Ended        
     December 26,
2010
    December 27,
2009
    Change     December 26,
2010
    December 27,
2009
    Change  

Net Sales:

                        

Americas

   $ 8,815         25   $ 9,449         28     (7 %)    $ 25,834         23   $ 25,332         26     2

Asia

     21,130         60     19,580         58     8     69,299         62     57,381         60     21

Europe

     5,420         15     4,902         14     11     17,101         15     13,668         14     25
                                                                        

Total

   $ 35,365         100    $ 33,931         100      $ 112,234         100    $ 96,381         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 nine months ended December 26, 2010, net sales in the Americas included $0.2 million and $1.4 million of Neterion sales, respectively.

 

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For the three and nine months ended December 26, 2010, net sales in Asia included $0.4 million and $1.0 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           Nine Months Ended        
     December 26,
2010
    December 27,
2009
    Change     December 26,
2010
    December 27,
2009
    Change  

Net Sales

   $ 35,365         $ 33,931           $ 112,234         $ 96,381        

Cost of sales:

                        

Cost of sales

     17,749         50     15,686         46     13     55,401         49     46,060         48     20

Fair value adjustment of acquired inventories

     —           —       92         —       (100 %)      42         —       2,326         2     (98 %) 

Amortization of acquired intangible assets

     1,533         4     1,108         4     38     4,601         4     4,015         4     15
                                                                        

Gross profit

   $ 16,083         46    $ 17,045         50      $ 52,190         47    $ 43,980         46   
                                                                        

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 and acquired intellectual property;

 

   

the fair value adjustment of acquired inventories;

 

   

the provision for excess and obsolete inventory; and

 

   

the sale of previously reserved inventory.

The decrease in gross profit, as a percentage of net sales, for the three months ended December 26, 2010, as compared to the same period a year ago, was primarily due to an increase in write-down for excess and obsolete inventory and higher amortization of acquired intangible assets in connection with the Neterion acquisition.

The increase in gross profit, as a percentage of net sales, for the nine months ended December 26, 2010, as compared to the same period a year ago, was primarily due to improved manufacturing absorption and yields and the exclusion of any fair value adjustments of acquired inventories partially offset by a change in the product mix, an increase in write-down for excess and obsolete inventory and higher amortization of acquired intangible assets in connection with the Neterion acquisition.

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 we expect will have better margins, subcontract manufacturing costs, our ability to leverage fixed operational costs across increased shipment volumes or conversely, inability to reduce fixed costs while responding to reduced demand during inventory corrections and competitive pricing pressure on our products.

 

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Other Costs and Expenses

 

(in thousands, except percentages)    Three Months Ended           Nine Months Ended        
     December 26,
2010
    December 27,
2009
    Change     December 26,
2010
    December 27,
2009
    Change  

Net Sales

   $ 35,365         $ 33,931           $ 112,234         $ 96,381        

R&D expense:

                        

R&D - base

   $ 11,354         32   $ 10,444         31     9   $ 33,268         30   $ 31,820         33     5

Stock-based compensation

     645         2     467         1     38     2,866         3     1,701         2     68

Amortization expense – acquired intangibles

     72         —       635         2     (89 %)      2,220         2     1,858         2     19

Accelerated depreciation and other

     —           —       128         —       (100 %)      —           —       877         1     (100 %) 
                                                

Total R&D expense

   $ 12,071         34    $ 11,674         34      3   $ 38,354         34    $ 36,256         38      6
                                                

SG&A expense:

                        

SG&A - base

   $ 9,419         26   $ 9,462         28     —     $ 30,239         27   $ 29,608         31     2

Stock-based compensation

     585         2     751         2     (22 %)      2,882         3     2,225         2     30

Amortization expense – acquired intangibles

     294         1     178         1     65     889         1     499         1     78

Acquisition related costs

     —           —       297         1     (100 %)      328         —       4,843         5     (93 %) 
                                                

Total SG&A expense

   $ 10,298         29    $ 10,688         31      (4 %)    $ 34,338         31    $ 37,175         39      (8 %) 
                                                

 

* 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 such as existing technology and patents/core technology; and

 

   

facilities expenses.

The $0.9 million increase in base R&D expenses for the three months ended December 26, 2010 as compared to the same period a year ago was primarily a result of lower reimbursement of R&D expenses and incremental labor-related expenses due to the acquisition of Neterion. The $1.4 million increase in base R&D expenses for the nine months ended December 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 increased reimbursement of R&D expenses, lower mask sets, outside services and tool maintenance costs. As noted, included in the base R&D expenses are costs offset as discussed below.

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 third quarters of fiscal 2011 and 2010, we offset $0.5 million and $1.0 million, respectively, of R&D expenses in connection with this agreement. For the first nine months of fiscal 2011 and 2010, we offset $4.0 million and $3.4 million, respectively, of R&D expenses in connection with the same agreement.

Stock-based compensation expense recorded in R&D expenses was $0.6 million and $2.9 million for the three and nine months ended December 26, 2010, respectively, as compared to $0.5 million and $1.7 million, respectively, for the same periods a year ago.

 

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The $1.2 million increase in stock-based compensation for the nine months ended December 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 $0.6 million decrease in amortization expense of acquired intangibles for the three months ended December 26, 2010 as compared to the same period a year ago was a result of the completion of the amortization period of the underlying intangible asset. The $0.4 million increase in amortization expense of acquired intangibles for the nine months ended December 26, 2010 as compared to the same period a year ago was due to shortening the life of the underlying intangible asset.

Accelerated depreciation and other costs in the nine months ended December 27, 2009 are primarily associated with accelerated depreciation relating to shortened remaining lives of equipment of $0.6 million acquired from Hifn and employee severance costs.

We believe that 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 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.

Base SG&A expenses for the three months ended December 26, 2010 remained flat as compared to the same period a year ago. The $0.6 million increase in base SG&A expenses for the nine months ended December 26, 2010 as compared to the same period a year ago was primarily a result of an accrual for a lease dispute, incremental labor-related costs, incentives and trade show and advertising costs.

Stock-based compensation expense recorded in SG&A expenses was $0.6 million and $2.9 million for the three and nine months ended December 26, 2010, respectively, as compared to $0.8 million and $2.2 million, respectively, for the same periods a year ago. The $0.7 million increase in stock-based compensation for the nine months ended December 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.

Acquisition related costs in the nine months ended December 26, 2010 primarily reflects remaining payments on a vacated Neterion facility located in Sunnyvale, California. Acquisition related costs for the nine months ended December 27, 2009 are primarily associated with $2.8 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 $0.8 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 and legal costs.

 

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Other Income and Expenses

 

(in thousands, except percentages)    Three Months Ended           Nine Months Ended        
     December 26,
2010
    December 27,
2009
    Change     December 26,
2010
    December 27,
2009
    Change  

Net Sales

   $ 35,365        $ 33,931          $ 112,234        $ 96,381       

Interest income and other, net

     1,577        4     1,835        5     (14 %)      4,768        4     5,289        5     (10 %) 

Interest expense

     (313     (1 %)      (323     (1 %)      (3 %)      (947     (1 %)      (973     (1 %)      (3 %) 

Impairment charges on investments

     —          —       —          —       —       (62     —       (317     —       (80 %) 

Interest Income and Other, Net

Interest income and other, net primarily consists of:

 

   

interest income;

 

   

sublease income;

 

   

foreign exchange gains or losses; and

 

   

realized gains or losses on marketable securities.

The decrease in interest income and other, net during the three and nine months ended December 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 nine months ended December 26, 2010 was approximately $0.4 million and $1.1 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 capital 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 $0.8 million for the three and nine months ended December 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 an impairment charge of $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. During the third quarter of fiscal 2011, we sold our investment in GSAA Home Equity with a carrying value of $272,000 for $255,000 resulting in a realized loss of $17,000.

Provision for (Benefit from) Income Taxes

During the three months ended December 26, 2010, we recorded an income tax benefit of approximately $63,000. During the nine months ended December 26, 2010, we recorded an income tax expense of approximately $89,000. During the three and nine months ended December 27, 2009, we recorded an income tax benefit of $43,000 and $652,000, respectively. The income tax expense for the nine months ended December 26, 2010 was primarily due to expenses related to foreign taxable income.

LIQUIDITY AND CAPITAL RESOURCES

 

     Nine Months Ended  
     December 26,
2010
    December 27,
2009
 
     (dollars in thousands)  

Cash and cash equivalents

   $ 14,097      $ 22,166   

Short-term investments

     188,024        196,090   
                

Total cash, cash equivalents, and short-term investments

   $ 202,121      $ 218,256   
                

Percentage of total assets

     63     66

Net cash used in operating activities

   $ (3,434   $ (1,392

Net cash used in investing activities

     (5,908     (63,761

Net cash used in financing activities

     (2,047     (1,683
                

Net decrease in cash and cash equivalents

   $ (11,389   $ (66,836
                

Our net loss was approximately $16.8 million for the nine months ended December 26, 2010. After adjustments for non-cash items and changes in working capital, we used $3.4 million of cash for operating activities.

Significant non-cash charges included:

 

   

depreciation and amortization expenses of $14.8 million;

 

   

stock-based compensation expense of $6.1 million; and

 

   

provision for sales returns and allowances of $10.1 million.

 

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Working capital changes included:

 

   

a $5.3 million increase in accounts receivable primarily due to the exclusion of the $10.1 million noncash provision for sales returns and allowances line item of the consolidated statements of cash flow, net of the noncash provision for sales returns and allowances, accounts receivable decreased by $4.9 million due to the timing of shipments and collection of payments;

 

   

a $12.3 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 $2.9 million increase in accounts payable primarily due to higher inventory receipts; and

 

   

a $0.2 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 nine months ended December 26, 2010, net cash used in investing activities reflects net purchases of short-term marketable securities of $2.4 million and $3.2 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 nine months ended December 26, 2010 and the three and nine months ended December 27, 2009, we did not repurchase any shares under the 2007 SRP. As of December 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):

 

     December 26, 2010  
            Unrealized         
     Amortized
Cost
     Gross
Gains  (1)
     Gross
Losses  (1)
    Net Gain
(Loss)  (1)
     Fair Value  

Money market funds

   $ 8,284       $ —         $ —        $ —         $ 8,284   

U.S. government and agency securities

     51,228         293         (238     55         51,283   

Corporate bonds and commercial paper

     76,687         797         (113     684         77,371   

Asset and mortgage-backed securities

     59,342         232         (204     28         59,370   
                                           

Total investments

   $ 195,541       $ 1,322       $ (555   $ 767       $ 196,308   
                                           

 

     March 28, 2010  
            Unrealized         
     Amortized
Cost
     Gross
Gains  (1)
     Gross
Losses  (1)
    Net Gain
(Loss) (1)
     Fair Value  

Money market funds

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

U.S. government and agency securities

     58,943         835         (31     804         59,747   

Corporate bonds and commercial paper

     61,240         900         (18     882         62,122   

Asset and mortgage-backed securities

     64,329         496         (96     400         64,729   
                                           

Total investments

   $ 204,128       $ 2,231       $ (145   $ 2086       $ 206,214   
                                           

 

(1) Gross of tax impact

 

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As of December 26, 2010, asset-backed and mortgage-backed securities, accounted for 10% and 20%, respectively, of our total investments in marketable securities of $196.3 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 U.S. federal government 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 believe 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.

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 December 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.

 

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CONTRACTUAL OBLIGATIONS AND COMMITMENTS

Our contractual obligations and commitments at December 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)

   $ 17,960       $ 17,960       $ —         $ —         $ —     

Long-term lease financing obligations (2)

     3,174         2,784         390         —           —     

Lease obligations (3)

     1,704         1,337         367         —           —     

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

     293         293         —           —           —     

Remediation commitment (5)

     120         70         10         40         —     
                                            

Total

   $ 23,251       $ 22,444       $ 767       $ 40       $ —     
                                            

 

Note:    The table above excludes the liability for unrecognized income tax benefit of approximately $3.5 million at December 26, 2010 since we cannot predict with reasonable reliability the timing of cash settlements with the respective taxing authorities.

 

(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 $3.0 million. Also includes $0.1 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 on March 31, 2011. The Hillview Facility is in Milpitas, California and was leased under a 5-year Standard Form Lease agreement that we signed with Mission West Properties, L.P. on March 9, 2006 and amended on August 25, 2007.
(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 December 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 $196.3 million as of December 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 December 26, 2010, the increase or decline in the fair value of the portfolio would not be material. At December 26, 2010, the difference between the fair market value and the underlying cost of the investments portfolio was a net unrealized gain of $0.8 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 December 26, 2010, short-term investments consisted of asset and mortgage-backed securities, corporate bonds and government agency securities of $188.0 million.

 

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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 (our principal executive officer) (the “CEO”) and Chief Financial Officer (our principal 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, pursuant to 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 December 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.

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 and 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 Reports on Form 10-Q for the fiscal quarters ended June 27, 2010 and September 26, 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 Reports on Form 10-Q for the fiscal quarters ended June 27, 2010 and September 26, 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.

 

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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 economic 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;

 

   

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, such as gold, 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.

 

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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;

 

   

fluctuations in the capitalization of unabsorbed fixed manufacturing costs;

 

   

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;

 

   

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;

 

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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;

 

   

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.

Our fixed operating expenses and practice of ordering materials in anticipation of projected customer demand could make it difficult for us to respond effectively to sudden swings in demand and result in higher than expected costs and excess inventory. Such sudden swings in demand could therefore have a material adverse impact on our business, financial condition and results of operations.

Our operating expenses are relatively fixed in the short to medium term, and therefore, we have limited ability to reduce expenses quickly and sufficiently in response to any revenue shortfall. In addition, we typically plan our production and inventory levels based on forecasts of customer demand, which is highly unpredictable and can fluctuate substantially. From time to time, in response to anticipated long lead times to obtain inventory and materials from our outside suppliers and foundries, we may order materials in advance of anticipated customer demand. This advance ordering may result in excess inventory levels or unanticipated inventory write-downs if expected orders fail to materialize. This incremental cost could have a materially adverse impact on our business, financial condition and results of operations.

 

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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