Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors including those set forth in the section entitled "Risk Factors" and in other sections of this quarterly report.

The following is management's discussion and analysis of financial condition and results of operations of the Company and its subsidiaries for the six-month and three-month periods ended June 30, 2004 and June 30, 2003. This discussion and analysis should be read in conjunction with the condensed consolidated financial statements and notes thereto included elsewhere herein and the Company's 2003 annual report on Form 10-K. Management's discussion and analysis provides information concerning our business environment, consolidated results of operations and liquidity and capital resources.

We prepare and release quarterly unaudited financial statements prepared in accordance with generally accepted accounting principles or GAAP. We also disclose and discuss Earnings Before Interest, Taxes, Depreciation, asset impairments and Amortization ("EBITDA") as a measure of liquidity in our filings with the Securities and Exchange Commission. We believe the disclosure of such information helps investors more meaningfully evaluate the results of our liquidity. However, we recommend that investors carefully review the GAAP financial information included as part of this report and read the associated reconciliation.

Our interim results are based on fiscal quarters of thirteen weeks in duration ending on the last Sunday of each calendar quarter. However, for ease of reading our financial reports, we have labeled our interim fiscal periods as ending on a calendar month-end date. The operating results for any interim period are not necessarily indicative of results for any subsequent period or the full fiscal year, which ends on December 31 of each year.

We believe our critical accounting estimates are as follows:

• estimating sales returns and allowances;
• estimating allowance for doubtful accounts;
• estimating write-downs of excess and obsolete inventories; and
• asset impairments.

On an on-going basis, we evaluate our estimates, including those related to sales returns, allowance for doubtful accounts, inventory write-downs and asset impairments. We base our estimates on historical trends and various other assumptions that we believe to be reasonable at the time the estimates are made. Actual results could differ from those estimates. A brief description of each of these policies is set forth below.

Estimating sales returns and allowances. Our net sales to OEM customers consist of gross product sales reduced by expected future sales returns and allowances. To estimate sales returns and price allowances, we analyze historical returns and allowance activity to establish a baseline reserve level. We then evaluate whether there are any underlying product quality or other customer specific issues that require additional specific reserves above the baseline level. Because the reserve for sales returns and allowances is based on our judgments and estimates, our reserves may not be adequate to cover actual sales returns and other allowances. If our reserves are not adequate, our net sales and accounts receivable could be adversely affected.

Our net sales to distributors that have rights of return and/or price protection allowances on unsold merchandise held by them are deferred until such products are resold by the distributors to end users of our devices. At the time that we recognize distributor sales as revenue, we record a reserve for estimated price adjustments that the distributors will reclaim from us on the merchandise they have resold to end users. These reserves are recorded as a reduction to our net sales and a reduction to our accounts receivable. To estimate this distributor price adjustment reserve, we analyze our historical price adjustment payments and pending price adjustments that have been authorized by us but have not yet been claimed by our distributors. Because our distributor allowance reserve is based upon our judgments and estimates, such reserves may not be adequate to cover actual distributor price allowances. If our reserves are not adequate, our net sales and accounts receivable could be adversely affected.

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

Estimating write-downs of excess and obsolete inventories. Each inventory component is assessed for excess or obsolescence by using an algorithm that we established. This algorithm is based on historical trends, demand forecasts and inventory age. We review the result of this algorithm and generally write-off all work-in-process inventory more than one year old and finished goods inventory quantities in excess of our current backlog. Write- offs of excess and obsolete inventories are reflected as a reduction to inventory values in the accompanying consolidated balance sheets, and an increase in cost of sales. If actual market conditions or customer demand patterns are less favorable than, or inconsistent with our assumptions, we may be required to take further write-downs of our inventory value, which could adversely impact our cost of sales and operating results.

Asset impairments. We apply the provisions of Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" and Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets." We assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

• significant changes in the manner of our use of the acquired assets;
• significant changes in the strategy for our overall business; and
• significant negative industry or economic trends.

When we determine that the carrying value of long-lived assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, and the undiscounted cash flows estimated to be generated by those assets are less than the asset's carrying value, the carrying value of the assets are reduced to their estimated fair value. The estimated fair value is determined based on an estimate of future discounted cash flows, independent appraisals or purchase offers received from independent third parties. Asset impairments are recorded as a reduction in the asset value in our consolidated balance sheets and as special charges in our consolidated statements of operations.

The intangible assets created by the adoption of fresh-start accounting on our emergence from bankruptcy consist of existing technology, brand name as well as excess enterprise value, or goodwill. The existing technology and brand name are being amortized based on a pattern-of-use method in proportion to the discounted cash flows from such assets. The goodwill is not subject to amortization, but is tested for impairment at least annually, as required by FAS 142.

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

Following the April 2004 announcement of the closure of our MOD II facility, we recorded asset impairment charges to reflect the excess of book value over the current estimated fair value of our MOD II fixed assets as prescribed under SFAS No. 144. The estimates we used to determine fair value of MOD II land and buildings were based upon an independent appraisal and the fair value of MOD II equipment was determined based upon offers to purchase these assets that have been received from independent third parties. There can be no assurance that the ultimate value that we will realize from the ultimate sale or disposition of these assets will be equal to the appraised fair value. If the ultimate net value realized upon the disposition of MOD II assets is less than the estimated fair value, our future results of operations could be adversely impacted.

Adjustments to record additional impairment of our MOD II or other long-lived assets or intangible assets could have a material adverse impact on our financial condition and results of operations in the period or periods in which such impairment is identified.

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

                                                     Three Months Ended       Six Months Ended
                                                          June 30,                  June 30,
                                                ------------------------- -------------------------
                                                    2004         2003         2004         2003
                                                ------------ ------------ ------------ ------------
Net sales by region:
Americas.......................................       $14.5        $14.5        $26.9        $28.3
Asia...........................................         9.9          8.5         19.5         15.8
Europe.........................................         3.5          2.7          7.5          6.8
                                                ------------ ------------ ------------ ------------
   Total by region.............................       $27.9        $25.7        $53.9        $50.9
                                                ============ ============ ============ ============

Net sales by channel:
OEM............................................       $14.9        $13.0        $28.6        $26.1
Distributor....................................        13.0         12.7         25.3         24.8
                                                ------------ ------------ ------------ ------------
   Total by channel............................       $27.9        $25.7        $53.9        $50.9
                                                ============ ============ ============ ============
Net sales by busines line:
   Micrologic Devices:
     8-bit Microcontrollers and
     Microprocessors...........................       $18.9        $14.7        $38.4        $33.1
                                                ------------ ------------ ------------ ------------
   Other Devices:
     Serial Communications Controllers.........        $4.1         $3.1         $8.1         $6.5
     Modems....................................         0.7          0.6          1.3          1.0
     IrDA transceivers.........................         0.3          0.5          1.3          1.1
     Television, PC peripherals and other......         1.2          1.4          1.9          2.9
                                                ------------ ------------ ------------ ------------
       Total Other Devices.....................        $6.3         $5.6        $12.6        $11.5
                                                ------------ ------------ ------------ ------------
     Base business (excluding foundry).........       $25.2        $20.3        $51.0        $44.6
   Foundry services............................         2.7          5.4          2.9          6.3
                                                ------------ ------------ ------------ ------------
     Total net sales...........................       $27.9        $25.7        $53.9        $50.9
                                                ============ ============ ============ ============

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

                                               As of June 30, and for
                                              the three month periods
                                                     then ended
                                            -------------------------
                                                2004         2003
                                            ------------ ------------
Days sales outstanding.....................      52           38
Net sales to inventory ratio (annualized)..     8.1          10.7
Weeks of inventory at distributors.........      11           11
Current ratio..............................     2.8          1.6

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

Days sales outstanding, DSO, is a common metric used to analyze how quickly our customers pay us. This metric is calculated as our ending net accounts receivable divided by our average daily net sales during the period and it is influenced largely by the timing and mix of our customer billings and collections. For instance, at June 30, 2004, our DSO was 52 days which is higher than our 2003 levels. This increase in DSO reflects higher sales levels in 2004, non linearity in shipments in 2004 versus 2003 and for certain OEM customers longer payment cycles. Because the increase in our DSO is primarily attributable to longer payment cycles from our OEM customers and is not due to increased credit risk, we do not believe that the increase in our DSO reflects degradation in the overall collectability of our accounts receivable. In addition, our bad debts have historically been minimal.  

Net sales to inventory ratio is a metric we use to analyze how quickly our investment in inventories is recovered by our sales. This metric may not be comparable to those other companies use to analyze inventory and is not the same as a typical inventory turns ratio. Our net sales to inventory ratio decreased in the second quarter of 2004 as compared to the same period in 2003 as we increased our inventory levels to build ahead inventory to ensure uninterrupted supply of product to our customers following our decision to close our MOD II wafer manufacturing facility in Nampa, Idaho and move production of these products to X-FAB, a third party foundry wafer manufacturer. These products will be manufactured in X-FAB's 6 inch wafer manufacturing facility in Lubbock, Texas

Weeks of inventory at distributors measures how quickly our distributors sell the inventories that we sell to them. Although our distributors in various regions of the world maintain different inventory stocking levels, overall our goal is to maintain 10 to 13 weeks of inventories at our distributors to satisfy their end demand.

Current ratio represents current assets divided by current liabilities and is commonly used to assess a company's liquidity. The Company uses this ratio to make spending determinations on discretionary items. Our current ratio improved markedly as of June 30, 2004 compared to June 30, 2003 primarily due to an increase in cash from the proceeds of our March, 2004 common stock offering.

Net Sales. Overall, our net sales of $27.9 million for the three- months ended June 30, 2004, represents an increase of 9% from net sales of $25.7 million of net sales during the same period of 2003. For the six-months ended June 30, 2004, net sales were $53.9 million or 6% above net sales during the same period of 2003.

Net sales of our Micrologic devices increased 28% to $18.9 million in the three-months ended June 30, 2004 compared to $14.7 million in the three months ended June 30, 2003. For the six-months ended June 30, 2004, net sales of our Micrologic devices were $38.4 million or 16% above net sales during the same period of 2003.

The increases in 2004 for both the three-month and six-month periods reflect a marked increase in unit sales of our Infra Red (IR) remote control devices. The improvement in IR revenues is attributable entirely to much higher unit shipments to our large OEM customers that make universal remote control products. Overall, we anticipate that market demand and net sales for our general purpose microcontrollers will decline over time as a result of customers moving from these older Z80 and Z8 products to alternative technologies, primarily microcontrollers with embedded flash technology and the need for further integration of peripheral functions and capabilities. Since November 2002, we have released our new Z8 Encore!, eZ80 Acclaim! and Z8 Encore! XP products that are focused on the embedded flash market, with a strategy of recapturing sales to these customers and entering new markets. Orders for our embedded flash microcontroller products totaled $1.4 million for the three months ended June 30, 2004, as our design wins with customers move to production and therefore product needs. These orders are expected to result in net sales to the Company beginning in the third quarter of 2004.

Net sales of our other devices, which excludes Foundry sales, for the three months ended June 30, 2004 increased 13% to $6.3 million, which is up from $5.6 million in the same period of 2003. For the six months ended June 30, 2004, net sales of our other devices were $12.6 million or 10% above net sales during the same period of 2003.

The increase in net sales during the three-month period and six-month period of 2004 compared to the same periods of 2003 primarily reflects higher unit shipments of Serial Communications Controllers through the distribution channel.

Net sales of Foundry Services, for the three-month and six-month periods ended June 30, 2004 decreased 50% and 54%, respectively, compared to the same periods in 2003. Overall, our Foundry business has been opportunistic and is solely dependent on the needs of one customer. We are not anticipating significant foundry business since we closed our wafer fabrication facility in July, 2004.

Gross Margin. Our cost of sales primarily represents manufacturing costs relating to wafer fabrication, package assembly and product testing operations. Cost of sales fluctuates, depending on materials and services prices from our vendors, manufacturing productivity, product mix, equipment utilization and depreciation. Gross margin as a percent of net sales was 49% in the three months ended June 30, 2004, up from 47% in the same period of 2003. For the six months ended June 30, 2004 our gross margin was 50% compared to 44% in the same period of 2003. During the second quarter of 2004, our gross margin was impacted by one-time charges totaling $0.6 million relating to closure expenses for our MOD II wafer facility. These charges were offset by the favorable impact of incremental royalty revenue of $0.7 million that was received during the second quarter of 2004 resulting from a royalty audit. The improvement in overall grossmargin for both the three and six month periods ended June 30, 2004 compared tothe same periods of 2003 relates primarily to underutilization of our MOD II wafer manufacturing facility in 2003, reflecting lower demand for wafer capacity consistent with our lower net sales at that time. In addition, our gross margin was improved because MOD II cost absorption was higher in 2004 compared with 2003 due to an inventory build-up of buffer-stock in anticipation of the transition of production to outside foundries. The majority of products that were previously manufactured in our five-inch wafer fab have been transferred to X-FAB's six-inch facility in Lubbock, Texas. We will continue to purchase our 0.35 micron wafers from our foundries primarily in Taiwan, including wafers for our new embedded flash based Z8 Encore! and eZ80 Acclaim! products.

Research and Development Expenses. Research and development expenses were $5.3 million in the three months ended June 30, 2004, reflecting a 13% increase from the $4.7 million of research and development expenses reported in the three months ended June 30, 2003. On a year-to date basis, research and development expenses increased 21% to $10.4 million. The increase in research and development spending in 2004 reflects continued investments in new products, including out latest line of Flash-based Microcontrollers called Z8Encore!XP™. We are also investing in product development to add peripheral features to our Z8Encore! and eZ80Acclaim! product lines as well as new devices and software features for our Crimzon line of consumer solution products concentrated in the Infra red remote control market segment.

Selling, General and Administrative Expenses. Selling, general and administrative expenses increased to $7.7 million in the three months ended June 30, 2004 from $7.1 million in the three months ended June 30, 2003. On a year- to date basis, selling, general and administrative expenses increased 10% to $14.6 million. The increase in our selling, general and administrative spending for both the three-month and six-month periods of 2004, compared to 2003 primarily reflects higher incentive compensation and commissions commensurate with our increased number of sales reps and higher sales levels. In the first half of 2003 we initiated significant shutdowns to reduce costs driven by lower sales in the quarter. Generally, we continue to review overall headcount supporting sales, marketing, general and administrative activities, but any cost savings may be offset by higher ongoing consulting, professional and administrative costs associated with activities stemming from our public offering of stock in March, 2004.

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

                                                 Three Months Ended        Six Months Ended
                                                      June 30,                   June 30,
                                            ------------------------- -------------------------
                                                2004         2003         2004         2003
                                            ------------ ------------ ------------ ------------
Asset impairments:
   MOD II assets...........................        $5.4        $--           $5.4        $--
   Other...................................        --           --           --            0.2
Restructuring of operations:
   MOD II employee severance and
     termination benefits..................         1.8         --            1.9          0.6
   MOD II period closure costs.............         0.1         --            0.1         --
   MOD III period maintenance costs .......         0.4          0.4          0.7          0.7
Professional fees for debt
   restructuring...........................        --            0.1          0.1          0.3
                                            ------------ ------------ ------------ ------------
                                                   $7.7         $0.5         $8.2         $1.8
                                            ============ ============ ============ ============

The following table summarizes activity in accrued special charges which is included within accrued liabilities on the condensed consolidated balance sheets (in millions):

                                                 Severance     MOD III       MOD II
                                                    and         Period       Period        Debt
                                                Termination  Maintenance    Closure    Restructur-
                                                  Benefits      Costs        Costs         ing         Total
                                                ------------ ------------ ------------ ------------ ------------
    Balance at December 31, 2003...............       $ --          $0.1        $ --         $ --          $0.1
    Provisions to special charges..............         1.9          0.7          0.1          0.1          2.8
    Provisions to cost of sales relating to
       MOD II closure..........................         0.4        --           --           --             0.4
    Cash paid..................................        (0.1)        (0.7)        (0.1)        (0.1)        (1.0)
                                                ------------ ------------ ------------ ------------ ------------
    Balance at June 30, 2004...................        $2.2         $0.1        $ --         $ --          $2.3
                                                ============ ============ ============ ============ ============

Restructuring of operations during the six-month period ended June 30, 2004, included severance and termination benefits of approximately $1.9 million primarily related to the Company's reduction-in-force due to the closure of its MOD II five-inch wafer fabrication facility in Nampa, Idaho on July 11, 2004. The Company recorded $5.4 million of asset impairments, primarily related to the write-down of MOD II assets to fair value during the period. Approximately $0.7 million and $0.1 million of special charges for the period relate to post- closure maintenance costs of the MOD III eight-inch and MOD II five-inch wafer fabrication facilities, respectively. These costs consist of utilities, taxes, insurance, and other maintenance costs required to maintain the facilities in a condition required for the sale of the respective properties and are expensed to special charges as incurred. Approximately $0.1 million of special charges during the period relate to third-party professional legal service fees for activities associated with finalizing the Company's May 2002 debt and equity restructuring. We anticipate that there will be additional MOD II period expenses for ongoing closure, decommissioning and maintenance costs of approximately $3.1 million during the third and fourth quarters of 2004. Any gain received upon the sale of MOD II assets will be credited to special charges. Upon completion of the migration of MOD II production to outside foundries, will have finalized our strategy of becoming fully fabless and our legacy products will be primarily sourced from X-FAB and our newer products will be sourced from foundries in Asia.

Restructuring of operations during the six-month period ended June 30, 2003, included severance and termination benefits of $0.6 million related to a reduction-in-force at the Company's MOD II manufacturing plant which eliminated approximately 56 positions. Approximately $0.7 million of special charges for the six-month period ended June 30, 2003 relate to post-closure maintenance costs of the MOD III eight-inch wafer fabrication facility in Idaho consisting of utilities, taxes, insurance and other maintenance costs required to maintain the facility in a condition required for the sale of the property. Approximately $0.3 million of special charges during the first six months of 2003 relate to third-party professional fees for legal and accounting services to register 11.7 million shares of common stock as required by the Company's 2002 Plan of Reorganization. Asset impairment charges during the three and six months ended June 30, 2003 relate to redundant computer equipment with a net book value of $0.2 million that was retired in connection with the consolidation of our information technology data center.

Stock-Based Compensation. During the three-month periods ended June 30, 2004 and 2003, we recognized $0.6 million and $0.4 million of stock- based compensation, respectively. And for the six-month periods ended June 30, 2004 and 2003, we recognized $1.0 million and $0.8 million of stock-based compensation, respectively. These charges were recorded to reflect the intrinsic value of awards of restricted stock and stock options to certain executives, employees and consultants. These non-cash charges are primarily included in our selling, general and administrative expenses. During the second quarter of 2004 we canceled a restricted stock award to our CEO and replaced it with stock options that resulted in a non-cash compensation charge of approximately $0.2 million. Our right to repurchase shares of restricted stock for $0.01 per share generally lapses 25% on the award date and 25% on each of the first three anniversaries following the award date. Compensation expense for employee stock awards was measured on the award date and will be recognized over each of the next three years as these restrictions lapse. Charges for stock awards to consultants is measured as the awards vest and will be recognized over the periods that the restrictions lapse.

Amortization of Intangible Assets. Effective January 1, 2002, we adopted the provisions of FASB Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("FAS 142"). Under FAS 142, goodwill and intangible assets with indefinite lives are not amortized, but are reviewed annually or more frequently if impairment indicators arise. Separable intangible assets that are deemed to have defined lives will continue to be amortized over their useful lives (but with no maximum life). Intangible assets acquired prior to July 1, 2001 were being amortized on a straight-line basis over lives ranging from three to five years. In connection with the Company's fresh-start reporting, separable intangible assets based on independent valuations were created with deemed defined lives. These intangible assets are being amortized utilizing the pattern-of-use method over their estimated useful lives of six years for current technology and ten years for brand name.

The separable intangible assets identified in connection with fresh-start accounting and included in the consolidated balance sheet are as follows (in millions):

                                                  Current       Brand
                                                 Technology      Name        Total
                                                ------------ ------------ ------------
Gross carrying amount..........................       $17.0         $9.2        $26.2
Accumulated amortization.......................        13.8          3.0         16.8
                                                ------------ ------------ ------------
Carrying amount at June 30, 2004...............        $3.2         $6.2         $9.4
                                                ============ ============ ============

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

                           Current        Brand         Total
            Year          Technology       Name      Amortization
      ----------------- -------------- ------------ --------------
      July-December 2004         $1.4         $0.7           $2.1
            2005                  1.1          1.1            2.2
            2006                  0.4          1.0            1.4
            2007                  0.2          0.8            1.0
            2008                  0.1          0.7            0.8
         Thereafter              --            1.9            1.9
                        -------------- ------------ --------------
            Total                $3.2         $6.2           $9.4
                        ============== ============ ==============

Interest Expense. During the first six months of 2004 and 2003, our interest expense was primarily accrued in connection with our borrowings under our three-year $15.0 million senior secured revolving line of credit facility.

Income Taxes. The Company's income tax benefit for the three-months and six-months ended June 30, 2004 reflects an effective tax rate of 11% and 13%, respectively. Our expected tax rate is 14% for the entire year of 2004 based on our projections, excluding the financial impacts associated with any taxable gains or that could be recognized upon the disposition of any assets of either MOD II or MOD III. Our 2004 annual income tax provision is expected to include taxable income in the U.S. resulting from items that are expensed for book purposes but are nondeductible for tax purposes, as well as amortization of deferred tax charges. The book charges which are non-deductible for tax primarily include amortization of intangible assets, depreciation of pre-May 2002 property, plant and equipment, and stock-based compensation. In addition, we will provide for income tax expense in foreign jurisdictions where our operations are profitable and taxable.

Our provision for income taxes during the three-month and six-month periods ended June 30, 2003 reflected the estimated income tax rate for the year, including foreign income taxes for the jurisdictions in which our business was profitable as well as foreign withholding taxes and state minimum taxes.

In May 2002, we entered into a three-year $15.0 million senior secured revolving credit facility with a commercial lender under which borrowings bear interest at a rate per annum equal, at our option, to the commercial lender's stated prime rate or LIBOR, plus 2.5%. We have elected the LIBOR interest rate option, which, as of June 30, 2004, was 3.7%. As of June 30, 2004, we had outstanding borrowings of $2.4 million and standby letters of credit of $0.2 million. Our ability to borrow under the facility is based on a monthly borrowing base calculation that is determined as a percentage of eligible accounts receivable. At June 30, 2004 our availability for additional borrowings under the facility totaled $5.7 million. We are subject to certain financial covenants under the facility, including tangible net asset balance and fixed charge coverage ratios only if the total of our cash, cash equivalents and availability on the facility are less than $7.5 million at any month end.

At June 30, 2004, we had cash and cash equivalents of $38.5 million, compared to $22.0 million at December 31, 2003. Cash used by operating activities was $4.2 million for the six months ended June 30, 2004, compared to $3.2 million of cash used by operating activities in the six months ended June 30, 2003.

During the six-month period ended June 30, 2004, cash used by operating activities of $4.2 million primarily reflects our net loss of $7.2 million and increases in accounts receivable and inventories of $3.0 million and $4.1 million, respectively, as well as a $1.2 million decrease in other accrued liabilities, deferred income in shipments to distributors and accrued special charges. These uses of cash were offset partially by non-cash charges of $7.0 million, a $0.1 million decrease in accounts payable and a $2.2 million decrease in prepaid expenses and other assets. Non-cash charges include a decrease of deferred income taxes of $3.3 million, and an increase of $2.1 million for amortization of Fresh Start intangible assets, $1.8 million in depreciation and other amortization charges impairment of long-lived assets of $5.4 million and stock-based compensation expense of $1.0 million.

During the six-month period ended June 30, 2003, cash used by operating activities of $3.2 million primarily reflects our net loss of $4.9 million partially offset by decreases in inventories and prepaid expenses and other current and non-current assets of $1.0 million and $1.8 million, respectively, and a $1.6 million decrease in accounts payable, a $3.7 million decrease in accrued compensation and employee benefits, and a $0.6 million decrease in other accrued liabilities, deferred income in shipments to distributors and accrued special charges. These uses of cash were offset partially by non-cash charges of $4.8 million. Non-cash charges include a decrease of deferred income taxes of $2.5 million, and an increase of $3.4 million for amortization of Fresh Start intangible assets, $2.9 million in depreciation and other amortization charges, impairment of long lived assets of $0.2 million and stock-based compensation expense of $0.8 million. The primary use of cash for operating activities was a result of changes in working capital driven by:

• payout of the 2002 annual employee incentive bonuses of $3.3 million;
• payments pertaining to prior quarter accrued special charges of $0.5 million; and
• payment of vacation accruals reflecting shut-downs and mandatory time-off taken by employees during the quarter totaling $0.7 million.

Cash used by investing activities was $1.1 million and $1.3 million in the six-month periods ended June 30, 2004 and 2003, respectively. Cash used for investing activities in both of these periods reflects capital expenditures for building improvements, software and equipment.

Cash provided by financing activities for the six-month period ended June 30, 2004 of $21.8 million primarily reflects the net proceeds of $21.6 million from the Company's public offering of 2.0 million shares of common stock at a price of $12.50 per share, net of offering expenses. The stock offering proceeds were offset by repayments of $2.6million of borrowings under our revolving line of credit and $0.1 million for the repurchase of restricted common stock from a former employee. In April 2004, our underwriters purchased 251,100 shares of common stock relating to their over-allotment option. The $2.8 million net proceeds from our over-allotment stock sale was recorded net of offering expenses.

Cash used by financing activities was $3.5 million for the six-month period ended June 30, 2003, which reflected the repayment of borrowings under our revolving line of credit of $1.9 million and $1.1 million for the repurchase of restricted common sock from current and former employees, and $0.5 million for the repurchase of common stock outstanding.

On July 29, 2004, we announced that our board of directors has authorized a stock repurchase program pursuant to which we may repurchase up to $5.0 million in market value of our outstanding shares of common stock. Purchases under the program may be made, from time-to-time, in the open market, through block trades or otherwise. Depending upon market conditions and other factors, these purchases may be commenced or suspended at any time or from time-to-time without prior notice. Purchases of common stock under this program, if any, may impact our cash used by financing activities in future periods.

EBITDA as presented below reflect a non-GAAP measure of our liquidity. EBITDA reflects our net income adjusted for non-cash items, interest and income taxes. Our management uses separate "adjusted EBITDA" calculations for purposes of determining certain employees' incentive compensation and, subject to meeting specified adjusted EBITDA amounts, for accelerating the vesting of EBITDA-linked stock options. This measure of adjusted EBITDA was approved as part of our plan of reorganization. Adjusted EBITDA, as we define it, excludes interest, income taxes, effects of changes in accounting principles and non-cash charges such as depreciation, amortization, in-process research and development, and stock-based compensation expense. It also excludes cash and non-cash charges associated with reorganization items and special charges, which represent operational restructuring charges, including asset write-offs, employee termination costs, and lease termination costs. EBITDA is presented because management uses EBITDA as a measure of cash earnings for budgeting and financial performance measurement.

The differences between the EBITDA amounts below and our adjusted EBITDA relate to the following cash-settled reorganization and special items that are added-back in our adjusted EBITDA computations:

• Employee retention bonuses, severance pay and termination benefits;
• Professional fees for debt restructuring;
• Lease termination costs;
• Termination and exit charges, and
• MOD III closure costs.

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

                                                     Three Months Ended        Six Months Ended
                                                          June 30,                   June 30,
                                                ------------------------- -------------------------
                                                    2004         2003         2004         2003
                                                ------------ ------------ ------------ ------------
Reconciliation of net income (loss) to EBITDA:
   Net loss....................................       ($7.2)       ($2.0)       ($7.2)       ($4.9)
   Depreciation and amortization...............         1.6          3.1          3.9          6.3
   Interest expense, net.......................         --           0.1          0.1          0.1
   Income taxe expense (benefit)...............        (0.9)         0.1         (1.1)         0.2
                                                ------------ ------------ ------------ ------------
EBITDA.........................................       ($6.5)        $1.3        ($4.3)        $1.7
                                                ============ ============ ============ ============

Reconciliation of EBITDA to net cash used by
operating activities cash flow:
   EBITDA......................................       ($6.5)        $1.3        ($4.3)        $1.7
   Interest expense, net.......................         --          (0.1)        (0.1)        (0.1)
   Benefit (provision)for income taxes.........         0.9         (0.1)         1.1         (0.2)
   Deferred income taxes.......................        (2.5)        (1.3)        (3.3)        (2.5)
   Asset impairments...........................         5.4          --           5.4          0.2
   Stock-based compensation....................         0.6          0.4          1.0          0.8
   Changes in operating assets and
      liabilities..............................         0.1          0.4         (4.0)        (3.1)
                                                ------------ ------------ ------------ ------------
Net cash provided (used) by operating
   activities..................................       ($2.0)        $0.6        ($4.2)       ($3.2)
                                                ============ ============ ============ ============

Our cash needs for 2004 primarily include working capital, special charges and capital expenditures. In April 2004, we announced the closure of our MOD II wafer fabrication facility which resulted in the elimination of approximately 150 positions. We anticipate the remaining cash costs of this action will be approximately $3.2 million for incentive bonuses, severance benefits and other cash costs to be paid primarily during the third and fourth quarters of 2004. However, we currently anticipate that available cash and cash provided by operating activities will be adequate to satisfy our cash requirements for at least the next twelve months.

We expect fiscal 2004 capital expenditures will total approximately $2.0 million to $2.5 million, primarily for test equipment, building improvements and internal use software. Decisions related to cash requirements for investing activities are influenced by our expected cash provided by operations, our existing cash reserves and the investment needs of the business as we continue to expand our development activities.

Management has not determined how much, if any, common stock will be purchased under our $5.0 million stock repurchase program. Any such purchases will impact our cash used by financing activities in future periods.

Contractual Obligations. We lease certain of our facilities and equipment under non-cancelable operating leases, which expire in 2004 through 2009. These facility lease agreements generally provide for base rental rates which increase at various times during the terms of the leases and also provide for renewal options at fair market rental value. We are also responsible for common area maintenance charges on certain office leases, which are not included in the above table. These charges are generally less than 10% of base rents. Total operating lease expense, including month-to-month rentals, was approximately $2.7 million, $1.7 million, $1.2 million and $6.9 million for the year ended December 31, 2003, the eight-month period ended December 31, 2002 and the four-month period ended April 30, 2002. We did not have any capital leases as of December 31, 2003 or 2002.

We generally make purchases under cancelable purchase orders and do not enter into long-term supply agreements. Certain of our wafer foundry, assembly, materials suppliers, software vendors and support tool manufacturers require non-cancelable purchase orders since they often provide products and services tailored to our specifications. Summarized in the table below are minimum future commitments under operating leases and non-cancelable purchase obligations as of December 31, 2003 (in millions):

                                                                          Payment due by period
                                                             ---------------------------------------------------
                                                                                         More than
                                                               Within 1   --------------------------------------
                                                   Total         Year      1-3 years    3-5 years     5 years
                                                ------------ ------------ ------------ ------------ ------------

Operating lease obligations....................        $6.9         $1.9         $3.4         $1.4         $0.2

Purchase obligations...........................         5.8          4.5          1.2          0.1         --
                                                ------------ ------------ ------------ ------------ ------------
    Total......................................       $12.7         $6.4         $4.6         $1.5         $0.2
                                                ============ ============ ============ ============ ============

During the second quarter of 2004, we placed purchase orders with our new foundry vendor, X-Fab, which total $1.3 million of outstanding purchase commitments as of June 30, 2004. We also entered into a new building lease for a design center in Meridian, Idaho which has future minimum lease payments totaling $0.7 million over a 62 month period.

From time to time we have agreed to indemnify certain customers for potential allegations of infringement of intellectual property rights and patents arising from the use of the Company's products. Currently, we have an indemnification agreement with a customer that limits our net contingent obligation to pay for the customer's defense costs, if any, up to a maximum of $500,000.

We believe that inflation and/or deflation had a minimal impact on our overall operations during the periods included in these financial statements.

Sales typically increase in the second quarter and peak in the third quarter driven by increased holiday demand from our customers in the home entertainment and consumer products markets. Our revenues are generally lower in the first and fourth quarters compared to the rest of the year. We believe that this historical seasonal trend could be impacted in the current year by general economic conditions and reduction in sales of our previously de-emphasized products. Additionally, general world-wide economic, political and regional instabilities may impact our results of operations in any given period.

In January 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46 ("FIN 46"), "Consolidation of Variable Interest Entities." In December 2003, the FASB issued Interpretation No. 46 (revised December 2003), "Consolidation of Variable Interest Entities ("FIN 46R")," which addresses how a business enterprise should evaluate whether it has a controlling financial interest in an entity through means other than voting rights. The interpretation replaces Interpretation No. 46, "Consolidation of Variable Interest Entities," which was issued in January 2003.

Effective January 1, 2004, the Company adopted the provisions of FIN 46R. Under the provisions of FIN 46R, our investment in ZiLOG, MOD III, Inc. ("MOD III") was determined to be a variable interest entity and we are not the primary beneficiary. The adoption of FIN 46R did not have an impact on prior periods. The adoption of FIN 46R did not have an impact on prior periods. And accordingly, the $30.0 million book value and minority interest in MOD III were unconsolidated effective January 1, 2004. We expect to continue incurring period expenses of approximately $0.1 million to $0.2 million per quarter within special charges for the ongoing costs of maintaining the assets of MOD III in a salable state and such costs may become recoverable from any proceeds received upon the ultimate sale of MOD III assets.

In December 2003, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 104 ("SAB 104"), which revises or rescinds portions of the interpretative guidance included in Topic 13 of the codification of staff accounting bulletins to make this interpretative guidance consistent with current authoritative accounting and auditing guidance and SEC rules and regulations. SAB 104 also rescinds the Revenue Recognition in Financial Statements Frequently Asked Questions and Answers document issued in conjunction with Topic 13. The application of the requirements of SAB 104 did not have an impact on our financial position or results of operations.

• The cost of closing and decommissioning MOD II could be more expensive than anticipated;
• The closing and decommissioning could take longer than anticipated;
• Production yields at X-FAB could be unsatisfactory and result in higher costs than expected;
• Production of wafers at X-FAB could fail to meet our product specifications or our customers' qualification requirements;
• X-FAB may be unable to meet our need for wafers or to meet our delivery requirements on a timely basis; or
• After the first year of our agreement with X-FAB, they could substantially raise the price we pay for wafers or they may terminate their contract with us.

Any one or more of these factors could result in a material reduction in our sales and increase in our costs or a loss of customers.

In each of the past three years our net sales have declined significantly and our future financial results are anticipated to be subject to substantial fluctuations. Our total net sales were $103.6 million for the year ended December 31, 2003, $139.6 million in 2002 and $172.3 million in 2001. Our future financial performance and success are largely dependent on our ability to implement our new product strategy, which consists partly of refocusing our business on the next generation of micrologic products built around our core 8-bit micrologic architecture, beginning with the Z8 Encore! and eZ80 Acclaim! flash products. In November 2002 we launched our new 8-bit Z8 Encore! micrologic product, and in February 2003 we launched our new eZ80 Acclaim! micrologic product. These products typically have a long lead time from design to production, which can range from twelve months to thirty-six months. To date these products have only been sold in insignificant quantities, and we do not currently expect these products to contribute a meaningful percentage of net sales until the second half of 2004. If the market for these new products does not develop as we currently expect, if we are unable to develop new products in a manner that timely meets changing market requirements, or if we are not able to achieve significant sales of our new 8- bit micrologic products for any reason, our product strategy may fail and our net sales and operating results may continue to decline or not grow as currently expected.

On February 28, 2002, we filed a voluntary petition for reorganization under Chapter 11 of the United States Bankruptcy Code. The United States Bankruptcy Court for the Northern District of California confirmed our prepackaged plan of reorganization on April 30, 2002, and we emerged from bankruptcy on May 13, 2002. The effect, if any, that our Chapter 11 case and plan of reorganization may have had, and may continue to have, upon our continued operations cannot be reasonably estimated, predicted or quantified. Some entities may be uncomfortable doing business with a company that emerged from bankruptcy approximately two years ago. The fact that we have a Chapter 11 bankruptcy on our credit record could adversely affect our relationships with our customers, suppliers and employees.

Our operating results depend on our ability to introduce and sell new products on a timely basis that can compete effectively on the basis of price and performance and that address customer requirements. Rapidly changing technologies and industry standards, along with frequent new product introductions, characterize the

 industries that are currently the primary end-users of semiconductors. As these industries evolve and our customers and potential customers introduce new products, our success will depend on our ability to adapt to such changes in a timely and cost-effective manner by designing, developing, manufacturing, marketing and providing customer support for new products and technologies. In the past, we have brought products to market on an untimely basis or canceled the introduction of previously planned products, such as our Cartezian line of 32-bit microprocessors. Our ability to introduce and sell new products successfully depends on several factors, including:

• development of support tools and technical documentation that make complex products easy for engineers to understand and use;
• proper new product selection;
• timely completion and introduction of new product designs;
• support from our foundry service providers;
• complexity of the new products to be designed and manufactured; and
• market acceptance of our products and our customers' products.

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

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

The semiconductor industry is intensely competitive and is characterized by price erosion, rapid technological change and heightened competition in many markets. The industry consists of major domestic and international semiconductor companies, many of which have substantially greater financial and other resources than we do with which to pursue engineering, manufacturing, marketing and distribution of their products. Emerging companies are also increasing their participation in the semiconductor industry. Our current and future products compete with, or may compete with, products offered by Atmel, Cypress Semiconductor, Intel, Microchip, Motorola, National Semiconductor, Renasas, ST Microelectronics and Texas Instruments, among others. Some of our principal products such as the Z80 microprocessor are licensed by our competitors or are in the public domain and can be manufactured and sold to our customers by our competitors, possibly with added features or at lower prices than we charge. Our ability to compete successfully in our markets depends on factors both within and outside of our control, including:

• our ability to design and manufacture new products that implement new technologies, including our eZ80 Acclaim! and Z8 Encore! product families;
• our ability to protect our products by effectively utilizing intellectual property laws;
• our product quality, reliability, ease of use and price;
• the diversity of our product line and feature sets within our products;
• our efficiency of production;
• our ability to obtain adequate supplies of raw materials and other supplies at acceptable prices;
• the pace at which customers incorporate our devices into their products; and
• the success of our competitors' products and general economic conditions.

Our quarterly operating results are likely to fluctuate and may fail to meet expectations, which may cause the price of our securities to decline.

Our quarterly operating results have fluctuated in the past and will likely continue to fluctuate in the future. If our quarterly operating results fail to meet expectations, the price of our securities could fluctuate or decline significantly. In addition, high proportions of our costs are fixed, due in part to our significant sales, research and development and manufacturing costs. Therefore, small declines in revenue could disproportionately affect our operating results in a quarter. A variety of factors could cause our quarterly operating results to fluctuate, including:

• our ability to introduce and sell new products and technologies on a timely basis, such as our Z8 Encore! and eZ80 Acclaim! device families and extensions of these product families;
• any shortage of wafer or assembly manufacturing capacity at our third-party vendors;
• competitive developments, including pricing pressures;
• technological change and product obsolescence;
• changes in product mix or fluctuations in manufacturing yields;
• variability of our customers' product life cycles;
• the level of orders that we receive and can ship in a quarter and customer order patterns;
• seasonality;
• increases in the cost or scarcity of raw materials; and
• gain or loss of significant customers.

We depend on orders that are received and shipped in the same quarter, and therefore our results of operations may be subject to significant variability from quarter to quarter.

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

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

The semiconductor industry is highly cyclical and has experienced significant economic downturns, often in connection with, or in anticipation of, maturing product cycles (for semiconductors and for the end- user products in which they are used) and declines in general economic conditions. These downturns have been characterized by diminished product demand, erosion of average selling prices, production over-capacity and high inventory levels. For example, beginning in the fourth quarter of 2000 we experienced a three-year downturn in our business cycle. We believe that, in light of these events, some of our customers curtailed and may in the future delay or further curtail spending on technology, which could negatively affect our quarterly results or financial condition in the future. Any economic downturn in the semiconductor industry could increase pressure on us to reduce our prices, which could impair our revenues, gross margins and operating cash flow. From time to time, the semiconductor industry also has experienced periods of increased demand and production capacity constraints. We have in the past experienced substantial period-to-period declines in operating results, and will likely in the future experience substantial period-to-period fluctuations in operating results that are attributable to semiconductor industry conditions or events occurring in the general economy.

Average selling prices in the semiconductor industry typically decline over time, which directly affects our revenue and margins.

Historically, average selling prices in the semiconductor industry have decreased over the life of any particular product. To the extent that our products achieve market acceptance, competitors typically seek to offer competitive products or embark on discount pricing strategies. We have in the past and may in the future be required to reduce selling prices in response to competition. If we are unable to offset any reductions in the selling prices of our products by introducing new products at higher prices or by reducing our costs, our revenues, gross margins and operating results could be impaired.

A significant amount of our revenues comes from relatively few of our customers and distributors, and any decrease of revenues from these customers and distributors, or the loss of their business, could significantly harm our financial results.

We depend on relatively few distributors for a substantial portion of our sales.

Historically we have been, and we expect to continue to be, dependent on a relatively small number of distributors for a significant portion of our revenues. We depend on third-party distributors to market and sell our products, and these third-party distributors accounted for approximately 47% of our net sales for both 2003 and the second quarter of 2004 and the six-month period ended June 30, 2004 and approximately 44% of our net sales for 2002. In addition, our five largest distributors accounted for approximately 33% of net sales for 2003. Future Electronics accounted for approximately 18% of our net sales for 2003. Our distributors decide whether to include our products among those that they sell, and they may carry and sell product lines that are competitive with ours. Because our distributors are not required to make a specified minimum level of purchases from us, we cannot be sure that they will prioritize selling our products. We also rely on our distributors to accurately report to us on a timely basis their sales of our products and provide certain support services to our customers. Our inability to obtain accurate and timely reports and to successfully manage these relationships could adversely affect our business and financial reports. Our distributors may not continue to effectively market, sell or support our products.

We depend on relatively few major customers for a substantial portion of our sales.

Our ten largest customers, including our distributors, accounted for approximately 68% of net sales for the second quarter of 2004 and 66% for the six-month period ended June 30, 2004, 63% of our net sales for 2003, approximately 54% of our net sales for 2002 and approximately 55% of our net sales for 2001. Concentration of net sales to particular customers may change from period to period, but we expect that sales to a limited number of customers will continue to account for a significant percentage of our revenues in any particular period for the foreseeable future. We have very few long-term contracts with our customers, and, like us, our customers typically compete in cyclical industries. We routinely manufacture or purchase inventory based on customers' estimates of demand for their products, which is difficult to predict. We recently increased our inventory stocking levels in anticipation of the closure of our MOD II facility and the related transition of production to outside foundries. Our customers may decide not to purchase our products at all, to purchase fewer products than they did in the past, or to alter their purchasing patterns on short notice, particularly because substantially all of our sales are made on a purchase order or sales order acknowledgment basis, which permits our customers to cancel, change or delay product purchase commitments upon 30 days notice for standard products and 60 days notice for custom products without paying a cancellation or rescheduling charge. Customers may still cancel or reschedule within these time periods, however they routinely incur a cancellation or rescheduling charge. This cancellation risk is increased because our customers can purchase some similar products from our competitors. The loss of one or more major customers or any reduction, delay or cancellation of orders by any of these customers or our failure to market successfully to new customers could result in a significant reduction in net sales during one or more periods, excess inventory or write-downs of inventory.

Our international operations subject us to risks inherent in doing business in foreign countries that could impair our results of operations.

Approximately 65% of our net sales for the six-month period ended June 30, 2004, approximately 66% of our net sales for 2003, and approximately 56% for 2002 were made to foreign customers, and we expect that international sales will continue to represent a significant portion of our net sales in the future. We maintain significant operations or rely on a number of contract manufacturers in the Philippines, Indonesia, Taiwan, Thailand, India and other locations in Asia. We cannot assure you that we will be successful in overcoming the risks that relate to or arise from operating in international markets. Risks inherent in doing business on an international level include:

• economic and political instability;
• changes in regulatory requirements, tariffs, customs, duties and other trade barriers;
• transportation delays;
• power supply shortages and shutdowns;
• difficulties in staffing and managing foreign operations and other labor problems;
• existence of language barriers and cultural distinctions;
• acts of God, including floods, typhoons and earthquakes;
• Taxation of our earnings and the earnings of our personnel; and
• other uncertainties relating to the administration of, or changes in, or new interpretation of, the laws, regulations and policies of the jurisdictions in which we conduct our business.

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

The risks inherent in our international operations have been increased by the terrorist attacks of September 2001. These attacks, coupled with the international military response, have created an uncertain economic environment, and we cannot predict the impact of these events, any subsequent terrorist acts or any related military action, on our customers or our business.

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

We have had a history of losses for each of the years in the five-year period ended December 31, 2003, excluding the one-time gain on extinguishment of debt and fresh-start adjustments in 2002. We may not be profitable in the future.

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

We depend on our ability to attract and retain highly skilled technical and managerial personnel. We believe that our future success in developing marketable products and achieving a competitive position will depend in large part on our ability to identify, recruit, hire, train, retain and motivate highly skilled technical, executive, managerial, marketing and customer service personnel. Competition for these personnel is intense, especially in Northern California, where our headquarters are located, and we may not be able to successfully recruit, assimilate or retain sufficiently qualified personnel. Our failure to recruit and retain necessary technical, executive, managerial, marketing and customer service personnel could harm our business and our ability to obtain new customers and develop new products. In addition, our history of losses and our bankruptcy filing could impair our ability to recruit and retain employees.

Our current policy is that we not enter into or extend employment agreements with executives. Mr. Thorburn's employment agreement expired in May 2004 and he currently has an at-will employment relationship with us. If we are unable to retain Mr. Thorburn as our Chief Executive Officer of any of the other key executives, our business may be harmed.

We may fail to protect our proprietary rights, and the cost of protecting those rights, whether we are successful or not, may harm our ability to compete.

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

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

Litigation may be necessary to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of our proprietary rights or the proprietary rights of others. Any such litigation could require us to incur substantial costs and divert significant valuable resources, including the efforts of our technical and management personnel, which may harm our business materially. For example, we recently filed suit against QuickLogic Corporation alleging that QuickLogic's FPGA and ESP products infringe claims of ZiLOG's U.S. patent number 4,670,749 and seeking to recover monetary damages resulting from the alleged infringement. While we believe we would ultimately be successful in this litigation, it is possible that QuickLogic could assert a number of defenses, such as non-infringement, or counterclaims of invalidity or unenforceability. Nonetheless, we do not currently believe that any outcomes of such defenses or counterclaims would have a material adverse effect on our business.

The semiconductor industry is characterized by frequent litigation regarding patent and other intellectual property rights, both defensive and offensive.

From time to time we have received, and may in the future receive, communications from third parties asserting that a product offered by us, or an aspect of our business, infringes a patent held by the third party and/or requires a license thereto. With respect to those third party communications that are currently pending, we believe, after having consulted with counsel, that either (i) we have meritorious defenses, (ii) based on license terms previously offered to us or typically available in the industry, we can obtain any necessary licenses on commercially reasonable terms, or (iii) we can modify our products to avoid such rights, but if this is not the case, we may be sued and assessed damages for past infringement. Indeed, licenses may not be available on commercially reasonable terms, or at all. In addition, we have certain indemnification obligations to customers with respect to the infringement of third party intellectual property rights by our devices.

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

P>Intellectual property lawsuits are subject to inherent uncertainties due to the complexity of the technical issues involved, and we may not be successful in defending ourselves against intellectual property claims. The cost of defending against patent infringement or other intellectual property litigation, in terms of management time and attention, legal fees and product delays, could be substantial, whatever the outcome. If any patent or other intellectual property claims against us are successful, we may be prohibited from using the technologies subject to these claims, and if we are unable to obtain a license on acceptable terms, license a substitute technology, or design new technology to avoid infringement, we could be prohibited from using or selling the infringing products or technologies and be required to pay substantial damages. Such a result could have a material adverse effect on our business.

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

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

• replacements or recalls could impose substantial costs on us;
• rumors, false or otherwise, may be circulated by the press and other media, which could cause a decrease in sales of our products; and
• customers or end users may file suits or assert other legal claims against us alleging damages caused by defective products or errors in products. If we do not successfully defend such suits, we could be required to pay substantial damages. Even if we prevail in suits filed by customers or end users, we may be required to expend significant funds in defense.

Changes in technologies or consumption patterns could reduce the demand for our products.

As a result of technological changes, from time to time our customers change the design of their products so as not to include our products, which may have a negative impact on our net sales. For example, in 1999 and 2000, a number of our customers changed the designs of computer mouse pointing devices that they manufactured, and as a result, these devices no longer contain our products. Because we do not have long-term supply contracts with most of our customers, changes in the designs of their products can have sudden and significant impacts on our sales. For example, net sales of our computer mouse pointing devices and other computer peripheral products decreased substantially from approximately $15.4 million in 2000 to approximately $4.9 million in 2001, approximately $2.4 million in 2002, and approximately $0.7 million for 2003 and approximately $65,000 for the six months ended June 30, 2004. These reduced sales due to design changes have harmed us in the past, and additional design changes could result in lower revenues in the future.

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

We have implemented significant cost cutting measures in the past, including during 2003. These cost cutting efforts have included:

• restructuring our manufacturing operations, which included consolidating our wafer fabrication facilities, outsourcing significant wafer and assembly operations and consolidating probe and final test operations at our Philippines site;
• refocusing our strategic priorities;
• closing of MOD II;
• reallocating personnel and responsibilities to better utilize human resources;
• reducing research and development and capital expenditure spending;
• reducing our workforce; and
• instituting temporary office and facility shutdowns.

Cost cutting measures may not increase our efficiency or lead to profitability, and our reduction in research and development spending could harm our ability to introduce new products in the future. If our revenue or operating results significantly decline in the future, we may be required to institute further cost reduction measures.

From time to time, we evaluate our strategic alternatives with respect to our facilities and we may take actions, which may result in the occurrence of accounting charges. Some or all of these charges may be non-cash. Such charges would have a negative impact on our GAAP profitability and may have a negative impact on our cash balance in the fiscal period or periods in which such charges are taken.

We are subject to various environmental laws and regulations that could have a material adverse effect on us.

Our manufacturing processes require us to use various hazardous substances, and, as a result, we are subject to a variety of environmental laws and regulations governing the storage, use, emission, discharge and disposal of, and human exposure to, such substances. In particular, the process of manufacturing silicon wafers uses large amounts of corrosive and other hazardous chemicals and huge quantities of distilled, de- ionized water. Our failure to comply with present or future laws and regulations or the loss of any permit required to conduct our business could result in fines being imposed on us, the limitation or suspension of production, or cessation of our operations. Compliance with environmental laws and regulations also could require us to acquire additional equipment or to incur substantial other expenses. Any failure by us to control the use of, or adequately restrict the discharge of, hazardous substances could subject us to future liabilities that could materially harm our business, including under laws and regulations that impose liability and clean-up responsibility for releases of hazardous substances into the environment. Under certain of these laws and regulations, current or previous owners or operators of property may be liable for clean-up costs and other damages without regard to whether they knew of, or caused, the contamination. The presence of, or failure to remediate, contamination could adversely affect the value of, and the ability to transfer or encumber, our property. In addition, we may be required to incur significant expense in connection with governmental investigations of environmental or employee health and safety matters.

If we are unable to obtain adequate production capacity, our business will be harmed.

We rely on independent third-party foundry manufacturers to fabricate all of our products since we closed MOD II in June 2004. Since we closed MOD II, industry-wide shortages in foundry capacity could harm our financial results. As a result of our fables business model, we are more vulnerable to shortages of wafer supply or price increases by our foundry suppliers. If we are unable to obtain the requisite foundry capacity to manufacture our products, or if we have to pay higher than anticipated prices to foundries in periods of tight capacity, we may not be able to meet our customers' demand for our products. Any delay in initiating production at third- party foundries, any inability to have new products manufactured at such foundries or any failure to meet our customers' demands could damage our relationships with our customers and may decrease our sales.

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

• reduced control over the cost of our products, delivery schedules and product quality;
• limited warranties on wafers or products supplied to us;
• increased exposure to potential misappropriation of our technology;
• vulnerability to third-party foundries' financial, operations or production difficulties; and
• the time and cost associated with switching foundries.

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

We use outside contract assemblers in Indonesia, Thailand and the Philippines for packaging our products. These countries have been subject to political instability and terrorist activities. The packaging of semiconductors is a complex process requiring, among other things, a high degree of technical skill and advanced equipment. If we are unable to obtain additional assembly capacity on sufficiently favorable terms, our ability to maintain or grow our net sales could be impaired. Shortages in contract assembly capacity could cause shortages in our products and could also result in the loss of customers as a result of delays. Because we rely on these third parties, we also have less control over our costs, delivery schedules and quality of our products and our technology is at greater risk of misappropriation.

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

To increase our business and maintain our competitive position, we have made acquisitions in the past and may do so in the future. For example, in April 1999, we acquired substantially all of the assets and assumed the operating liabilities of Seattle Silicon Corporation, and in July 2000 we acquired Calibre, Inc.

Acquisitions involve a number of risks that could harm our business and result in the acquired business not performing as expected, including:

• insufficient experience with technologies and markets in which the acquired business is involved, which may be necessary to successfully operate and integrate the business;
• problems integrating the acquired operations, personnel, technologies or products with the existing business and products;
• diversion of management time and attention from our core business to the acquired business;
• potential failure to retain key technical, management, sales and other personnel of the acquired business;
• difficulties in retaining relationships with suppliers and customers of the acquired business; and
• subsequent impairment of the acquired assets, including intangible assets.

In addition, acquisitions could require investment of significant financial resources and may require us to obtain additional equity financing, which may dilute our stockholders' equity, or to incur additional indebtedness.

Acts of war or terrorism could harm our business.

The September 11, 2001 terrorist attacks on the United States created immediate significant economic and political uncertainty. The long-term effects of such attacks on the world economy and our business are unknown, but could be material to our business. Further terrorists acts or acts of war, whether in the United States or abroad, also could cause damage or disruption to our business, our suppliers, our freight carriers, or our customers, or could create political or economic instability, any of which could have a material adverse effect on our business. Continuing tensions between India and Pakistan particularly pose an increased risk to our design operations in India, which could be disrupted in the event of the outbreak of war between the two countries.

Recently enacted and proposed changes in securities laws and regulations may increase our costs.

The Sarbanes-Oxley Act of 2002 that became law in July 2002 has previously required changes in some of our corporate governance practices. The Act also requires the SEC to promulgate new rules on a variety of subjects. We expect these new rules and regulations to increase our legal and financial compliance costs, and to make some activities more difficult, time consuming and/or more costly. These new rules and regulations have made and may increasingly make it more costly to obtain director and officer liability insurance coverage, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These new rules and regulations could also make it more difficult for us to attract and retain qualified members of our board of directors, particularly to serve on our audit committee, and qualified executive officers.

Changes in accounting principles generally accepted in the United States may adversely affect our reported financial results or otherwise harm our business.

We prepare our financial statements in conformity with accounting principles generally accepted in the United States. These accounting principles are subject to interpretation by the Financial Accounting Standards Board, the American Institute of Certified Public Accountants, the Securities and Exchange Commission and various bodies formed to interpret and create appropriate accounting policies. A change in these policies or interpretations could have a significant effect on our reported financial results, and could affect the reporting of transactions completed before the announcement of a change. For example, while current accounting rules allow us to exclude the expense of stock options from our financial statements, influential business policy groups, including the Financial Accounting Standards Board, have suggested that the rules be changed to require these options to be expensed. Technology companies generally, and our company, specifically, rely heavily on stock options as a major component of our employee compensation packages. If we are required to expense options, we may be less likely to achieve profitability or we may have to decrease or eliminate options grants. Decreasing or eliminating option grants may negatively impact our ability to attract and retain qualified employees.

The agreements governing our credit facility may limit our ability to finance future operations or capital needs or engage in business activities that may be in our interest.

We have a $15.0 million senior secured revolving credit facility, under which $2.4 million in borrowings were outstanding as of June 30, 2004 and approximately $5.7 million was available for additional borrowing based on our current borrowing base. Borrowings under this credit facility are secured by substantially all of our assets. The terms of our credit facility contain restrictive covenants, which may impair our ability to take corporate actions that we believe to be in the best interests of our stockholders, including restricting the ability to:

• dispose of assets;
• incur additional debt;
• prepay other debts or amend some debt instruments;
• pay dividends or repurchase stock;
• create liens on assets;
• enter into sale-leaseback transactions;
• make investments, loans or advances;
• make acquisitions or engage in mergers or consolidations;
• change the business activities conducted by us or our subsidiaries;
• make capital expenditures or engage in specific transactions with affiliates; and
• otherwise restrict corporate activities.

In addition, this credit facility requires us to maintain certain financial ratios. Our ability to comply with these borrowing terms may be affected by events beyond our control, including prevailing economic, financial and industry conditions. The breach of any of such covenants or restrictions could result in a default, which would permit our lender to cause all amounts we owe them to accelerate and become due and payable, together with accrued and unpaid interest and give our lender the right to seize collateral securing repayment of the indebtedness. In the future, we may not be able to repay all of our borrowings if they were accelerated, and in such event, our business may be harmed materially and the value of our common stock could decrease significantly. This credit facility is scheduled to expire on May 13, 2005, at which time we may be required to renew, refinance, or modify the credit facility with our lender or locate alternative financing. We may not be able to do so on acceptable terms, or at all.

Our North American distributor could emphasize competing products and we may lose some of our customers as a result.

Our North American distributor, Future Electronics, distributes products of our competitors that may directly compete with our product offerings. If Future Electronics chooses to promote those products over our products, our operating results could be harmed significantly. In addition, if Future Electronics were to terminate our distribution agreement, we could experience a period of significant interruption of our business while we obtained other distribution channels.

Provisions in our organizational documents and Delaware law could discourage acquisition proposals or delay a change in control that would be beneficial to our stockholders.

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

• providing for a classified board of directors with staggered terms;
• limiting the persons who may call special meetings of stockholders; and

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

Our directors, named executive officers and two large stockholders, who beneficially own approximately 23% of our common stock in the aggregate, may have interests that conflict with the interests of our other stockholders.

Our directors and named executive officers, together with two large stockholders, UBS Willow Management, L.L.C. and funds managed by Capital Research and Management Company, beneficially owned approximately 23% of our outstanding common stock, in the aggregate, as of June 30, 2004, following the consummation of our recent underwritten offering. As a result of their ownership and positions, our directors and named executive officers, together with UBS Willow Management and Capital Research and Management Company, collectively are able to significantly influence all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. Such concentration of ownership may also have the effect of delaying or preventing a change in control. If the ownership of our common stock continues to be highly concentrated, it may prevent you and other stockholders from influencing significant corporate decisions. The investment objectives of these stockholders may differ from those of our other stockholders, including our future public stockholders.

Item 3. Quantitative and Qualitative Disclosure About Market Risk

Interest Rate Risk

Our exposure to market risk for changes in interest rates relates primarily to our short-term investment portfolio and borrowings under our revolving credit facility. We do not use derivative financial investments in our investment portfolio. Our primary investment objectives are to preserve capital and maintain liquidity. These objectives are met by investing in high-quality credit issuances and limiting the amount of credit exposure to any one company. Our policy is to mitigate default risk by investing in only the highest quality securities and monitoring the credit ratings of such investments. As of June 30, 2004, our cash equivalents were invested in bank time deposits and money market funds. We have no significant cash flow exposure due to rate changes for our cash equivalents as these instruments have very short maturities.

The table below presents principal amounts and related average rates by year of maturity for our cash equivalents and debt obligations as of June 30, 2004 (dollars in millions):

                                                           Carrying
                                                            Value      Fair Value
                                                         ------------ ------------
Cash Equivalents:
  Fixed rate ...........................................       $35.6        $35.6
  Average interest rate ................................        0.67%        --

Short Term Debt:
  Variable-rate debt....................................        $2.4         $2.4
  Interest rate.........................................         3.7%        --

Foreign Currency Exchange Risk. We transact business in various foreign countries, but the vast majority of our consolidated net sales and purchases are denominated in U.S. dollars. Currently, we do not employ a foreign currency hedging program to mitigate our foreign currency exchange risk as foreign currency transactions and we believe the risks to date have not been significant. We maintain local currency bank accounts in our international offices to facilitate payment of local operating costs.

Item 4. Controls and Procedures

Evaluation of Controls and Procedures

As of June 30, 2004, the Company's management carried out an evaluation, under the supervision and with the participation of the Company's Chief Executive Officer, James Thorburn, and the Company's Chief Financial Officer, Perry J. Grace, of the effectiveness of the design and operation of the company's disclosure controls and procedures. Based upon that evaluation, Mr. Thorburn and Mr. Grace concluded that the Company's disclosure controls and procedures are effective in causing material information to be collected, communicated and analyzed by management of the Company on a timely basis and to ensure that the quality and timeliness of the Company's public disclosures complies with its SEC disclosure obligations.

Changes in Internal Controls

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

PART II

OTHER INFORMATION

Item 1. Legal Proceedings

We are participating in litigation and responding to claims arising in the ordinary course of business. We intend to defend ourselves vigorously in these matters. Our management believes that it is unlikely that the outcome of these matters will have a material adverse effect on our financial statements, although there can be no assurance in this regard.

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

On July 29, 2004, ZiLOG announced that its board of directors has authorized a stock repurchase program pursuant to which ZiLOG may repurchase up to $5,000,000 in market value of its outstanding shares of common stock. ZiLOG's common stock trades on the Nasdaq National Market and purchases under the program may be made, from time-to-time, in the open market, through block trades or otherwise. Depending upon market conditions and other factors, these purchases may be commenced or suspended at any time or from time-to-time without prior notice.

Item 4. Submission of Matters to a Vote of Security Holders.

On May 26, 2004, at the Company's annual meeting of stockholders, the following proposals were approved:

Proposal 1: Election of Directors

* Elected Michael D. Burger and Federico Faggin to serve as Group II directors until our 2007 annual meeting of stockholders.

* Approved the appointment of Ms. Robin A. Abrams and Mr. David G. Elkins as Group I directors to serve the remainder of a 3-year term expiring at our 2006 annual meeting of stockholders.

14,794,543 votes were cast for the election of Michael D. Burger (88% of the outstanding shares), and 915,180 votes were withheld; 14,739,493 votes were cast for the election of Federico Faggin (88% of the outstanding shares), and 970,230 votes were withheld; 14,473,300 votes were cast for the approval of the appointment of Robin A. Abrams (86% of the outstanding shares) and 1,236,423 votes were withheld; and 15,135,250 votes were cast for the approval of the appointment of David G. Elkins (90% of the outstanding shares) and 574,473 votes were withheld. Election to, or approval of appointment to, our board of directors requires an affirmative vote of a plurality of the votes present in person or represented by proxy and entitled to vote.

Proposal 2: Ratification of Independent Auditors

* Ratified the selection of KPMG LLP as our independent auditors for our fiscal year ending December 31, 2004.

15,628,208 votes were cast for the foregoing proposal (93% of the outstanding shares), 75,115 votes were cast against the foregoing proposal, and 6,400 shares abstained. Approval of the foregoing proposal required an affirmative vote of a majority of the outstanding shares.

Item 6. Exhibits and Reports on Form 8-K

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

 Exhibit
  Number                          Description
- ---------- --------------------------------------------------------------------------------
 2.1 (a)   Joint Reorganization Plan, as confirmed by order of the U.S. Bankruptcy
           Court for the Nothern District of California, dated April 30, 2002.

 3.1 (b)   Amended and Restated Certificate of Incorporation of ZiLOG, Inc., as amended
           and corrected.

 3.2 (b)   Amended and Restated Bylaws of ZiLOG, Inc.

 4.1 (c)   Form of Restricted Stock Purchase Agreement.

 4.2 (c)   Form of Non-Qualified EBITDA-Linked Option Grant Agreement.

 4.3 (c)   Form of Non-Qualified Non-EBITDA-Linked Option Grant Agreement.

31.1       Certification of Chief Executive Officer pursuant to Securities Exchange Act
           Rules 13a-14 and 15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley
           Act of 2002, dated August 11, 2004.

31.2       Certification of Chief Executive Officer pursuant to Securities Exchange Act
           Rules 13a-14 and 15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley
           Act of 2002, dated August 11, 2004.

32         Certifications of Chief Executive Officer and Chief Financial Officer pursuant
           to Section 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
           Sarbanes-Oxley Act of 2002, dated August 11, 2004.

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

(b) Incorporated herein by reference to the item of the same name filed as an exhibit
    to the Company's annual report on Form 10-K for the fiscal year ended December 31, 2003.

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

b) Reports on Form 8-K:

• On April 6, 2004, ZiLOG Inc. filed a Current Report on Form 8-K announcing that it closed a sale of common stock in connection with an exercise of an over-allotment option granted to its underwriters in connection with its public offering.





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ZiLOG, INC.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	ZiLOG, INC.

	(Registrant)

	By:	/s/ Perry J. Grace

	Perry J. Grace
	Vice President and Chief Financial Officer
	(Duly Authorized Officer)

	By:	/s/ James M. Thorburn

	James M. Thorburn
	Chairman, Chief Executive Officer and Director
	(Duly Authorized Officer)

Date: August11, 2004