SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

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

 

For the Fiscal Year Ended December 31, 2001

 

Commission File Number 0-23006

 

DSP GROUP, INC.

(Exact name of registrant as specified in its charter)

 

 

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

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

 

The aggregate market value of the voting stock held by non-affiliates of the Registrant, based on the closing price of the Common Stock on March 14, 2001, as reported on the Nasdaq National Market, was approximately $410,871,768.  Shares of Common Stock held by each officer and director and by each person who owns 5% or more of the outstanding Common Stock have been excluded from this computation in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

 

As of March 14, 2002, the Registrant had outstanding 26,975,486 shares of Common Stock.

 

INDEX

 

DSP GROUP, INC.

 

			Page No.
PART I
Item 1.	BUSINESS		3
Item 2.	PROPERTIES		28
Item 3.	LEGAL PROCEEDINGS.		28
Item 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS		28
PART II
Item 5.	MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS		29
Item 6.	SELECTED FINANCIAL DATA		29
Item 7.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONAL AND RESULTS OF OPERATIONS		30
Item 7A.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK		37
Item 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA		38
Item 9.	CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE		72
PART III
Item 10.	DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT		73
Item 11.	EXECUTIVE COMPENSATION		75
Item 12.	SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT		85
Item 13.	CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS		87
PART IV
Item 14.	EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K		89
	SIGNATURES		96

 

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This Annual Report on Form 10-K contains certain forward-looking statements that are based on the beliefs of, and estimates made by and information currently available to, DSP Group’s management.  The words “expect,” “anticipate,” “intend,” “plan” and similar expressions identify forward-looking statements.  These statements are subject to risks and  uncertainties.  Actual results could differ materially from those discussed here.   Factors that could cause or contribute to such differences include, but are not limited to, those discussed  below in “Risk Factors” and elsewhere in this Annual Report on Form 10-K.

 

This Annual Report on Form 10-K includes trademarks and registered trademarks of DSP Group.  Products or service names of other companies mentioned in this Annual Report on Form 10-K may be trademarks or registered trademarks of their respective owners.

 

PART I

 

Item 1.  BUSINESS.

 

Introduction

 

DSP Group was incorporated in California in 1987 and reincorporated in Delaware in 1994.  We have two business segments.  In our product business, we design and sell integrated circuits that perform speech related functions in telephone answering machines, cordless telephones, personal computers and other products.  In our intellectual property licensing segment we develop and license proprietary digital signal processing (DSP) algorithms or speech related, software-based microprocessor cores that we license to semiconductor companies and original equipment manufacturers (OEMs).  See note 5 of the attached Note to the Consolidated Financial Statements for the year ended December 31, 2001 for a description of the revenues, gross margin and assets of each of these two segments.

 

In January 2000, we announced that we intended to separate our two segments into two companies and, subject to obtaining a favorable revenue ruling from the IRS, market conditions and other factors, expected that we would sell a portion of the intellectual property licensing subsidiary to the public and distribute the remaining shares to our stockholders.  The requisite revenue ruling was issued on September 26, 2001. Due to the recent capital market conditions, the intended public offering of our intellectual property licensing business had been deferred.

 

On March 15, 2002, we confirmed that we were in preliminary discussions regarding a potential combination of its intellectual property licensing business with the business of Parthus Technologies plc, an Irish public company listed on the London Stock Exchange with American Depository Shares traded on the Nasdaq National Market.

 

This Form 10-K, in particular the description of our business, the risk factors we face, and the forward-looking statements in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” are based on the assumption that our intellectual property licensing business segment and our products business segment will continue to be part of a single business.  If these two business segments are separated, each will be subject to its own risks and uncertainties, some of which may be material to that segment but not to the

 

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combined enterprise and some of which may relate to one segment but not to the other.  We intend to make appropriate revisions to the description of our business and our published financial information if such a separation occurs.

 

General Business

 

DSP Group develops and markets products and technologies that perform digital signal processing — the electronic manipulation of digitized speech and other digital signals.  Our products are used in a wide variety of telecom applications.

 

Digital signal processing based solutions are more cost effective and provide a broader range of features than analog based solutions.  Many applications, including digital cellular and wireless communications, broadband modems, Voice over the Internet and digital audio/video, all use digital signal processing techniques extensively.

 

Our work in the field of digital signal processing has yielded four synergetic product families:

 

•      Digital Signal Processor  (DSP) Cores.  A  family of programmable digital signal processors that, when combined with other hardware elements such as memory and input/output devices, forms a software enabled chip that is  targeted for specific applications.

 

•      Integrated Digital Telephony (IDT).  A family of chips comprised of the following:

 

Speech and Telephony.  A highly integrated DSP core based chip that handles telephony functions and advanced speech algorithms targeted for the telephony market.

 

Cordless Telephony.  A 900 megahertz / 2.4 gigahertz digital spread spectrum chip set.  The chip set is composed of a RF transceiver and a highly integrated DSP based chip.  The DSP based chip combines three main functions into one chip: the wireless base band modem, speech processing and telephony functions.

 

•                      Voice Over Packet.  A DSP based, highly integrated speech processor targeted for the low to medium density Integrated Accesses Device (IAD), residential gateway and IP telephony markets.

 

•                        TrueSpeech®.  A family of proprietary speech compression algorithms.

 

DSP-Based Speech and Telephony Processors

 

DSP Group has developed two lines of speech and telephony processing chips: integrated digital telephony processors, which are designed for use in the consumer telephone market; and Voice over IP (VoIP) speech co-processors, which are designed for use in network telephony and video conferencing products.  Both product lines are based upon our DSP core designs and incorporate our TrueSpeech speech compression algorithms.

 

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Integrated Digital Telephony Speech Processors

 

Our integrated digital telephony (IDT) speech processors are currently incorporated in more than 120 models of featured phones.  These models are being sold in Europe, Japan, Australia and the United States.

 

Our IDT speech processors are based on our PineDSPCore® and TeakLite DSPCore®, which are more fully described below.  Our integrated digital telephony speech processors use our TrueSpeech speech compression technology to provide high quality speech recording and playback.  They incorporate the following speech and telephony technologies in various combinations:

 

Technology		Description
Triple Rate Coder™		Instructs the telephone answering system to decide automatically between better voice quality and longer recording time.
True Full-Duplex SpeakerPhone™		Allows simultaneous two-way (full-duplex), hand free operation of the telephone and suppresses and cancels acoustic and electrical echoes.
G.723.1		Provides speech compression for Voice over IP and video conferencing over standard telephone lines.
Caller ID and Call Waiting Caller ID		Identifies to the party being called the telephone number of the calling party, whether or not the party being called is already engaged in another call.
Call Progress Tone Detection		Detects standard telephony signals during the progress of a telephone call.
DTMF Signaling		Detects and generates touch tone (DTMF) signals that comply with telephone industry frequency standards.
Speech Prompts		Provides the ability to stamp a message with a time and date and vocal operating instructions prompts.
Variable Speed Playback (FlexiSpeech®)		Permits playback of recorded speech at different speeds without distorting the natural sound of the speech.
Voice Operated Switch (VOX) (Smart-Vox®)		Detects human speech and stops recording during periods of silence, thereby conserving available memory.
Alpha Least Cost Routing (LCR)/Super LCR		Automatically chooses from a number of telephone service providers in order to select the lowest available rates.
Voice Recognition		Allows a user to operate a telephone or answering machine device by giving voice commands.

 

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We introduced the first integrated digital telephony speech processors in 1989.  Since then, we have shipped approximately 97 million units of speech processors and RF devices to original equipment manufacturers (OEMs), of which approximately 30 million were shipped in 2001.  Our IDT speech and RF processor and RF sales accounted for approximately 73% of our total revenues in 2001.

 

In 1999, we started the shipment of the D16000 family of fully integrated speech processors, which combines the components of a mixed signal system on a single chip.  Each speech processor in the D16000 family contains a DSP core, converters that transform analog signals into digital signals and vice versa, and various signal amplifiers, all embedded on a single chip.  In addition to implementing DSP algorithms, including data compression, caller ID and full-duplex speaker phone, these speech processors also perform tasks that would typically be handled by a separate central processing unit (CPU) chip.  Our goal was for the D16000 processors to provide high value to telephony product vendors by eliminating the need for almost any other electronic components and thus reducing materials and manufacturing costs.

 

In 2000, we developed the D36000 family of fully integrated speech processors based on our TeakLite Core, which can support two line telephony as well as cordless base band modems with low power usage.  This product, which entered into mass production in the second quarter of 2001, has so far been accepted very well in the market as an upgrade for D16000 family for cordless and corded feature telephony standard.

 

The following table presents the main features of the primary IDT speech processors that we currently offer:

 

DSP Group’s IDT Speech Processors

 

		D36569		D16559		D6571		D6587
Process Geometry (microns)		0.25		0.45		0.5		0.5
Minutes Record, 4 Mbit Memory		22-25, 10,15		22-25, 10,15		22-25, 10,15		22-25, 10,15
Memory Type		Flash		Flash		Flash		Flash
DSP Core:		TeakLite		Pine		Pine		Pine
Advanced Features:
Speech Prompts		Yes		Yes		Yes		Yes
Variable Speed Playback		Yes		Yes		Yes		Yes
Full Duplex Speakerphone		Yes		Yes		Yes		Yes
Caller ID & Call Waiting Caller ID		Yes		Yes		Yes		Yes
Voice Recognition		—		—		—		Yes
System On Chip-Included Peripherals:
Microcontroller		Yes		Yes		—		—
Line Codec		Yes		Yes		—		—
Speaker Codec		Yes		Yes		—		—
Amplifiers		Yes		Yes		—		—

 

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             Cordless Telephony

 

In the beginning of 1999, we acquired two integrated groups of engineers, one located in Israel and the other in the United States.  These twenty-five engineers specialize in the design of integrated circuits for wireless communications.  In addition, we acquired technology and products, including associated intellectual property, related to 900 megahertz narrow-band cordless telephones (the transmissions between the handset and base unit of these telephones are at or near a frequency of 900 megahertz) and 900 megahertz spread spectrum cordless telephones (the transmissions between the handset and base unit of these telephones are “spread” in a pseudo-random pattern over a range of frequencies).

 

In 2000, in anticipation of limited growth in the U.S. 900 MHz spread spectrum market, we initiated the development of a new line of cordless products to address this changing market trend.

 

In 2001, we entered into mass production of 900MHz cordless chip set.  The chip-set includes a D36000 fully featured telephony and baseband device and an integrated RF device.  During this year, we completed the design for our advanced chip set for 2.4 Ghz single handsets and multi-handsets for the US market.  During 2001, we also developed an integrated RF CMOS device which is an important part of the development efforts to integrate the telephony feature, communication modem and RF device into an integrated POC™ (Phone on a Chip).

 

The following table presents the main features of the cordless chipsets that we currently offer:

 

DSP Group’s IDT Cordless Speech Processors

 

		900MHz DSS		900MHz Digital		2.4GHz SH Ditigal		2.4Ghz EDCT Ditigal
Process Geometry baseband (microns)		0.35		0.25		0.25		0.25
RF Process		Bipolar		Bipolar		CMOS		CMOS
Advanced Features:
Digital Answering Machine		No		Yes		Yes		Yes
Full Duplex Speakerphone		No		Yes		Yes		Yes
Caller ID & Call Waiting Caller ID		No		Yes		Yes		Yes
System On Chip-Included Peripherals:
Line Codec		Yes		Yes		Yes		Yes
Speaker Codec		No		Yes		Yes		Yes
Amplifiers		Yes		Yes		Yes		Yes
Multihandset Capability		No		No		No		Yes

 

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Voice over Packet Speech Co-Processors

 

Our Voice over Packet (VoIP, VoDSL) speech co-processors were developed for use in conjunction with other microprocessors to transmit voice-over-packet-based public and private networks, including the Internet, local area networks (LANs), frame relay networks, xDSL links, cable networks and other data networks and combined data/voice networks.  “Voice over IP” refers to the transmission of voice signals over networks using the Internet Protocol (IP), which involves dividing the signals into numerous small data packets that are individually transmitted over a network and re-assembled in the correct order at their destination.  This technology can also be used to implement the speech component of video conferencing applications.

 

We have developed a family of TrueSpeech co-processors that integrate the various versions of TrueSpeech with important telephony capabilities.  This product line is known as the CT8000 TrueSpeech Co-processor family.

 

In March 2000, we acquired approximately 73% of VoicePump, Inc., a company which specializes in speech coding and telecom algorithms for VoIP, VoDSL and other voice-over-packet applications developed for voice gateway, customer-oriented equipment manufacturers and broadband network providers.  In March 2001, we exercised our option to acquire the remaining founders’ shares of VoicePump, which is now one of our wholly-owned subsidiaries.

 

In 2001 VoicePump launched its first products in the VP100 family.  The VP100 family of products is based on DSP Group TeakLite core processor, which includes an integrated set of peripherals optimized for VoDSL Integrated Access Device (IADs), VoIP and other packet voice applications.  VoicePump plans to offer its current and future product lines as low cost efficient applications for both VoDSL and VoIP solutions.

 

We anticipate that VoicePump’s speech co-processors will take advantage of the G.723.1, a speech compression algorithm that has been incorporated into various international communications standards, which is more fully discussed below, to provide cost-effective, high quality speech compression.  The following table sets forth other features of the VoIP speech co–processors that we currently offer:

 

DSP Group’s Voice over Packet Speech Co-Processors

 

		CT8022		VP110		VP120		VP140
Number of channels supported simultaneously		1		1		2		4
DSP Core		Oak		TeakLite		TeakLite		TeakLite
Process Geometry (microns)		0.5		0.25		0.25		0.25
ITU-T Standard Speech Coders		G.723.1, G.729AB		G.726, G.723.1, G.729AB		G.726, G.723.1, G.729AB		G.726, G.723.1, G.729AB
Analog Front-End Integrated		—		Yes		Yes		Yes
Features:
Full Duplex Speakerphone		Yes		Yes		Yes		Yes
Variable Speed Message Playback		—		—		—		—
Full Duplex DSVD		Yes		Yes		Yes		Yes
Video Conferencing		Yes		Yes		Yes		Yes
Internet Telephony		Yes		Yes		Yes		Yes
Line Echo Cancellation G168		No		Yes		Yes		Yes

 

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The following is a list of manufacturers and resellers whose products incorporate our devices:

 

VoIP, IDT & Cordless Manufacturers and Resellers

 

 

DSP Cores

 

We have developed proprietary, programmable DSP core architectures and designs that provide low-power, high performance, cost-effective solutions for current and emerging digital signal processing applications.  Our DSP cores are incorporated in our own family of speech and telephony, cordless, voice over packet and telephony processors and also are licensed to more than 60 entities, including Adaptec, Atmel, DSP Communications (now a subsidiary of Intel), Fujitsu, Kawasaki, LSI Logic, Marvell, Mobilink, NEC, Oki, Prairiecomm, Seiko Epson, Samsung, Siemens/Infinion, Sony, Tower Semiconductors, Zoran and Philips.

 

Our SmartCoresä family is currently composed of five generations of fixed-point DSPs: PineDSPCore®; OakDSPCore®; TeakLite®; Teak®; and PalmDSPCore®.  By offering a range

 

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of performance, price and power consumption balances, our cores family addresses a wide range of applications, from low-end, high-volume applications, such as digital answering machines, hard disk controllers, low speed modems and VoIP terminals, to high performance applications such as third generation (3G) cellular communication devices, broadband modems, consumer multimedia and VoIP gateways.

 

Our DSP core designs are currently licensed to a wide variety of licensees under more than 60 license agreements, including leading semiconductor companies such as Atmel, Fujitsu, Infineon, Intel, Kawasaki, LSI Logic, Mitsubishi, National Semiconductor, NEC, Oki, Philips, Samsung, Seiko-Epson and Sony.

 

We believe the following to be the key benefits of our solution:

 

•                  Low Power Consumption.  Our cores have been designed to satisfy low power consumption requirements.  This is key as applications within the embedded DSP Group market either rely on batteries, such as cell phones and portable audio products, or are sensitive to power dissipation as in the case of telecommunications equipment (DSLAM or multi-channel voice gateways).

 

•                  Low Cost.  Our technology is designed to address the cost requirements for high volume, highly-competitive applications.  Reduction of chip cost is achieved by reducing the overall physical size of the chip.  Our technology contributes to this reduction by reducing the size of the programmable DSP core through careful selection of functions and mechanisms to be included within the core.  We also reduce chip size by minimizing the memory size used for running a specific application.  Through our DSP algorithms, we offer instruction sets suited for targeted applications and encode the instructions in a very condensed form.  The instruction code density factor has recently gained more significance, as the emerging applications in our markets are using more and more memory.

 

•                  Flexibility.  Our architecture allows our licensees to differentiate their products while still taking advantage of the benefits of our “open architecture” designs.  We license our technology as a “soft core,” allowing each of our semiconductor licensees or system OEMs to take advantage of their respective manufacturing strengths.  In addition, our architecture has flexible memory size, which enables our licensees to tailor their chip to include the specific memory size required for a targeted application.

 

•                  Programmable Solution.  Our intellectual property allows our licensees to develop software-based, application-specific chips as opposed to a hard-wired implementation.  A programmable solution allows our licensees to use the same IC design for several generations or variations of products, implementing these differentiations through software, thus shortening the time to market and reducing engineering costs.  Additionally, a programmable solution allows for “field upgrades” of the chips, where software can be replaced through remote down-loading rather than through replacing the chip.

 

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•                  Improving Customers Time to Market.  A typical design cycle for a semiconductor company can be lengthy and painful.  Our technology shortens this design cycle and improves our customers overall time to market by addressing two of the main time-consuming stages of the design cycle: the process of porting the core design to physical hardware layout; and by providing ready-made software development environments for designing the software used in our core designs.

 

•                  Broad Product Line of DSP Cores and DSP Based Solution Set.  We have developed five generations of programmable DSP cores, which were designed to meet the performance, power consumption and cost requirements of various applications within the embedded DSP market.  We intend to continue to enhance our DSP cores and design new cores to meet future market demands.  Our family of cores offers broad selection of different price performance points, although each is designed for low power consumption, thereby enabling the crafting of optimal balance of performance, cost and power efficiency.  In addition, our latest DSP cores, the Teak and the PalmDSPCore, use advanced techniques of instruction level parallelism - Single Instruction Multiple Data (SIMD) and Multiple Instruction Multiple Date (MIMD), thereby enabling our cores to be embedded in high-performance applications such as telecommunications equipment (Multi-Channel Voice Gateways, DSLAM) and third generation smartphones.  During year 2001, we enhanced our offering with DSP based solution which incorporates, in addition to the DSP core, application specific software and hardware.  So far, our solution offering include the VoPKey, a customer premise/enterprise VoIP solution, and DSCKey for digital still camera market.

 

•                  Soft Core / Foundry Neutral.  Our cores are “soft cores,” which means that they include a complete software-based description of the circuits as well as simulation and verification data. This allows the licensee to create diversified versions of their embedded intellectual property solutions through the selection of different physical library vendors or silicon suppliers and allows our cores to be easily integrated across multiple semiconductor manufacturing processes with different geometry technologies.  This manufacturing independence enables our customers to select any foundry vendor or semiconductor process to manufacture their designs.

 

•                  Open Architecture.  Our SmartCore architecture is offered to a broad range of SoC manufacturers that provide solutions for system OEMs and has been adopted by leading worldwide semiconductor companies.  Our architecture has been adopted by several different categories of companies that play a role in the design of advanced DSP-based systems.  As a result, the system OEMs who are the consumers of our intellectual property enjoy the ability to choose multiple suppliers offering solutions based on our technology, and can leverage their buying power.

 

•                  Responsiveness to Our Customers Needs.  We have accumulated experience in supporting and assisting customers to get into production in the fastest way.  We train our licensees, provide them with detailed application notes, design examples and software libraries for their use in the design process.  We continue to be responsive to

 

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our customer needs and implement changes to our solutions for the benefit of our licensees.  Our development and support teams consist of experienced and highly-skilled engineers who enable us to provide a broad range of services and design aids.

 

•                  Technology Partner Network.  We have established a network of independent third parties that provide services and technologies complementary to ours, including leading service companies such as Tality, EDA vendors such as Mentor, Synopsis and Cadence, Real Time Operating Systems (RTOS) vendors such as CMX, multi-core debugger vendors such as Allant (a subsidiary of ARM Holding) and DSP software companies such as MEICOM, Espico and  Ensigma.  We believe that these third party partners offer existing and potential users of our technologies value-added solutions and help to establish our cores as an industry standard.

 

•                  Tightly Coupled Development Tools and Architecture.  We believe that it is a great benefit for our licensees that we provide them with both the DSP cores and the related software development and hardware emulation tools to assist in product development.  The close relationship between the DSP core architectures and the design development tools results in a design environment composed of optimized, code-efficient compilers as well as efficient and accurate hardware emulation prototypes, which we believe our customers prefer.

 

With each new core we have developed, we have added features and enhanced overall performance.  Our first core, the PineDSPCore, was released in 1992 and was developed for use in our IDT product line.  It also gained success in other DSP applications, such as hard disk drive applications, and VoIP phones.  In 1994, we introduced our OakDSPCore, an enhanced version of the PineDSPCore that, among other things, achieves a higher processing speed through improved architecture and includes an advanced, more efficient instruction set.  The OakDSPCore is especially well-suited for use in digital cellular phones, conventional modems, IP phones and portable audio.  Algorithms that use the PineDSPCore instruction set also can be run on the OakDSPCore.

 

In 1999, we introduced the TeakDSPCore.  The TeakDSPCore is a family of two low power, low-cost cores: the TeakLiteÔ and the Teak^Ò.  These cores incorporated two new methodologies known as “soft core” and “synthesizable core” which significantly simplifies and shortens the process of porting the design technology to the licensee’s manufacturing process and technologies.  The TeakLite takes advantage of the wide adoption of the OakDSPCore and offers the advantages of lower power and higher operating speeds over its predecessor.  The Teak offers, in addition to the TeakLite benefits, two (as opposed to one) arithmetic units functioning in parallel (Dual MAC), which improves the performance of a notable portion of the DSP application.  The TeakDSPCore family is aimed at emerging applications in the digital cellular communications, including products implementing the Global System for Mobile communications (GSM), half-rate GSM, Time Division Multiple Access (TDMA) and Code Division Multiple Access (CDMA) standards.  We also have targeted these cores for products implementing emerging digital audio standards and formats such as AC3 and MP3, as well as for VoIP gateways.

 

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In 1999, we also introduced the first version of our high performance PalmDSPCore.  The PalmDSPCore is a family of three cores, with each core version intended for a different market segment.  These cores are intended for a wide range of high performance applications, including third generation cellular communications, digital subscriber lines (DSL), VoIP gateways and consumer multimedia.  The following table sets forth the primary features of each of our SmartCores products:

 

DSP Group’s Core Designs

 

		PineDSPCore		OakDSP Core		TeakLite		Teak		PalmDSPCore
Data Word Length		16 bit		16 bit		16 bit		16 bit		16/20/24 bit
Design Methodology		Hard		Hard		Soft		Soft		Soft
Architecture		Single MAC		Single MAC		Single MAC		Dual MAC		Dual MAC & Instruction Level Parallelism
Program Address Space		64Kwords		64K words		64Kwords		4M words		16Mwords
Program Word Size		16 bit		16 bits		16 bit		16 bit		16/32 bit

 

In addition to incorporating our DSP core designs in our speech and telephony processors, we also license them to third parties together with our advanced software development tools, so that these licensees can incorporate our DSP core designs into their semiconductor chip products.  These licenses are generally granted in exchange for a license fee payment, a support fee and a royalty.  The license fee is generally recognized when persuasive evidence of an agreement exists, delivery has occurred, the fee is fixed on determinable and collectability is probable.  The monthly support fee is typically paid in advance for a period of one or two years, and is recognized during that period.  Ongoing per-unit royalties are based on the number of units of products containing the core that are shipped by the licensee and are recognized as they are reported to us by these licensees.  Nonrefundable payment on account of future royalties are recognized upon receipt of the payment, provided no future obligation exists.  The timing and amount of royalties that we receive from our core licensees depends on the timing of each licensee’s product development and the degree of market acceptance of each licensee’s products, neither of which are within our control.  In 2001, 16 licensees shipped products utilizing our cores, an increase over the previous year.

 

The following is a partial list of companies who have licensed our DSP core designs and representative applications for which they use our DSP core designs:

 

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DSP Core Design Licenses

 

Licensees		Representative Applications
Adaptec		Disk Drives
Atmel		ASIC, Communications
DSP Communications (a subsidiary of Intel)		Cellular Telephones
Fujitsu		ASIC, ADSL, Communications
Infineon		Cellular Communications;
Kawasaki		3G Cellular, ASIC
Kenwood		Audio Products
Legerity		Communications
LSI Logic		ASIC, DAB, Servo, Cellular
Marvell		Data Storage
Mitel		ASIC, Cellular, VoIP
Mitsubishi		Cellular
Mobilink		Cellular
National Semiconductor		Cellular
NEC		ASIC, Communications
Oki		3G Cellular, Modems, VoIP
PrairieComm		3G cellular
Philips Semiconductors		ASIC, Communications, Audio, Wireless
ROHM		ASIC, Cellular
Samsung		ASIC, Cellular and Multimedia, Data Storage
Seiko-Epson		ASIC, Communications
Sony		PDA, Audio, Servo
ST Microelectronics		Disk Drives
TDK Semiconductor		Modems
Tower		Foundry
Tioga		ADSL
Xemics		Low Voltage Applications
Zoran		Digital Still Camera

 

In 2001 the number of our core licensees increased as a result of several contracts signed for our DSPCores products.  During 2001, our licensees came out with solutions for the emerging markets of:  3G cellular in Japan, PDAs, wireless enabled PDAs and digital still cameras.  During 2001, we were also able to license our technology to companies that are specifically targeting the China market, which has the potential to be the largest market in terms of the number of cellular subscribers.

 

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TrueSpeech Products

 

TrueSpeech is a family of high-quality, cost-effective speech compression technologies based on complex mathematical algorithms that are derived from the way airflow from the lungs is shaped by the throat, mouth and tongue during speech.  This shaping of bursts of air is what the ear interprets as speech.  TrueSpeech converts these sounds into digital data and then selectively eliminates and enhances certain sound data to replicate human speech.

 

Originally developed for consumer telephone applications, we have also enhanced our TrueSpeech products for use in the computer telephony and VoIP markets.  We have both incorporated our TrueSpeech technology into our speech and telephony processors, as well as offer licenses of our TrueSpeech technology to computer telephony, personal computer and VoIP companies for inclusion in their products.

 

Our TrueSpeech technology has become one of the leading digital speech compression solutions in several markets.  In the personal computer market, Microsoft has incorporated one of our TrueSpeech algorithms in its Windows 95, Windows 98 and NT products.  In February 1995, the International Telecommunications Union established its G.723.1 standard for low bit rate speech compression, which incorporates the TrueSpeech 6.3 and 5.3 algorithms.  In March 1997, the International Multimedia Teleconferencing Consortium, a nonprofit industry group, recommended the G.723.1 standard as a default low bit rate audio compression technology for all voice transmissions over the Internet and for conferencing products conforming to the International Telecommunication Union’s H.323 standard for packet-based multimedia communication systems.  G.723.1 is also part of the International Telecommunication Union’s H.324 standard for video conferencing over standard telephone lines.  Since its adoption and endorsement by the International Telecommunications Union and the International Multimedia Teleconferencing Consortium, the G.723.1 standard has gained considerable momentum in the video and audio conferencing industry.

 

We believe that the principal advantages of TrueSpeech, as compared with other currently available digital speech compression technologies, are as follows:

 

•                  Industry Acceptance and Field Proven.  As described above, a TrueSpeech algorithm, the G.723.1, was adopted as a standard by the International Telecommunications Union and was recommended as the a default speech algorithm for VoIP by the International Multimedia Teleconferencing Consortium.  This encourages broad usage of the algorithm, especially in VoIP and video conferencing applications.

 

•                  High Quality Speech.  Another advantage of TrueSpeech is that it reproduces high quality speech playback with minimum distortion by selectively eliminating nonessential and background sound data without significant loss of speech quality.  Our TrueSpeech technology has received high scores for speech quality from a number of independent evaluators.  For example, TrueSpeech scored the highest on the ITU’s test used to numerically rate the quality of the five competing speech compression algorithms submitted for adoption as the G.723.1 standard for video telephones.  In independently conducted tests performed by Dynastat, Inc., a company

 

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specializing in the performance evaluation of voice communication systems, TrueSpeech 6.3 received a mean opinion score of 3.98, where the standard of regular telephone quality was assigned a mean opinion score of 4.0.

 

•                  Cost Effectiveness.  TrueSpeech’s ability to achieve high speech compression with lower computational complexity provides it with a competitive cost advantage.  For example, competing speech compression algorithms evaluated by the ITU use 20% to 50% more computing power for the same compression and transmission rates, and require more memory for storage and operation.  Consequently, these competing speech compression algorithms require larger, more expensive DSPs and result in higher cost solutions than those based on our technologies.

 

Our TrueSpeech licensees include, among others, Analog Devices, Cirrus Logic, Creative Labs, Dialogic, IBM, Intel, Microsoft, Philips, Siemens/Infinion, Smith Micro, Texas Instruments, Unisys, US Robotics, Winbond and White Pine Software.  In addition, we have ported our TrueSpeech algorithms to certain DSP platforms offered by Analog Devices, Motorola and Texas Instruments, three leading merchant vendors of programmable DSP chips.

 

Sales, Marketing and Distribution

 

We market and distribute our products through our direct sales and marketing organization, as well as through a network of distributors and independent manufacturers’ representatives.  A marketing and sales team located in our headquarters in Santa Clara, California and in Israel pursues business with our customers in North America and closely monitors new markets, trends and customer needs to shape our strategic decisions.  In Japan, we operate from a marketing and support office in Tokyo and through Tomen Electronics, a local distributor.  In September 2000, we invested approximately $485,000 in Tomen’s parent company.  For more information, see Note 2 to the attached Notes to Consolidated Financial Statements for the year ended December 31, 2001.  In the rest of Asia, we operate through sales representatives in Hong Kong, India, South Korea and Taiwan.  To handle sales and distribution in Europe, we operate a marketing and support office located in France and have sales representatives in Denmark, Germany, Sweden and the United Kingdom.  Our sales representatives and distributors are not subject to minimum purchase requirements and can cease marketing our products at any time.  The loss of one or more representatives or their failure to renew agreements with us upon expiration could harm our business, financial condition and results of operations.

 

Sales to Tomen Electronics comprised 56% of our total revenues in 2001, 52% in 2000 and 47% in 1999.  Export sales accounted for 89% of our total revenues in 2001, 86% in 2000 and 97% in 1999.  Due to our export sales, we are subject to the risks of conducting business internationally, including unexpected changes in regulatory requirements, fluctuations in exchange rates that could increase the price of our products in foreign markets, delays resulting from difficulty in obtaining export licenses for certain technology, tariffs, other barriers and restrictions and the burden of complying with a variety of foreign laws.  All of our sales to foreign entities are denominated in United States dollars.  See Note 5, of the attached Notes to

 

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Consolidated Financial Statements for the year ended December 31, 2001, for a summary of our operations within various geographic areas.

 

Manufacturing and Design Methodology

 

Since our products are based on our proprietary DSP core designs, which are not dependent upon a particular foundry’s library cells, these products can be manufactured at a number of independent foundries. Accordingly, all of our manufacturing occurs at independent foundries.  We contract fabrication services for speech and telephony processors from Taiwan Semiconductor Manufacturing Company, Sony and UMC.  Under non-exclusive agreements, these independent foundries normally provide us with either finished, packaged and tested speech processors at variable prices depending on the volume of units purchased or as sorted good wafers.  We customarily pay for fully-tested products meeting predetermined specifications.  To ensure the integrity of their quality assurance procedures, we develop detailed testing procedures and specifications for each product and require each foundry to use these procedures and specifications before shipping us finished products.

 

We intend to continue to use independent foundries to manufacture digital speech processors, cordless devices and other products for the consumer telephone and computer telephony markets.  To obtain an adequate supply of finished wafers in the future, we are producing most of our materials in various alternative production fabs.  Our reliance on independent foundries involves a number of risks, including the foundries’ ability to achieve acceptable manufacturing yields and their allocation of sufficient capacity to us to meet our needs.  In addition, foundries in Taiwan produce a significant portion of our wafer supply.  As a result, earthquakes, aftershocks or other natural disasters in Asia could preclude us from obtaining an adequate supply of wafers to fill customer orders and could harm our business, financial condition, and results of operations.

 

In addition to our speech processors, our IDT speech processor products require an external component in the finished product to provide Analog Random Access Memory circuits (ARAMs) and flash memory that are supplied by third party manufacturers.  Temporary fluctuations in the pricing and availability of these components could negatively impact sales of our IDT speech processors, which could in turn harm our business, financial condition and results of operations.

 

Competition

 

The markets in which we operate are extremely competitive and we expect that competition will increase in the future.  In each of our business activities, we face current and potential competition from competitors that have significantly greater financial, technical, manufacturing, marketing, sales and distribution resources and management expertise than we do.  Our future prospects will depend greatly on our ability to successfully develop and introduce new products that are responsive to market needs.  We cannot assure you that we will be able to successfully develop or market any of these products.

 

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The principal competitive factors in the cordless telephony market include price, system integration level, range, customer support and the timing of product introductions by us and our competitors.  We believe that we are competitive with respect to most of these factors.  Our principal competitors in the cordless market include National Semiconductor, Philips and Siemens/Infinion.

 

The principal competitive factors in the Voice over Packet market include price, system integration level, customer support and the timing of product introductions by us and our competitors.  We believe that we are competitive with respect to most of these factors.  Our principal competitors in the Voice over Packet market include TI/Telogy, Virata, AudioCodes and Ishoni.

 

The principal competitive factors in the DSP core designs market for high volume, low cost applications include such features as small size, low power, flexible I/O blocks and associated development tools.  Our DSP core designs compete with companies such as 3DSP, BOPS, LSI Logic and Siemens/Infinion, which license DSP cores, and companies such as Analog Devices, Agere, Motorola, and Texas Instruments, which sell their own complete general purpose DSP or application specific DSP solutions.

 

Several digital speech compression technologies exist and are currently being developed that may be promoted by our competitors as industry standards for the computer telephony and personal computer markets.  Our TrueSpeech algorithms compete with other proprietary speech algorithms like the RealAudio and the speech compression standards such G.729A/B and AMR. each of which is available for licensing or public domain.  There are many versions of these algorithms that have been developed by different parties, including AT&T, which has been actively involved in the development of GSM speech compression, and Motorola, which developed the original VSELP algorithm.  Although TrueSpeech has achieved a degree of acceptance in the computer telephony, personal computer and VoIP markets, ADPCM and the speech compression technologies for the GSM and VSELP protocols are widely used in the development and implementation of new products in the telephony industry.  In addition, other advanced speech compression algorithms have been introduced by competitors that offer compression ratios comparable to or higher than the TrueSpeech algorithms.  In addition, large companies, such as AT&T, Creative Labs, Motorola and Lucent, have speech processing technologies that can be applied to speech compression for use in the same markets for which our products are targeted.

 

Price competition in the markets in which we currently compete and propose to compete is intense and may increase, which could harm our business, financial condition and results of operations.  We have experienced and expect to continue to experience increased competitive pricing pressures for our IDT processors.  We were able to partially offset price reductions which occurred during 2001 through manufacturing cost reductions, by achieving a higher level of integration in our products and by combining other functions, which used to be parts of separate chips, into our DSP Group chips.  However, we cannot assure you that we will be able to further reduce production costs, or be able to compete successfully with respect to price or any other key competitive factors in the future.

 

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Research and Development

 

We believe that the continued timely development and introduction of new products is essential to maintain our competitive position.  We currently conduct most of our product development at our facilities.  At December 31, 2001, we had a staff of 130 research and development personnel, of which 106 were located in Israel.  We also employ independent contractors to assist with certain product development and testing activities.  We spent approximately $26.2 million in 2001, $20.9 million in 2000 and $15.4 million in 1999, on research and development activities.

 

Licenses, Patents and Trademarks

 

We have been granted eighteen United States patents, one Canadian patent, one European patent and four Japanese patents, and have forty-five patents pending in the United States,  four patents pending in Japan, one patent pending in Taiwan, sixteen patents pending in Israel, four patents pending in Korea and four patent pending in Europe.  We actively pursue foreign patent protection in other countries of interest to us.  Our policy is to apply for patents or for other appropriate statutory protection when we develop valuable new or improved technology.  The status of any patent involves complex legal and factual questions, and the breadth of claims allowed is uncertain.  Accordingly, we cannot assure you that any patent application filed by us will result in a patent being issued, or that our patents, and any patents that may be issued in the future, will afford adequate protection against competitors with similar technology; nor can we provide assurance that patents issued to us will not be infringed or designed around by others.  In addition, the laws of certain countries in which our products are or may be developed, manufactured or sold, including Hong Kong, Japan and Taiwan, may not protect our products and intellectual property rights to the same extent as the laws of the United States.

 

We attempt to protect our trade secrets and other proprietary information through agreements with our customers, suppliers, employees and consultants, and through other security measures.  Although we intend to protect our rights vigorously, we cannot assure you that these measures will be successful.

 

The semiconductor and software industries are subject to frequent litigation regarding patent and other intellectual property rights.  While we have not been involved in any material patent or other intellectual property rights litigation to date, we cannot provide assurance that third parties will not assert claims against us with respect to existing or future products or that we will not need to assert claims against third parties to protect our proprietary technology.  For example, AT&T has asserted in the past that G.723.1, which is primarily composed of our TrueSpeech algorithm, includes certain elements covered by a patent held by AT&T.  AT&T has requested that video conferencing equipment manufacturers license this technology from AT&T and has sued Microsoft, one of our TrueSpeech licensees, for infringement.  We have not been named in AT&T’s suit against Microsoft.  If litigation becomes necessary to determine the validity of any third party claims or to protect our proprietary technology, it could result in significant expense to us and could divert the efforts of our technical and management personnel, whether or not the litigation is determined in our favor.  In the event of an adverse result in any litigation, we could be required to expend significant resources to develop non-infringing

 

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technology or to obtain licenses to the technology that is the subject of the litigation. We cannot provide assurance that we would be successful in developing non-infringing technology or that any licenses would be available on commercially reasonable terms.

 

We have been issued registered trademarks for the use of the PineDSPCore, Pine assyst simulatorm, Pine, OakDSPCore, TeakDSPCore, Teak, PalmDSPCore, OCEM, TrueSpeech, Full Duplex SpeakerPhone, TeakLite, Triple Rate Coder and Flexispeech trademarks.  In addition, we applied for trademarks for PalmAssyst, Assyst, SmartCores, Phone-on-a-Chip and Total Telephony Solution.

 

While our ability to compete may be affected by our ability to protect our intellectual property, we believe that because of the rapid pace of technological change in our industry, our technical expertise and ability to innovate on a timely basis will be more important in maintaining our competitive position than protection of our intellectual property.  In addition, we believe that because of the rapid pace of technological change in the consumer telephone, computer telephony and personal computer industries, patents and trade secret protection are important but must be supported by other factors, including the expanding knowledge, ability and experience of our personnel, new product introductions and frequent product enhancements.  Although we continue to implement protective measures and intend to defend our intellectual property rights, we cannot assure you that these measures will be successful.

 

Backlog

 

At December 31, 2001, our backlog was approximately $21.5 million compared with approximately $36.2 million at December 31, 2000.  We include in our backlog all accepted product purchase orders with respect to which a delivery schedule has been specified for product shipment within one year and fees have been specified in executed licensing contracts.  Our business in IDT speech processors is characterized by short-term order and shipment schedules.  Product orders in our current backlog are subject to changes in delivery schedules or to cancellation at the option of the purchaser without significant penalty.  Accordingly, although useful for scheduling production, backlog as of any particular date may not be a reliable measure of our sales for any future period.

 

Employees

 

At December 31, 2001, we had 212 employees, including 130 in research and development, 31 in marketing and sales and 51 in corporate and administration and manufacturing coordination.  Competition for personnel in the semiconductor, software and personal computer industries in general is intense.  We believe that our future prospects will depend, in part, on our ability to continue to attract and retain highly-skilled technical, marketing and management personnel, who are in great demand.  In particular, there is a limited supply of highly-qualified engineers with digital signal processing experience.  None of our employees is represented by a collective bargaining agreement, nor have we ever experienced any work stoppage.  We believe that relations with our employees are well established.

 

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Risk Factors

 

Various discussions in this Annual Report on Form 10-K contain forward-looking statements concerning our future products, expenses, revenue, liquidity and cash needs, as well as our plans and strategies.  These forward-looking statements are based on current expectations and we assume no obligation to update this information.  Numerous factors could cause our actual results to differ significantly from the results described in these forward-looking statements, including the following risk factors.

 

Our Quarterly Operating Results May Fluctuate Significantly.  Our quarterly results of operations may vary significantly in the future for a variety of reasons, including the following:

 

•                  fluctuations in volume and timing of product orders;

 

•                  level of per-unit royalties;

 

•                  changes in demand for our products due to seasonal customer buying patterns and other factors;

 

•                  timing of new product introductions by us or our customers, licensees or competitors;

 

•                  changes in the mix of products sold by us or our competitors;

 

•                  fluctuations in the level of sales by original equipment manufacturers (OEMs) and other vendors of products incorporating our products; and

 

•                  general economic conditions, including the changing economic conditions in the United States.

 

             Each of the above factors is difficult to forecast and could harm our business, financial condition and results of operations.  Through 2002, we expect that revenues from our DSP core designs and TrueSpeech algorithms will be derived more from license fees than per unit royalties.  The uncertain timing of these license fees has caused, and may continue to cause, quarterly fluctuations in our operating results.  Our per unit royalties from licenses are dependent upon the success of our OEM licensees in introducing products utilizing our technology and the success of those OEM products in the marketplace.  Per unit royalties from TrueSpeech licensees have not been significant to date, and we do not expect them to increase significantly in the future.

 

             Furthermore, 2001 was a challenging year for the telecommunication and semiconductors industries, thereby resulting in longer sales cycles and delays in the purchase decision-making process of potential customers for our DSP Core technology.  The longer sales cycles and various delays have further resulted in limited business visibility for completion of future license agreements.  Accordingly, we may have difficulty in accurately forecasting our licensing revenues for any future quarter.

 

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Our Average Selling Prices Continue to Decline.  Sales of our IDT products consisted of 73% of our total revenues in 2001.  However, we have experienced a decrease in the average selling prices of our IDT processors, which we have to date been able to partially offset on an annual basis through manufacturing cost reductions.  However, we cannot guarantee that our on-going efforts will be successful or that they will keep pace with the anticipated, continuing decline in average selling prices of our IDT processors.

 

We Depend on the IDT Market Which is Highly Competitive.  Sales of IDT products comprise 73% of our product sales.  Any adverse change in the digital IDT market or in our ability to compete and maintain our position in that market would harm our business, financial condition and results of operations.  The IDT market and the markets for our products in general are extremely competitive and we expect that competition will only increase.  Our existing and potential competitors in each of our markets include large and emerging domestic and foreign companies, many of which have significantly greater financial, technical, manufacturing, marketing, sale and distribution resources and management expertise than we do.  It is possible that we may one day be unable to respond to increased price competition for IDT processors or other products through the introduction of new products or reduction of manufacturing costs.  This inability would have a material adverse effect on our business, financial condition and results of operations.  Likewise, any significant delays by us in developing, manufacturing or shipping new or enhanced products in this market also would have a material adverse effect on our business, financial condition and results of operations.

 

Although the 900 Mhz Digital Spread Spectrum RF and Base Band technology acquired in 1999 from Advances Micro Devices gave us a “cheap entry ticket” into this market, this technology is not state of the art and we have noticed a trend of decreasing sales for product models which are based on this technology.  In 2001, we introduced new RF and Base Band models.  However, we cannot assure you that these new other enhanced models which we are developing will be accepted by the market.

 

Despite the recent success of development and sales of our DSP Cores, our customers continue to request new technologies not currently owned by us, and we may not succeed in developing such technologies in a timely basis and in a cost-effective manner, which could affect our competitive position and results of operations.

 

We Depend on Foundries to Manufacture Our Integrated Circuit Products.  All of our integrated circuit products are manufactured by independent foundries.  While these foundries have been able to adequately meet the demands of our increasing business, we are and will continue to be dependent upon these foundries to achieve acceptable manufacturing yields, quality levels and costs, and to allocate to us a sufficient portion of their foundry capacity to meet our needs in a timely manner.  We currently do not have long-term supply contracts with any of these foundries.  Therefore, they are not obligated to perform services or supply products to us for any specific period or in any specific quantities.  To meet our increased wafer requirements, we have added additional independent foundries to manufacture our processors.  Our reputation, competitive position and revenues could be harmed should any of these foundries fail to meet our request for products due to a shortage of production capacity, process difficulties, low yield rates or financial instability.  For example, foundries in Taiwan produce a significant portion of our

 

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wafers.  As a result, earthquakes, aftershocks or other natural disasters in Asia could preclude us from obtaining an adequate supply of wafers to fill customer orders and could harm our reputation, business, financial condition, and results of operations.  Our business could also be harmed if one or more of the foundries terminates its relationship with us and we are unable to obtain satisfactory replacements to fulfill customer orders on a timely basis.

 

Furthermore, there are other significant risks associated with relying on these third-party foundries, including:

 

•         risks due to the fact that we have reduced control over production cost, delivery schedules and product quality;

 

•         less recourse if problems occur as the warranties on wafers or products supplied to us are limited; and

 

•         increased exposure to potential misappropriation of our intellectual property.

 

We May Need to Increase Our Research and Development Efforts to Remain Competitive.  The DSP Cores market is experiencing extensive efforts by some of our competitors to use new technologies to manipulate their chip designs to increase the parallel processing of the chips and/or designs they offer.  For example, one such technology used is Very Long Instruction Word (VLIW), which some of our competitors possess elements of, but which we do not possess at the present time.  If such technology continues to improve the programming processing of these chips, or if other new technologies are demanded by our customers, we may need to further our research and development to obtain such technologies or our failure to remain competitive could have an adverse effect on our results of operations.  We spent $26.2 million, or 23% of our total revenues, in 2001, on research and development and expect to continue to invest heavily in this area.  However, we cannot assure you that this or future expenditures will result in new and enhanced products or such products will be accepted in the market.

 

We Depend on International Operations.  We are dependent on sales to customers outside the United States.  We expect that international sales will continue to account for a significant portion of our net product and license sales for the foreseeable future.  For example, export sales, primarily consisting of Integrated Digital Telephony (IDT) speech processors shipped to manufacturers in Europe and Asia, including Japan, as well as license fees on DSP core designs, represented 89% of our total revenues for 2001.  As a result, the occurrence of any negative international political, economic or geographic events could result in significant revenue shortfalls.  These shortfalls could cause our business, financial condition and results of operations to be harmed.  Some of the risks of doing business internationally include:

 

•                      unexpected changes in regulatory requirements;

 

•                      fluctuations in the exchange rate for the United States dollar;

 

•                      imposition of tariffs and other barriers and restrictions;

 

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•                      burdens of complying with a variety of foreign laws;

 

•                      political and economic instability; and

 

•                      changes in diplomatic and trade relationships.

 

We Rely on a Primary Distributor and the Failure of This Distributor to Perform as Expected Could Reduce Our Future Sales and Revenues.  We sell our products to customers primarily through distributors and OEMs.  Particularly, revenues from one distributor, Tomen Electronics, accounted for 56% of our total revenues in 2001.  Our future performance will depend, in part, on this distributor to continue to successfully market and sell our products.  The loss of this distributor and our inability to obtain a satisfactory replacement in a timely manner may harm our sales and results of operations.

 

We Face Risks From Operating in Israel.   Our principal research and development facilities are located in the State of Israel and, as a result, at December 31, 2001, 164 of our 212 employees were located in Israel, including 106 out of 130 of our research and development personnel.  In addition, although we are incorporated in Delaware, a majority of our directors and executive officers are residents of Israel.  Although substantially all of our sales currently are being made to customers outside Israel, we are nonetheless directly influenced by the political, economic and military conditions affecting Israel.  Any major hostilities involving Israel, or the interruption or curtailment of trade between Israel and its present trading partners, could significantly harm our business, operating results and financial condition.

 

Israel’s economy has been subject to numerous destabilizing factors, including a period of rampant inflation in the early to mid-1980’s, low foreign exchange reserves, fluctuations in world commodity prices, military conflicts and civil unrest.  In addition, Israel and companies doing business with Israel have been the subject of an economic boycott by the Arab countries since Israel’s establishment.  Although they have not done so to date, these restrictive laws and policies may have an adverse impact on our operating results, financial condition or expansion of our business.

 

Since the establishment of the State of Israel in 1948, a state of hostility has existed, varying in degree and intensity, between Israel and the Arab countries.  Although Israel has entered into various agreements with certain Arab countries and the Palestinian Authority, and various declarations have been signed in connection with efforts to resolve some of the economic and political problems in the Middle East, hostilities between Israel and some of its Arab neighbors have recently escalated and intensified.  We cannot predict whether or in what manner these conflicts will be resolved.  Our results of operations may be negatively affected by the obligation of key personnel to perform military service.  In addition, certain of our officers and employees are currently obligated to perform annual reserve duty in the Israel Defense Forces and are subject to being called for active military duty at any time.  Although we have operated effectively under these requirements since our inception, we cannot predict the effect of these obligations on the company in the future.  Our operations could be disrupted by the absence, for a significant period, of one or more of our officers or key employees due to military service.

 

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Moreover, part of our expenses in Israel are paid in Israeli currency, which subjects us to the risks of foreign currency fluctuations and to economic pressures resulting from Israel’s general rate of inflation.  While significant part of our sales and expenses are denominated in United States dollars, a portion of our expenses are denominated in new Israeli shekels.  Our primary expenses paid in new Israeli shekels are employee salaries and lease payments on our Israeli facilities.  As a result, an increase in the value of Israeli currency in comparison to the United States dollar could increase the cost of our technology development, research and development expenses and general and administrative expenses.  We cannot assure you that currency fluctuations, changes in the rate of inflation in Israel or any of the other factors mentioned above will not have a material adverse effect on our business, financial condition and results of operations.  From time to time, we use derivative instruments in order to minimize the effects of such developments, but our hedging positions may be partial, may not exist at all in the future or may not succeed to minimize our foreign currency fluctuation risks.

 

Any Future Profitability May Be Diminished If Tax Benefits from the State of Israel Are Reduced or Withheld.  We receive certain tax benefits in Israel, particularly as a result of the “Approved Enterprise” status of our  facilities and programs.  To be eligible for tax benefits, we must meet certain conditions, relating principally to adherence to the investment program filed with the Investment Center of the Israeli Ministry of Industry and Trade and to periodic reporting obligations.  We believe that we will be able to continue to meet such conditions.  Should we fail to meet such conditions in the future, however, we would be subject to corporate tax in Israel at the standard rate of 36%, and could be required to refund tax benefits already received.  We cannot assure you that such grants and tax benefits will be continued in the future at their current levels or otherwise.  The termination or reduction of certain programs and tax benefits (particularly benefits available to us as a result of the Approved Enterprise status of our facilities and programs) or a requirement to refund tax benefits already received may have a material adverse effect on our business, operating results and financial condition.

 

We Depend on OEMs and their Suppliers to Obtain Required Complementary Components.  Some of the raw materials, components and subassemblies included in the products manufactured by our OEM customers, which also incorporate our products, are obtained from a limited group of suppliers.  Supply disruptions, shortages or termination of any of these sources could have an adverse effect on our business and results of operations due to the delay or discontinuance of orders for our products by customers until those necessary components are available.

 

We Depend Upon the Adoption of Industry Standards that Use TrueSpeech Technology.  Our business is partially dependent upon the establishment of industry standards for digital speech compression based on TrueSpeech algorithms in the computer telephony and VoIP markets.  The development of industry standards utilizing TrueSpeech algorithms would create an opportunity for us to develop and market speech co-processors that provide TrueSpeech solutions and enhance the performance and functionality of products incorporating these co-processors.

 

In February 1995, the International Telecommunications Union established G.723.1, which is predominately composed of a TrueSpeech algorithm, as the standard speech compression technology for use in video conferencing over public telephone lines.  In March

 

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1997, the International Multimedia Teleconferencing Consortium, a nonprofit industry group, recommended the use of G.723.1 as the default audio coder for all voice transmissions over the Internet or for IP applications for H.323 conferencing products.  If TrueSpeech algorithms are not adopted as the standard speech compression technology for different applications, the sales of our TrueSpeech products may not achieve anticipated levels.  If new standards are developed based on technology we did not possess, our business could be harmed.

 

There Are Risks Associated with Our Acquisition Strategy.  We have pursued, and will continue to pursue, growth opportunities through internal development and acquisition of complementary businesses, products and technologies.  We are unable to predict whether or when any other prospective acquisition will be completed.  The process of integrating an acquired business may be prolonged due to unforeseen difficulties and may require a disproportionate amount of our resources and management’s attention.  We cannot  assure you that we will be able to successfully identify suitable acquisition candidates, complete acquisitions, integrate acquired businesses into our operations, or expand into new markets.  Further, once integrated, acquisitions may not achieve comparable levels of revenues, profitability or productivity as our existing business or otherwise perform as expected.  The occurrence of any of these events could harm our business, financial condition or results of operations.  Future acquisitions may require substantial capital resources, which may require us to seek additional debt or equity financing.

 

Risks of Infringement of Intellectual Property Rights of Others.  As is typical in the semiconductor industry, we have been and may from time to time be notified of claims that we may be infringing patents or intellectual property rights owned by third parties. For example, AT&T has asserted that G.723.1, which is primarily composed of our TrueSpeech algorithm, includes certain elements covered by a patent held by AT&T. AT&T has requested that video conferencing manufacturers license the technology from AT&T and has sued Microsoft, one of our TrueSpeech licensees, for infringement. Other organizations including Agere, NTT and VoiceCraft have raised public claims that they also have patents related to the G.723.1 technology.  If litigation becomes necessary to determine the validity of any third party claims, it could result in significant expense to us and could divert the efforts of our technical and management personnel, whether or not the litigation is determined in our favor.

 

If it appears necessary or desirable, we may try to obtain licenses for those patents or intellectual property rights that we are allegedly infringing.  Although holders of these types of intellectual property rights commonly offer these licenses, we cannot assure you that licenses will be offered or that the terms of any offered licenses will be acceptable to us.  Our failure to obtain a license for key intellectual property rights from a third party for technology used by us could cause us to incur substantial liabilities and to suspend the manufacturing of products utilizing the technology.

 

Alternatively, we could be required to expend significant resources to develop non-infringing technology.  We cannot assure you that we would be successful in developing non-infringing technology.

 

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Protection of Our Intellectual Property Rights is Limited.  Our success and ability to compete is in part dependent upon our internally developed technology and other proprietary rights, which we protect through a combination of copyright, trademark and trade secret laws, as well as through confidentiality agreements and licensing arrangements with our customers, suppliers, employees and consultants.  In addition, we have filed a number of patents in the United States and in other foreign countries with respect to new or improved technology that we have developed.  However, the status of any patent involves complex legal and factual questions, and the breadth of claims allowed is uncertain.  Accordingly, we cannot assure you that any patent application filed by us will result in a patent being issued, or that the patents issued to us will not be infringed by others.  Also, our competitors and potential competitors may develop products with similar technology or functionality as our products, or they may attempt to copy or reverse engineer aspects of our product line or to obtain and use information that we regard as proprietary.  Moreover,  the laws of certain countries in which our products are or may be developed, manufactured or sold, including Hong Kong, Japan and Taiwan, may not protect our products and intellectual property rights to the same extent as the laws of the United States.  Policing the unauthorized use of our products is difficult and may result in significant expense to us and could divert the efforts of our technical and management personnel.  Even if we spend significant resources and efforts to protect our intellectual property, we cannot assure you that we will be able to prevent misappropriation of our technology.  Use by others of our proprietary rights could materially harm our business and expensive litigation may be necessary in the future to enforce our intellectual property rights.

 

Terrorist Attacks and Threats or Actual War May Negatively Impact All Aspects of Our Operations, Revenues, Costs and Stock Price.  Recent terrorist attacks in the United States, as well as future events occurring in response or connection to them, including, without limitation, future terrorist attacks against United States targets, rumors or threats of war, actual conflicts involving the United States or its allies or military or trade disruptions impacting our domestic or foreign suppliers of merchandise, may impact our operations, including, among other things, causing delays or losses in the delivery of wafer supplies to us and decreased sales of our products.  More generally, any of these events could cause consumer confidence and spending to decrease or result in increased volatility in the United States and worldwide financial markets and economy.  They also could result in economic recession in the United States or abroad. Any of these occurrences could have a significant impact on our operating results, revenues and costs.

 

Our Stock Price May Be Volatile.  Announcements of developments related to our business, announcements by competitors, quarterly fluctuations in our financial results, changes in the general conditions of the highly dynamic industry in which we compete or the national economies in which we do business, and other factors could cause the price of our common stock to fluctuate, perhaps substantially.  In addition, in recent years the stock market has experienced extreme price fluctuations, which have often been unrelated to the operating performance of affected companies.  These factors and fluctuations could have a material adverse effect on the market price of our common stock.

 

Preliminary Discussions with Parthus Technologies plc.  We had previously announced that we contemplated a spin-off of our intellectual property licensing business.  However, recently, we confirmed that we were in preliminary discussions with Parthus Technologies plc regarding a

 

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potential combination of Parthus’ business with our IP licensing business.  As of March 22, 2002, we have not come to any final agreements with Parthus regarding this potential transaction, and we cannot predict  whether or when any business combination with Parthus Technologies will occur, if at all.  If we do agree to combine our licensing business segment with Parthus Technologies, the process of separating our licensing business and integrating it with that of Parthus may be prolonged due to unforeseen difficulties and may require a disproportionate amount of our resources and management’s attention.  Further, even if a business combination with Parthus Technologies was completed, we cannot assure you the business combination will achieve the levels of revenues, profitability or productivity or otherwise perform as expected.  All of the forward-looking statements made herein with respect to our business, results of operation and financial condition are necessarily colored by, and would be materially affected by, any business transaction with Parthus Technologies, if it occurs.

 

Item 2. PROPERTIES.

 

Our operations in the United States are located in an approximately 14,345 square foot leased facility in Santa Clara, California. This facility houses our marketing and technical support, North American sales, operations, manufacturing coordination and administrative personnel. This facility is leased through March 31, 2004.  Our operations in Israel are located in approximately 29,800 square feet of leased facilities, with the primary leased facility located in Herzelia Pituach, Israel.  These facilities are leased through November 2003. VoicePump operations in the United States are located in approximately 4,000 square feet of leased facilities in Palo Alto, California and Chicago, Illinois.  The facility in Palo Alto is leased through October 2005.  The facility in Chicago is leased through November 2003.

 

Item 3. LEGAL PROCEEDINGS.

 

From time to time, we may become involved in litigation relating to claims arising from our ordinary course of business activities.  Also, as is typical in the semiconductor industry, we have been and may from time to time be notified of claims that we may be infringing patents or intellectual property rights owned by third parties.  For example, AT&T has asserted that G.723.1, which is primarily composed of our TrueSpeech algorithm, includes certain elements covered by a patent held by AT&T.  AT&T has sued Microsoft, one of our True Speech licensees, for infringement.  We have not been in named in the suit against Microsoft.  We believe, that there are no claims or actions pending or threatened against us, the ultimate disposition of which would have a material adverse effect on us.

 

Item 4.      SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

 

None.

 

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PART II

 

Item 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

 

DSP Group’s common stock, par value $0.001, trades on the Nasdaq National Market (Nasdaq symbol “DSPG”).  The following table presents for the periods indicated the high and low sales prices for our common stock as reported by the Nasdaq National Market:

 

 

 

As of March 14, 2002, there were approximately 86 holders of record of DSP Group’s common stock, which we believe represents approximately 11,768 beneficial holders.  We have not paid cash dividends on our common stock and presently intends to follow a policy of retaining any earnings for reinvestment in our business.

 

Item 6. SELECTED FINANCIAL DATA.

 

The following selected historical consolidated financial data presented below are derived from DSP Group’s consolidated financial statements.  The consolidated financial statements for the fiscal years ended December 31, 2001, 2000, 1999, 1998 and 1997 have been audited by Kost Forer & Gabbay, a member of Ernst & Young International.  The selected consolidated financial data set forth below is qualified in its entirety by, and should be read in conjunction with, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

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Year Ended December 31,		2001			2000			1999			1998			1997
		(U.S. dollars in thousands, except per share amount)
Statements of Operatations Data:
Revenues		$	114,674		$	109,513		$	76,433		$	63,850		$	61,959
Income from continuing operations		$	21,916		$	49,835		$	54,579		$	14,415		$	11,034
Weighted average number of Common Stock outstanding during the period used to compute basic net earnings per share		26,641			26,616			23,468			19,536			19,472
Weighted average number of Common Stock outstanding during the period used to compute diluted net earnings per share		27,606			28,669			25,442			20,032			20,406
Basic net earnings per share		$	0.82		$	1.87		$	2.33		$	0.74		$	0.57
Diluted net earnings per share		$	0.79		$	1.74		$	2.15		$	0.72		$	0.54
Balance Sheet Data:
Cash, cash equivalents, marketable securities and short term bank deposits		$	249,791		$	223,201		$	161,371		$	66,989		$	65,944
Working capital		$	107,328		$	82,613		$	123,810		$	12,750		$	51,859
Total assets		$	312,379		$	282,807		$	206,179		$	85,791		$	85,826
Total stockholders’ equity		$	278,977		$	246,165		$	183,957		$	75,695		$	74,170

 

Year Ended December 31, Fiscal Years by Quarter		2001												2000
Quarterly Data:		4th			3rd			2nd			1st			4th			3rd			2nd			1st
		(Unaudited, U.S. dollars in thousands, except per share amount)
Revenues		$	29,187		$	34,955		$	26,358		$	24,174		$	31,425		$	28,988		$	25,713		$	23,387
Gross profit		$	14,222		$	17,311		$	14,601		$	14,167		$	18,167		$	16,073		$	13,776		$	12,589
Net Income		$	4,043		$	6,854		$	5,357		$	5,662		$	8,743		$	8,428		$	17,255		$	15,409
Net earnings per share — Basic		$	0.15		$	0.26		$	0.20		$	0.21		$	0.33		$	0.31		$	0.65		$	0.60
Net earnings per share — Diluted		$	0.15		$	0.25		$	0.20		$	0.21		$	0.31		$	0.29		$	0.59		$	0.54

 

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

 

Results of Operations

 

Year 2001 was a challenging year for DSP Group.  However, despite the global economic downturn, the September 11 events and the challenges faced by companies operating in the telecommunication and semiconductors markets in 2001, we were among the few companies that demonstrated growth in their top line, and recorded operating and net profits of 12% and 19% of revenues, respectively.  In the second quarter of 2001, we successfully launched our new generation of cordless telephony products, 900MHz Narrow Band.  Our liquidity continued to improve throughout 2001 and by year end, we achieved new record highs for

 

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DSP Group with respect to cash, cash equivalents, marketable securities and short term bank deposits.  Such increases were derived primarily from increased revenues and reduced operating working capital and capital expenditure requirements.  Our future operating results will be dependent upon a variety of factors.  In evaluating our business, you should carefully consider the information set forth under the caption “Risk Factors” and in other sections of this Annual Report on Form 10-K.

 

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States.  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities.  On an on-going basis, we evaluate our estimates, including those related to product returns, bad debts, inventories, investments, intangible assets, taxes on income, financing operations, warranty obligations and contingencies and litigation.  We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions.

 

Our management believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements:

 

•       Revenue Recognition.  We recognize product revenue using the guidance from SEC Staff Accounting Bulletin No. 101 “Revenue Recognition in Financial Statements” and Statement of Financial Accounting Standards, or SFAS, No. 48 “Revenue Recognition When Right of Return Exists.”  We recognize software revenue in accordance with SOP 97-2, “Software Revenue Recognition,” as amended by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions.”  We periodically consider arrangements regarding certain customers with payment terms extending beyond customary payment terms not to be fixed or determinable.  We also record estimated reductions to revenue for product returns.  If our customers return more products than we estimate, additional reductions to revenue may be required.  In addition, we defer revenue associated with long-term customer maintenance contracts.  The value of these contracts is recognized ratably over the length of the customer contract.

 

•       Inventory.  We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions.  If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

 

•       Deferred Taxes.  We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. Carrying value of our net deferred tax assets assumes that we will be able to generate sufficient future taxable

 

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income in certain tax jurisdictions, based on estimates and assumptions.  If these estimates and related assumptions change in the future, we may be required to record additional valuation allowances against our deferred tax assets resulting in additional income tax expense in our consolidated statement of operations.

 

•       Investments in Available for Sale Marketable Equity Securities - AudioCodes Ltd. and Tomen Corporation.   We classify these investment securities as available-for-sale securities.  Pursuant to SFAS No. 115, such securities are measured at fair market value in the financial statements with unrealized gains or losses recorded in other comprehensive income until the securities are sold or otherwise disposed of.  However, in accordance with SFAS No. 115, a decline in fair market value below cost that is other than temporary is accounted for as a realized loss.

 

Total Revenues.  Our total revenues were $114.7 million in 2001, $109.5 million in 2000 and  $76.4 million in 1999.  This represents an increase in total revenues of 5% in 2001 as compared to total revenues in 2000, and an increase of 43% in total revenues in 2000 as compared to those in 1999.  The increase in revenues in 2001 as compared to 2000 was primarily the result of strong demand for our 900 MH Narrow Band chip set.  Our licensing revenues in 2001 were $26.6 million as compared to  $25.1 million in 2000 and $19.0 million in 1999.  This represents an increase in licensing revenues of 6% in 2001 as compared to 2000, and an increase of 32% in 2000 as compared to those in 1999.  The increase in our licensing revenues in 2001 as compared to 2000 was primarily the result of an increase in support and contract engineering activities.

 

In 2001, we witnessed a challenging environment in the telecommunication and semiconductors industries, resulting in longer sales cycles and delays in the purchase decision-making processes of potential customers for our DSP Core technology.  This resulted in fewer number of new license agreements executed in 2001, as compared to 2000, and limited business visibility for future license agreements.

 

Export sales, primarily consisting of Integrated Digital Telephony (IDT) speech processors shipped to manufacturers in Europe and Asia, including Japan, as well as license fees on DSP cores to foreign customers, represented 89% of our total revenues in 2001, as compared to 86% in 2000 and 97% in 1999.  The increase in export sales in 2001 as compared to 2000 was primarily due to higher sales to the Japanese market (especially IDT product sales) and less sales to the American market (especially in our licensing activities).  All export sales are denominated in U.S. dollars.

 

Significant Customers.  Revenues from one distributor, Tomen Electronics, accounted for 56% of our total revenues in 2001 as compared to 52% in 2000 and 47% in 1999.  The slight increase in 2001 as compared to 2000 is primarily due to a greater number of sales in Japan.  The loss of Tomen Electronics or one or more of our other major distributors or customers could harm our business, financial condition and results of operations.

 

Gross Profit.  Gross profit as a percentage of total revenues was 53% in 2001, 55% in 2000 and 57% in 1999.  The decrease in total gross profit in 2001 as compared to 2000 was due

 

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to a change in the product mix associated with the introduction of our new Cordless chip set and an inventory write-off of approximately $1.0 million associated with our old line of products consisting of CT000 and D6000.

 

Product gross profit as a percentage of product sales was 40% in 2001, 43% in 2000 and 42% in 1999.  In each of these years, we managed to partially offset the continued decline in average selling prices of our products with a reduction in manufacturing costs, partially due to technological improvements.

 

Research and Development Expenses.  Research and development expenses increased significantly to $26.2 million in 2001, from $20.9 million in 2000 and $15.4 million in 1999.  The increase in research and development expenses in 2001 as compared to those in 2000 were primarily due to the hiring of additional engineers associated with our VoIP and RF 2.4GHz CMOS design projects.  The increase in research and development expenses in 2000 as compared to those in 1999 were primarily due to the hiring of additional engineers associated with the acquisition of VoicePump, as well as from an increase in external services provided to our research and development team.  Our average engineering headcount in 2001 increased by 18% as compared to 2000 and 45% in 2000 as compared to 1999.  Research and development expenses as a percentage of total revenues were 23% in 2001, 19% in 2000 and 20% in 1999.

 

Sales and Marketing Expenses.  Our sales and marketing expenses were $12.1 million in 2001, $12.9 million in 2000 and $9.3 million in 1999.  The slight decrease in expenses in 2001 as compared to those in 2000 was primarily due to lower sales commission due to different commission rates applied on a change in product mix sold in 2001.  The increase in expenses in 2000 as compared to 1999 was due to an increase of 17% in our sales and marketing personnel, as well as to an increase in our sales commissions (due to the increase in our revenues) and higher facility costs for our Japanese subsidiary, Nihon DSP K.K.  Sales and marketing expenses as a percentage of total revenues were 11% in 2001 and 12% in both 2000 and 1999.

 

General and Administrative Expenses.  Our general and administrative expenses increased to $7.7 million in 2001 from $6.5 million in 2000 and from $5.5 million in 1999.  General and administrative expenses increased in 2001 from 2000, mainly due to additional personal as well as amortization of goodwill related to the acquisition of VoicePump.  General and administrative expenses increased in 2000 from 1999, mainly due to an increase in accounting, tax and legal professional expenses we incurred with respect to the proposed spin-off of our DSP Cores licensing division.  General and administrative expenses as a percentage of total revenues were 7% in 2001, 6% in 2000  and 7% in 1999.

 

Unusual Items.  In the first quarter of 2000, we recorded two unusual expense items amounting to approximately $14.2 million. A write-off of $11.9 million was recorded relating to the acquired in-process research and development in connection with the acquisition of approximately 73% of the outstanding shares of VoicePump.  An expense of $2.3 million was recorded reflecting the accelerated amortization of acquired assets and intangibles related to the 1999 acquisition of 900 MHz RF and baseband technology from Applied Micro Devices, Inc.  We did not record any unusual items in 1999 or 2001.

 

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Interest and Other Income (Expense).  Interest and other income and interest and other expenses, net, decreased slightly to income of $13.0 million in 2001 from income of $13.3 million in 2000.  Interest and other income net of interest expenses was $5.8 million in 1999.  The decrease in interest and other income net of interest expense in 2001 as compared to 2000 was a result of  overall lower market interest rates in 2001, off-set by higher levels of cash, cash equivalents,  marketable securities and short term bank deposits in 2001.  The increase in interest income in 2000 as compared to 1999, was a result of higher levels of cash, cash equivalents, marketable securities and short term bank deposits in 2000, mainly due to additional sales of a portion of our equity investment in AudioCodes, as well as higher yields on our financial investments in 2000.

 

Equity in Earnings of Affiliate.

 

Starting April 1, 2001, we no longer had significant influence over the operating and financial policies of AudioCodes and thus cannot implement the equity method of accounting for this investment.  Equity in income of equity method investees was $105,000 in 2001 (all of which were recorded in the first quarter of 2001), $2,644,000 in 2000 and $2,475,000 in 1999.

 

As of December 31, 2001, we owned approximately 4.5 million shares of AudioCodes common stock, which represents approximately 11% of the outstanding capital of AudioCodes.  All shares and per share numbers with respect to AudioCodes have been adjusted to reflect the 2 for 1 stock split effected by AudioCodes in October 2000.

 

As of December 31, 2001, the fair market value of our investment in AudioCodes was approximately $25.1 million.

 

For more information about related party transactions, see Note 8 to the attached Notes to Consolidated Financial Statement for the year ended December 31, 2001.

 

Capital Gain.

 

In May 1999, we exercised our warrant to purchase approximately 3.5% of the outstanding stock of AudioCodes for approximately $1.2 million.  In the same month, AudioCodes completed its initial public offering (IPO) and is now listed on the Nasdaq SmallCap Market under the symbol “AUDC.”  In its IPO, AudioCodes issued 7.0 million shares at a price of $7.00 per share.  As a result, we recorded in “Other income (expense)” in our consolidated statements of income for 1999 a one-time capital gain in the amount of $11.8 million.  This amount was comprised of $9.4 million, from the sale of our shares sold in the IPO and $2.5 million from the sale of approximately 496,000 of our AudioCodes shares to the underwriters to cover their over-allotment option.  The gross proceeds from our sale were approximately $3.2 million.  In October 1999, AudioCodes successfully concluded a follow-on public offering of 6.0 million shares at a price of $20.50 per share.  In the follow-on offering, AudioCodes issued and sold 3.0 million shares and an additional 3.9 million shares were sold by shareholders, of which approximately 2.1 million shares were sold by us in two separate transactions.  Our proceeds from these transactions were approximately $42.8 million, and we recorded in 1999 an additional capital gain in the amount of $47.1 million.  This amount was comprised of $10.8 million, which resulted from the public offering and $36.3 million from the

 

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sale of approximately 2.14 million AudioCodes’ shares.  As of December 31, 1999, we held approximately 5.8 million AudioCodes shares, which represented about 15% of its outstanding shares.  In January 2000, we sold 1.2 million shares of AudioCodes for approximately $43.8 million and recorded in the first quarter of 2000 a capital gain in the amount of $40.0 million.  In June 2000, we sold an addition 0.5 million shares of AudioCodes for approximately $19.2 million and recorded in the second quarter of 2000, an additional capital gain in the amount of $17.6 million. In the forth quarter of 2000, we purchased in the open market 300,000 of AudioCodes shares for approximately $4.9 million.  This transaction created an excess of purchase price over net assets acquired (approximately $3.75 million at the date of purchase), which was attributed to goodwill to be amortized over seven years.  As of December 31, 2001, we own approximately 4.5 million shares of AudioCodes common stock, which represents approximately 11% of the outstanding capital of AudioCodes.  All shares and per share numbers with respect to AudioCodes have been adjusted to reflect the 2 for 1 stock split effected by AudioCodes in October 2000.

 

Provision for Income Taxes.

 

Our effective tax rate was 20.5% for 2001, 18.0% (excluding tax on capital gain) for 2000 and 22.0% for 1999.  The tax rate for 2001 was higher compared to 2000, due to relative decrease in income subject to foreign tax holiday benefits.  The tax rate for 2000 was higher compared to 1999, due mainly to our higher utilization of foreign tax holiday benefits in 1999.

 

DSP Group Ltd., our Israeli subsidiary, has been granted “Approved Enterprise” status by the Israeli government according to five investment plans.  The Approved Enterprise status allows for a tax holiday for a period of two to four years and a reduced corporate tax rate of 10%-25% for an additional six or eight years, on the respective investment plans’ proportionate share of taxable income. The tax benefits under these investment plans are scheduled to gradually expire starting from 2005 through to 2012.

 

Our management has assessed the need for a valuation allowance against deferred tax assets and has concluded that it is more likely than not that $2.3 million deferred tax assets will be realized based on current levels of future taxable income and potentially refundable taxes.

 

Related Party Transactions.

 

From 1993 and until 2001, we engaged in a development and licensing agreement with AudioCodes.  Under the agreement, AudioCodes performed certain research and development services for us for which we paid AudioCodes a service fee.  We also paid AudioCodes royalty fees realized from the sale of our products that incorporated their technology.

 

In addition, we were a supplier of chips to AudioCodes for which we received $511,000 in 2001.  For more information about our various arrangements with AudioCodes, see Note 8 to the attached Notes to Consolidated Financial Statement for the year ended December 31, 2001.

 

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Liquidity and Capital Resources

 

During 2001, we generated $25.5 million of cash and cash equivalents from our operating activities, as compared to $9.6 million during 2000 and $2.7 million in 1999.  The significant increase in 2001 of cash and cash equivalents as compared to 2000 occurred even though we experienced a significant decrease in net income in 2001 as compared to 2000.  The increase was due mainly to the non-cash effects of the capital gains attributed to the sale of AudioCodes common stock, an increase in deferred income tax, net, and a decrease in our trade receivables.  The significant increase in 2001 of cash and cash equivalents was partially offset by the decrease in amortization of the in-process research and development costs in connection with the VoicePump acquisition, as well as decrease in trade payable, income tax payable and accrued expenses and other accounts payable.  The increase in 2000 of cash and cash equivalents as compared to 1999 was due mainly to the non-cash effects of the write-off of the in-process research and development costs in connection with the VoicePump acquisition and the increase in accounts payable and accrued expenses.  The increase in 2000 of cash and cash equivalents over 1999 was partially offset by the decrease in deferred income taxes, as well as to the increase in income tax payable.

 

We invest excess cash in short-term bank deposits and marketable securities of varying maturity, depending on our projected cash needs for operations, capital expenditures and other business purposes.  In 2001, we purchased $194.0 million of investments classified as short-term cash deposits and marketable securities, as compared to $155.0 million in 2000 and $131.4 million in 1999.  In addition, $162.9 million of our investments classified as marketable securities matured in 2001 as compared to $120.0 million in 2000 and $48.7 million in 1999.  During 2001 and 2000, the average maturity for our investments was approximately 23 months and 12 months, respectively.

 

Our capital equipment purchases amounted to $4.5 million in 2001, $3.4 million in 2000 and $5.2 million in 1999 for computer hardware and software used in engineering development, engineering test and lab equipment, leasehold improvements, vehicles, and furniture and fixtures.

 

In September 2000, we invested approximately $485,000 (50.0 million Yen) in exchange for stock in our Japanese distributor’s parent company, Tomen Corporation, as part of a long-term  strategic relationship.  Tomen’s shares are traded on the Japanese stock exchange, and are recorded in “Other Investments” on the balance sheets, and accounted for as available for sale marketable equity securities.  As of December 31, 2001, the fair market value of our investment in Tomen was approximately $292,000.

 

On February 2, 1999, we issued and sold 2.3 million shares (pre-split 2:1) of our common stock, which represented 19.6% of our outstanding common stock at the time of the transaction, to Magnum Technologies Ltd., an international investment fund, for an aggregate net proceeds to us of $34.5 million.  In February and August 2000, Magnum sold 2.9 million shares  of its holdings.  In August 2001 Magnum sold 906,500 shares of our common stock.  In the beginning of 2002, Magnum sold 749,200 shares of our common stock.  After the sales, Magnum currently holds approximately 1.3 million shares, representing approximately 4.7% of our outstanding shares of common stock as of March 14, 2002.

 

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Cash received upon the exercise of employee stock options and through purchases pursuant to our employee stock purchase plan in 2001 totaled $4.9 million, as compared to $15.6 million in 2000 and $20.4 million in 1999.

 

Stock Repurchase Program.

 

In March 1999, our Board of Directors authorized the company to repurchase up to an additional 2,000,000 shares of our common stock from time to time on the open market or in privately negotiated transactions, thereby increasing the total shares authorized to be repurchased by the company to 4,000,000 shares.  Accordingly, during the year 2001, we repurchased 40,000 shares of our common stock at an average price of $20.30 per share, for an aggregated purchase price of $0.8 million.  In 2001, we issued 451,000 shares of our common stock to employees who exercised their stock options.

 

At December 31, 2001, our principal source of liquidity consisted of cash, cash equivalent and cash deposits totaling $39.1 million and held to maturity marketable securities and short-term bank deposits totaling $210.6 million.  Our working capital at December 31, 2001 was $107.3 million.

 

We believe that our current cash, cash equivalents, cash deposits and marketable securities will be sufficient to meet our cash requirements through at least the next 12 months.  A decrease in our sales or demand for products incorporating our technology would likely affect our working capital amounts.  As part of our business strategy, we occasionally evaluate potential acquisitions of businesses, products and technologies.  Accordingly, a portion of our available cash may be used at any time for the acquisition of complementary products or businesses.  Such potential transactions may require substantial capital resources, which may require us to seek additional debt or equity financing.  There can be no assurance that we will consummate any such transactions.  See “Risk Factors — There are Risks Associated with our Acquisition Strategy” for more detailed information.

 

Item 7A  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS.

 

Interest Rate Risk.  It is our policy not to enter into interest rate derivative financial instruments, except for hedging of foreign currency exposures discussed below.  We do not currently have any significant interest rate exposure since we do not have any financial obligation and our financial assets are measured on a held to maturity basis.

 

Foreign Currency Exchange Rate Risk.  As a significant part of our sales and expenses are denominated in U.S. dollars, we have experienced only insignificant foreign exchange gains and losses to date, and do not expect to incur significant gains and losses in 2002.  However, due to the recent increase in the volatility of the exchange rate of the NIS versus U.S. dollar, we decided to hedge part of the risk of a devaluation of the NIS which could have an adverse effect on the expenses that we incur in the State of Israel.  For example, to protect against the increase in value of forecasted foreign currency cash flows resulting from salary payments during the year, we instituted a foreign currency cash flow hedging program.  At the end of first quarter of year 2001, we started to purchase put option contracts and entered into forward contracts to hedge a portion of the anticipated NIS payroll of our Israeli subsidiary for a period of two to ten months.

 

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These options contracts are designated as cash flow hedges, as defined by SFAS No. 133, and are all effective as hedges of these expenses.  As of December 31, 2001, we recorded a comprehensive loss amounting to $30.5 thousands which derives from our forward contracts in respect to anticipated payroll payments expected in the year 2002.  Such amounts will be recorded in earnings in 2002.  For more information about our hedging activity, see Note 2 to the attached Notes to Consolidated Financial Statement for the year ended December 31, 2001.

 

European Monetary Union.  Within Europe, the European Economic and Monetary Union (the “EMU”) introduced a new currency, the euro, on January 1, 1999.  Effective January 1, 2002, all EMU countries are expected to be operating with the euro as their single currency.  We have assessed the effect the euro formation has on our internal systems and the sale of our products and believe that the cost related to the euro conversion is not material to us and will not have a substantial effect on our financial condition and results of operations.

 

Item 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

 

Description:

Report of Kost Forer & Gabbay, a member of Ernst & Young International, Independent Auditors

Consolidated Balance Sheets as of December 31, 2001 and 2000

Consolidated Statements of Income for the years ended December 31, 2001, 2000 and 1999

Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2001, 2000 and 1999

Consolidated Statements of Cash Flows for the years ended December 31,2001, 2000 and 1999

Notes to Consolidated Financial Statements

 

38

 

Report of Independent Auditors

 

To The Stockholders of

DSP Group, Inc.

 

We have audited the accompanying consolidated balance sheets of DSP Group, Inc. (the “Company”) and its subsidiaries as of December 31, 2001 and 2000, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2001.  These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with auditing standards generally accepted in the United States.  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of DSP Group, Inc. and its subsidiaries as of December 31, 2001 and 2000, and the consolidated results of their operations and cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States.

 

KOST FORER & GABBAY

A member of Ernst & Young International

Tel Aviv, Israel

January 22, 2002

Except for Note 9 as to which the date is March 15, 2002

 

39

 

DSP Group, Inc.

Consolidated Balance Sheets

 

		December 31,
		2001			2000
		(US dollars in thousands)
Assets
Current assets:
Cash and cash equivalents		$	39,146			$	45,035
Marketable securities and short term bank deposits(*)		70,893				94,256
Trade receivable, less allowance for returns of $123 in 2001 and 2000 and for doubtful accounts of $418 in 2001 and $200 in 2000		14,430				16,932
Deferred income taxes		2,338				4,554
Other accounts receivable and prepaid expenses		1,866				1,445
Inventories		2,098				2,815
Total current assets		130,771				165,037
Property and equipment, net		7,589				6,451
Long term marketable securities(*)		139,752				83,910
Other investments		25,536				21,000
Other assets, net		6,419				4,259
Severance pay fund		2,312				2,150
Total long term assets		174,019				111,319
Total assets		$	312,379			$	282,807

(*) Reclassified

 

The accompanying notes are integral part of the consolidated financial statements

 

40

DSP Group, Inc.

Consolidated Balance Sheets (Cont'd)

 

		December 31,
		2001				2000
		(US dollars in thousands, except share data)
Liabilities and stockholders’ equity
Current liabilities:
Trade payable		$	5,830		$		8,092
Accrued compensation and benefits		6,033			5,276
Income taxes payable		5,301			6,414
Accrued royalties		2,723			2,472
Accrued expenses and other accounts payable		3,556			5,772
Total current liabilities		23,443			28,026
Long term liabilities:
Accrued severance pay		2,418			2,147
Deferred income taxes		7,541			5,559
Minority interest		—			910
Total long term liabilities		9,959			8,616
Commitments and contingencies
Stockholders’ equity:
Preferred Stock, $0.001 par value: Authorized shares — 5,000,000 as of December 31, 2001 and 2000 Issued and outstanding shares — none as of December 31, 2001 and 2000		—			—
Common Stock, $0.001 par value:
Authorized shares — 50,000,000 as of December 31, 2001 and 2000
Issued and outstanding shares — 26,873,717 as of December 31, 2001 and 26,248,057 as of December 31, 2000 (see Note 4)		27			27
Additional paid-in capital		155,969			151,787
Treasury stock		(8,623		)	(19,940			)
Accumulated other comprehensive income		2,652			—
Retained earnings		128,952			114,291
Total stockholders’ equity		278,977			246,165
Total liabilities and stockholders’ equity		$	312,379		$		282,807

 

The accompanying notes are integral part of the consolidated financial statements

 

41

 

DSP Group, Inc.

Consolidated Statements of Income

 

		Years Ended December 31,
		2001			2000			1999
		(US dollars in thousands, except per share data)
Revenues:
Product sales		$	88,069		$	84,384		$	57,397
Licensing, royalties and other		26,605			25,129			19,036
Total revenues		114,674			109,513			76,433
Costs of revenues:
Product sales		52,782			47,861			33,051
Software licensing, royalties and other		1,591			1,047			155
Total cost of revenues		54,373			48,908			33,206
Gross profit		60,301			60,605			43,227
Operating expenses:
Research and development, net		26,161			20,912			15,404
Sales and marketing		12,079			12,909			9,309
General and administrative		7,746			6,515			5,511
Impairment of tangible and intangible assets		—			2,285			—
In-process research and development write-off		—			11,869			—
Total operating expenses		45,986			54,490			30,224
Operating income		14,315			6,115			13,003
Financial and other income (expense):
Interest and other income		13,255			13,507			6,048
Interest and other expense		(271		)	(186		)	(232		)
Equity in earnings of affiliate		105			2,644			2,475
Minority interest in losses of subsidiary		173			627			—
Loss from issuance of subsidiary’s stock		—			(100		)	—
Capital gains from realization of investment		—			57,593			58,931
Income before taxes on income		27,577			80,200			80,225
Taxes on income		(5,661		)	(30,365		)	(25,646		)
Net income		$	21,916		$	49,835		$	54,579
Net earnings per share:
Basic		$	0.82		$	1.87		$	2.33
Diluted		$	0.79		$	1.74		$	2.15

 

The accompanying notes are integral part of the consolidated financial statements

 

42

 

DSP Group, Inc.

Consolidated Statements of Stockholders’ Equity

 

Three Years Ended December 31,2001		Number of Common Stock		Common Stock			Additional Paid-In Capital			Treasury Stock			Retained Earnings			Other Comprehensive Income			Total Stockholders’ Equity
		(in thousands)
Balance at January 1, 1999		9,406		$	9		$	75,610		$	(12,053	)	$	12,129		—			$	75,695
Net income		—		—			—			—			54,579			—			54,579
Total comprehensive income		—		—			—			—			—			—			54,579
Purchase of Treasury Stock		(200	)	(*		)	—			(2,710		)	—			—			(2,710		)
Issuance of Common Stock to investor		2,300		2			34,367			—			—			—			34,369
Exercise of Common Stock options by employees		256		(*		)	5,640			—			—			—			5,640
Issuance of Treasury Stock upon exercise of stock options		879		1			1,948			14,272			(1,813		)	—			14,408
Issuance of Treasury Stock upon purchase of ESPP shares		30		(*		)	7			491			(113		)	—			385
Income tax benefit from stock options exercised		—		—			1,591			—			—			—			1,591
Balance at December 31, 1999		12,671		$	12		$	119,163		—			$	64,782		—			$	183,957
Net income		—		—			—			—			49,835			—			49,835
Total comprehensive income		—		—			—			—			—			—			49,835
Purchase of Treasury Stock		(850	)	(1		)	—			(20,512		)	—			—			(20,513		)
Issuance of Common Stock in  acquisition of VoicePump		261		1			14,897			—			—			—			14,898
Exercise of Common Stock options by employees		1,032		1			14,660			—			—			—			14,661
Issuance of Stock upon purchase of ESPP shares		41		(*		)	651			—			—			—			651
Issuance of Treasury Stock upon exercise of stock options		24		1			—			572			(326		)	—			247
Income tax benefit from stock options exercised		—		—			2,429			—			—			—			2,429
Stock split effected as a stock dividend (100%)		13,069		13			(13		)	—			—			—			—
Balance at December 31,  2000		26,248		$	27		$	151,787		$	(19,940	)	$	114,291		$	—		$	246,165
Net income		—		—			—			—			21,916			—			21,916
Unrealized gains on available for sale marketable securities, net		—		—			—			—			—			2,683			2,683
Realized loss from hedging activities		—		—			—			—			—			(31		)	(31		)
Total comprehensive income		—		—			—			—			—			2,652			24,568
Purchase of Treasury Stock		(40	)	(*		)	—			(811		)	—			—			(811		)
Issuance of Common Stock in acquisition of VoicePump		161		(*		)	3,651			—			—			—			3,651
Issuance of Treasury Stock upon exercise of stock options		451		(*		)	—			10,841			(6,752		)	—			4,089
Issuance of Treasury Stock upon purchase of ESPP shares		53		(*		)	—			1,287			(503		)	—			784
Income tax benefit from stock options exercised		—		—			531			—			—			—			531
Balance at December 31,  2001		26,873		$	27		$	155,969		$	(8,623	)	$	128,952		$	2,652		$	278,977

 

(*) Represents an amount lower than $1.

 

The accompanying notes are an integral part of the consolidated financial statements.

 

43

 

DSP Group, Inc.

Consolidated Statements of Cash Flows

 

		Years Ended December 31,
		2001			2000			1999
Operating activities		(In Thousands )
Net income		$	21,916		$	49,835		$	54,579
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		3,233			2,758			2,455
In- process Research and Development write-off		—			11,869			—
Increase (decrease) in deferred revenue		—			(90		)	54
Increase  (decrease) in deferred income taxes, net		2,450			(1,337		)	8,487
Net gain on sale of property and equipment		(12		)	—			—
Capital gains from realization of investment (*)		—			(57,593		)	(58,931		)
Acquired assets and workforce		—			—			(2,000		)
Impairment of tangible, intangible and amortization of goodwill		964			2,764			885
Accrued interest and amortization of premium on held to maturity marketable securities		(1,389		)	(2,617		)	—
Equity in earnings of affiliate		(105		)	(2,644		)	(2,475		)
Minority interest in losses of subsidiary		(173		)	(627		)	—
Decrease (increase) in trade receivable		2,502			(6,301		)	(4,714		)
Decrease (increase) in other account receivable and prepaid expenses		(421		)	(3		)	246
Decrease (increase) in inventories		717			468			(1,101		)
Increase in other assets		(210		)	(230		)	—
Increase (decrease) in trade payable		(2,262		)	2,009			3,719
Increase in accrued compensation and benefits		757			802			1,652
Increase (decrease) in accrued severance pay, net		109			(44		)	10
Increase in tax benefit related to exercise of stock options		531			2,429			1,591
Increase (decrease) in income taxes payable		(1,113		)	2,931			(2,446		)
Increase in accrued royalties		251			1,669			156
Increase (decrease) in accrued expenses and other accounts payable		(2,247		)	3,575			484
Net cash provided by operating activities		$	25,498		$	9,623		$	2,651

 

(*) Reclassified

 

The accompanying notes are an integral part of the consolidated financial statements.

 

 

44

 

DSP Group, Inc.

Consolidated Statements of Cash Flows (Cont'd)

 

		Years Ended December 31,
		2001			2000			1999
		(In Thousands)
Investing activities
Purchase of held to maturity marketable securities and bank deposits		$	(194,020	)	$	(154,992	)	$	(131,357	)
Proceeds from sales and maturity of held to maturity marketable securities and bank deposits		162,930			120,038			48,715
Purchases of property and equipment		(4,507		)	(3,403		)	(5,167		)
Proceeds from sale of property and equipment		148			57			—
Proceeds from realization of investment in an investee (*)		—			63,023			46,048
Investment in investees		—			(5,353		)	(1,241		)
Cash acquired in acquisition of consolidated subsidiary		—			106			—
Net cash provided by (used in) investing activities		(35,449		)	19,476			(43,002		)
Financing activities
Issuance of Common Stock for cash upon exercise of options and employee stock purchase plan		4,873			15,559			20,432
Issuance of Common Stock to investor		—			—			34,369
Issuance of shares to minority shareholders in consolidated subsidiary		—			112			—
Purchase of treasury stock		(811		)	(20,513		)	(2,710		)
Net cash provided by (used in) financing activities		4,062			(4,842		)	52,091
Increase (decrease) in cash and cash equivalents		(5,889		)	24,257			11,740
Cash and cash equivalents at beginning of year		45,035			20,778			9,038
Cash and cash equivalents at end of year		$	39,146		$	45,035		$	20,778
Supplemental disclosures of cash flow activities
Cash paid during the period for:
Taxes on income		$	3,806		$	26,035		$	17,300

 

(*) Reclassified

 

The accompanying notes are an integral part of the consolidated financial statements.

 

45

 

DSP Group, Inc.

Consolidated Statements of Cash Flows (Cont'd)

 

		Year Ended December 31,
		2001			2000			1999
		(In Thousands)
Cash acquired in acquisition of VoicePump, Inc.
Estimated fair value of assets acquired and liabilities assumed of the subsidiary at the date of acquisition:
Working capital (excluding cash and cash equivalents)		$	—		$	(127	)	$	—
Property and equipment		—			(17		)	—
Minority interest in subsidiary at date of acquisition		(737		)	91			—
In-process research and development		__			(10,907		)	—
Goodwill		(2,914		)	(3,832		)	—
Issuance of DSP Group shares		3,651			14,898			—
		$	—		$	106		$	—

 

The accompanying notes are an integral part of the consolidated financial statements.

46

 

DSP Group, Inc.

Notes to Consolidated Financial Statements

December 31, 2001

 

1.   General

 

DSP Group, Inc. (the “Company”) is involved in the development and marketing of digital signal processing cores used in a wide range of applications for industries such as wireless communications, broadband communications, VoIP, multimedia, advanced telecommunications systems and personal computing. By combining its DSP core technology with its advanced speech processing algorithms, DSP Group also delivers a wide range of enabling application-specific Integrated Circuits (ICs), such as ICs for fully featured Integrated Digital Telephony (IDT) products and applications, including 900 MHz and 2.4 GHz wireless technologies and for IP telephony applications.

 

The Company has four synergetic product families:

 

•                  Integrated Digital Telephony (IDT) - a family of chips, comprised of Speech and Telephony chips and Cordless Telephony chips.

 

•                  Voice Over Packet - a DSP based, highly integrated speech processor targeted for the low to medium density Integrated Accesses Device (IAD), Residential gateway and IP telephony markets.

 

•                  DSP Cores - Digital Signal Processor Cores is a family of programmable digital signal processors that, when combined with other hardware elements such as memories and input/output devices, forms a software enabled chip that is targeted for specific applications.

 

•                  TrueSpeech - a family of proprietary speech compression algorithms software.

 

The Company has six wholly owned subsidiaries:  DSP Group Ltd. (“DSP Group Israel”), an Israeli corporation primarily engaged in research, development, marketing, sales, technical support and certain general and administrative functions; RF Integrated Systems Inc. (“RF US”), a USA corporation primarily engaged in research and development of RF technology for wireless products; Nihon DSP K.K. (“DSP Japan”), a Japanese corporation primarily engaged in marketing and technical support activities; DSP Group Europe SARL, a French corporation primarily engaged in marketing and technical support activities; Voicecom Ltd. (“Voicecom”), an Israeli corporation primarily engaged in research and development for 900 MHz  and 2.4 GHz  wireless telephony products (In 2001 all Voicecom activities were transferred to DSP Group Israel)  ; and VoicePump, Inc. (“VoicePump”) a USA corporation primarily engaged in the design, research, development and marketing of software applications for the Voice Over DSL (VoDSL) and Voice Over Internet Protocol (VoIP).

 

47

 

Revenues derived from the Company’s largest reseller Tomen Electronics represented 56%, 52% and 47% of the Company’s revenues for 2001, 2000 and 1999, respectively.

 

VoicePump, Inc.

 

VoicePump, Inc. (“VoicePump”) is a US corporation primarily engaged in the design, research, development and marketing of software applications for Voice Over DSL (VoDSL) and Voice Over Internet Protocol (VoIP). In March 2000, the Company acquired (1) approximately 1,960,250 shares of Common Stock of VoicePump from certain shareholders in exchange for approximately 261,000 shares of its Common Stock and a nominal amount of cash (to pay for fractional shares) and (2) approximately 1,027,397 shares of VoicePump common stock directly from VoicePump together with warrants to purchase up to 1,027,397 shares of VoicePump Common Stock at an exercise price of $4.866 per share within two years (of the issuance of the warrant) and up to 1,027,397 additional shares at an exercise price of $4.866 per share within three years (of the issuance of the warrant) for $5,000,000.  The shares acquired from VoicePump and its shareholders, for a total consideration of $19,898,000, (not including the shares issuable upon exercise of the warrants) represent approximately 73% of the outstanding shares of VoicePump. In addition, the Company received an option to purchase the remaining shares of VoicePump from its original shareholders.

 

In the second quarter of 2000 the investment in VoicePump was diluted due to exercise of warrants by a VoicePump shareholder to approximately 71% of the outstanding shares of VoicePump. Due to this transaction, the Company recorded in the second quarter of 2000 a loss of $100,000 which was attributed to minority gain in VoicePump’s stock issue. The Company’s original investment in VoicePump included the excess of purchase price over net assets acquired (approximately $16,070,000 at the date of purchase), which was attributed to in-process research and development and to goodwill.  The acquisition was treated on the basis of the purchase method of accounting in accordance with APB No. 16 “business combinations”.  The operating expenses in 2000 include unusual items in the amount of $11,869,000 related to the acquired in-process research and development which was written off in the first quarter of 2000. The write-off was due to unestablished technological feasibility and to no alternative future use of it.  Other intangible assets acquired had an estimated fair value of $4,201,000 and were recorded as goodwill to be amortized over seven years. The operations of VoicePump are included in the consolidated statements from the second quarter of year 2000.

 

In March 2001, the Company exercised its option and acquired the remaining shares of VoicePump (1,210,750 shares), in exchange for 161,433 shares of the Company’s Common Stock, as provided in the original stock-purchase agreement executed March 22, 2000. As a result of the purchase of the remaining equity, VoicePump became part of the Company’s U.S.-based broadband products group and will continue to focus on the development of its VP100 family of products, first announced in October 2000. The goodwill that was created at the purchase of the remaining shares of VoicePump, in the year 2001,  amounted to $2,914,000 and is amortized over the remaining period . The Company’s current investment in VoicePump included the excess of its purchase price over the net assets acquired (approximately $5,804,000 as of December 31, 2001), which was attributed to goodwill to be amortized for seven years from the date of purchase (for more information about goodwill amortization, see New Accounting Pronouncements note). Pro forma information in accordance with APB-16 “business

 

48

 

combinations” has not been provided, since the revenues of 2001 and 2000 were not material in relation to total consolidated revenues.

 

Concentration of Other Risks

 

All of the Company’s integrated circuit products are manufactured by independent foundries. While these foundries have been able to adequately meet the demands of the Company’s increasing business, the Company is and will continue to be dependent upon these foundries to achieve acceptable manufacturing yields, quality levels and costs, and to allocate to the Company sufficient portion of foundry capacity to meet the Company’s needs in a timely manner. To meet the Company’s increased wafer requirements, the Company has added additional independent foundries to manufacture its processors.  Revenues could be materially and adversely affected should any of these foundries fail to meet the Company’s request for products due to a shortage of production capacity, process difficulties, low yield rates or financial instability. For example, foundries in Taiwan produce a significant portion of the Company’s wafer supply. As a result, earthquakes, aftershocks or other natural disasters in Asia, could preclude the Company from obtaining an adequate supply of wafers to fill customer orders and could harm our business, financial condition, and results of operations. Additionally, certain of the raw materials, components, and subassemblies included in the products manufactured by the Company’s OEM customers, which also incorporate the Company’s products, are obtained from a limited group of suppliers.  Disruptions, shortages, or termination of certain of these sources of supply could occur.

 

2.  Significant Accounting Policies

 

The consolidated financial statements have been prepared in accordance with General Accepted Accounting Principles in the United States (“US GAAP”).

 

Use of Estimates

 

The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes.  Actual results could differ from these estimates.

 

Revenue Recognition

 

The Company generates its revenues from sale of products, software licensing, royalties, maintenance and support fees. The  Company  sells its products through direct sales force and throughout resellers and distributors. The Company licenses its software to semiconductor companies throughout the world. These semiconductor companies then manufacture, market and sell custom-designed chips to original equipment manufacturers (OEMs) of a variety of electronic products. The Company also licenses its software  directly to OEMs.

 

49

Product Sales

 

Product sales of integrated digital telephony (“IDT”) processors for communications applications, telephony and other products are recognized in accordance with Staff Accounting Bulletin (SAB) No. 101 “Revenue Recognition in Financial Statements” when persuasive evidence of an agreement exists, delivery of the product has occurred, the fee is fixed or determinable and collectability is probable. The Company generally does not grant a right of return to its customers. The Company maintains provision for product returns in accordance with SFAS No. 48  “Revenue Recognition When Right of Return Exists”. The provision was deducted from revenues, and amounted to  $123 for the years ended December 31, 2001, 2000 and 1999.

 

Revenues subject to certain price protection is deferred until such future price changes can be reasonably estimated. The provision for price protection was deducted from revenues, and amounted to  $194 thousands, $286 thousands and $322 thousands for the years ended December 31, 2001, 2000 and 1999, respectively.

 

Software licensing, Royalty and Other Revenues

 

The Company accounts for software license in accordance with Statement of Position (SOP) 97–2, as amended,  “Software Revenue Recognition”. SOP 97-2, generally requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fair value of the elements. The Company has adopted SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions,” for all multiple element transactions entered into after January 1, 2000. SOP 98-9 requires that revenue be recognized under the “residual method” when vendor specific objective evidence (VSOE) of fair value exists for all undelivered elements and VSOE does not exist for  one of the delivered elements.

 

Software licensing revenues are recognized when: (1) collection is probable; (2) delivery has occurred; (3) the license fee is otherwise fixed and determinable; and (4) persuasive evidence of an arrangement exists.

 

SOP 97-2 specifies that extended payment terms in a software licensing agreements may indicate that the software license fee are not deemed to be fixed or determinable. If the fee is not fixed or determinable, or if collection is questionable, revenue is recognized as payments become due from the customer provided that all other revenue recognition criteria have been met.However, SOP 97-2 specifies that if the Company has a standard business practice of using extended payment terms in software licensing arrangements and has a history of successfully collecting the software license fees under the original terms of the software licensing arrangement without making concessions, the Company overcomes the presumption that the software license fees are not fixed or determinable. Thus, the Company should recognize the software license fees when all other SOP 97-2 revenue recognition criteria are met. The Company has concluded that for certain software arrangements with extended payment terms, the “fixed or determinable” presumption has been overcome and software license fees have been recognized upon meeting the remaining SOP 97-2 revenue recognition criteria.

 

50

 

 

Maintenance and support revenue included in multiple element arrangements is deferred and recognized on a straight-line basis over the term of the maintenance and support agreement. Costs related to insignificant obligations, primarily telephone support, are accrued and recognized upon shipment and are included in cost of revenues.  The VSOE of fair value of undelivered elements (maintenance and support fees) is determined based on the price charged for the undelivered element where sold separately.

 

Certain royalty agreements provide for per unit royalties to be paid to the Company based on shipments by customers of units containing the Company’s products.  Revenue under such agreements is recognized at the time of shipment by the customers as they are reported to the Company by these customers. Non refundable payment on account of future royalties from similar agreements, are recognized upon payments, provided no future obligation exists. The Company does not grant rights of return on software licensing sales.

 

Fair Value of Financial Instruments

 

SFAS No. 107, “Disclosure About Fair Value of Financial Instruments”, requires disclosures about the fair value of financial instruments. The carrying values of cash and cash equivalents, short term bank deposits, trade receivables and trade payables approximate fair values due to the short-term maturities of these instruments. The fair value for held to maturity marketable securities is based on amortized cost, and do not differ significantly from the quoted market value.  The fair value of available for sale marketable securities are based on quoted market price.

 

Principles of Consolidation

 

The consolidated financial statements include the accounts of the Company and its subsidiaries. Intercompany transactions and balances, including profits from Intercompany sales not yet realized outside the group, have been eliminated in consolidation.

 

Property and Equipment, net

 

Property and equipment are stated at cost, net of accumulated depreciation.  Depreciation is calculated  using the straight-line method over the estimated useful lives of the assets, at the following annual rates:

 

		%
Computers and peripheral equipment		20-33
Office furniture and equipment		7-10
Motor vehicles		15
Leasehold improvements		(over the terms of the lease)

 

The Company accounts for asset impairment in accordance with the provisions of SFAS No. 121, “Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of”, which requires impairment losses to be recorded on long-lived assets used in operations,

 

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certain identifiable intangibles, and the goodwill related to those assets, when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets’ carrying amount. In this case, an impairment loss is recognized to the extent that the carrying amount exceeds the fair value of the assets. Statement No. 121 also addresses the accounting for long-lived assets that are expected to be disposed of. Such assets are reported at the lower of their carrying amount of fair value, less costs to sell the assets.

 

Non-royalty-bearing grants

 

Non-royalty-bearing grants from the Government of Israel for funding certain approved research and development projects are recognized at the time when the Company is entitled to such grants, on the basis of the related costs incurred, and included as a deduction from research and development costs.

 

The Company recorded grants participation in the amounts of $542 thousands, $ 578 thousands and $70 thousands for the years ended December 31, 2001, 2000 and 1999, respectively.

 

Inventories

 

Inventories are stated at the lower of cost or market value. Cost is determined using the average cost method.  The Company periodically evaluates the quantities on hand relative to current and historical selling prices and historical and projected sales volume.  Based on these evaluations, provisions are made in each period to write inventory down to its net realizable value.  Inventories are composed of the following:

 

		December 31,
		2001			2000
		(US dollars in thousands)
Work-in-process		$	853		$	34
Finished goods		1,245			2,781
		$	2,098		$	2,815

 

Other Assets

 

Other assets are composed as follows:

 

		December 31,
		2001			2000
		(US dollars in thousands)
Goodwill		$	5,804		$	3,854
Long term prepaid expenses and deposit		615			405
		$	6,419		$	4,259

 

In the beginning of 1999, the Company acquired two integrated groups of engineers, one located in Israel and the other in the United States.  These twenty-five engineers specialize in the design of integrated circuits for wireless communications.  In addition, the company acquired technology and products, including associated intellectual property, related to 900 MHz narrow-band cordless telephones and 900 MHz spread spectrum cordless telephones.

 

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In connection with the above, the Company capitalized approximately $2.0 million of acquired assets and work force. As of December 31, 1999, the net balance of the workforce was approximately $1.1 million. The Company accounts for asset impairment in accordance with the provisions of FASB Statement No. 121, “Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of”, accordingly, in the first quarter of 2000 the Company recorded an unusual expense item in the amount of $1,115,000, of which the outstanding balance of the capitalized assets were amortized. Management believes that the undiscounted cash flows estimated to be generated by those assets are less than the assets’ carrying amount.

 

Other Investments

 

Other investments are comprised of:

 

		December 31,
		2001			2000
		(US dollars in thousands)
Equity method investment:
AudioCodes Ltd. (1)		$	—		$	20,417
Available for sale investments:
AudioCodes Ltd. (1)		25,146			—
Tomen Corporation (2)		292			485
Cost method investment:
Other investment		98			98
		$	25,536		$	21,000

 

(1)  AudioCodes, Ltd.

 

AudioCodes, Ltd. (“AudioCodes”) is an Israeli corporation primarily engaged in design, research, development, manufacturing and marketing hardware and software products that enables simultaneous transmission of voice and data over networks including Internet, ATM and Frame Relay.  The Company acquired an approximate 35% ownership in AudioCodes in two separate transactions in 1993 and 1994.  In July 1997, AudioCodes completed a private placement of additional equity securities without the participation of the Company and, as a result, the Company’s equity ownership interest in AudioCodes was diluted from 35% to approximately 29%.  The Company also had an option under certain conditions to purchase up to an additional 5% of the outstanding stock of AudioCodes.

 

Until March 31, 2001, the Company accounted for its ownership in AudioCodes using the equity method.  The Company’s original investment in AudioCodes included the excess of purchase price over net assets acquired (approximately $1,907,000 at the date of purchase), which was attributed to developed technology to be amortized over seven years.  The private placement by AudioCodes in July 1997 was at a price per share greater than the Company’s then current investment in AudioCodes.  As a result, even though the Company’s ownership interest decreased from 35% to 29%, the Company’s proportionate share of the net assets of AudioCodes increased from $816,000 to $1,481,000 at the date of the private placement.  This increase in the Company’s proportionate share of the net assets of AudioCodes reduced the remaining

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unamortized excess of purchase price over net assets acquired from $1,080,000 to $415,000 as of the date of the private placement.

 

In May 1999, the Company exercised its option to purchase approximately 3.5% of the outstanding stock of AudioCodes for approximately $1.2 million. In the same month AudioCodes completed its initial public offering (IPO) and is traded  on the Nasdaq SmallCap Market under the symbol AUDC. In its IPO, AudioCodes issued 7.0 million shares at a price of $7.00 per share. As a result, the Company recorded in its consolidated statements of income for 1999 a one-time capital gain in the amount of $11.8 million. This amount was comprised of $9.4 million, from shares sold in the IPO and $2.5 million from the sale of approximately 496,000 AudioCodes shares to the underwriters, to cover their over-allotment option. The gross proceeds to the Company from this sale were approximately $3.2 million. In October 1999, AudioCodes successfully concluded a follow-on public offering of 6.0 million shares at a price of $20.50 per share. In the follow-on, AudioCodes issued and sold 3.0 million shares and an additional 3.9 million shares were sold by shareholders, of which approximately 2.1 million shares were sold by the Company in two separate transactions. The gross proceeds to the Company from these transactions were approximately $42.8 million, and were recorded as additional capital gain in the amount of $47.1 million. This amount was comprised of $10.8 million, which resulted from the public offering and $36.3 million from the sale of approximately 2.1 million AudioCodes shares. As of December 31, 1999, the Company amortized all the remaining portion of the excess of purchase price over net assets.

 

In January 2000, the Company sold an additional 1,200,000 shares of AudioCodes for approximately $43.8 million and recorded in the first quarter of 2000, an additional capital gain in the amount of $40.0 million. In May 2000 the Company sold addition 500,000 shares of AudioCodes for approximately $19.2 million and recorded in the second quarter of 2000, an additional capital gain in the amount of $17.6 million. In the fourth quarter of 2000 the Company purchased in the open market 300,000 of AudioCodes shares for approximately $4.9 million. This transaction created an excess of purchase price over net assets acquired (approximately $3.7 million at the date of purchase), which was attributed to goodwill to be amortized over seven years.

 

The Company currently owns approximately 4.5 million of AudioCodes shares, which represents approximately 11% of its outstanding shares. As of April 1, 2001, the Company no longer maintained a representative on the AudioCodes’ Board of Directors, and was not involved in any way in AudioCodes’ policy making processes. Therefore, commencing April 1, 2001, the Company does not have significant influence over the operating and financial policies of AudioCodes and thus cannot continue to account for this investment under the equity method of accounting.

 

As of April 1, 2001, the carrying amount of the investment in AudioCodes, under the equity method of accounting, amounted to $20.5 million. As of April 1, 2001, the investment in AudioCodes was  reclassified as available-for-sale marketable securities in accordance with SFAS 115 “Accounting for Certain Investments in Debt and Equity Securities”.

 

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Securities available for sale are carried at fair value, with the unrealized gains and losses, net of income taxes, reported as a separate component of stockholders’ equity -  “accumulated other comprehensive income”.

 

As of December 31, 2001, the fair market value of the Company’s investment in AudioCodes was approximately $25.1 million.

 

The consolidated balance sheet as of December 31 , 2001 include unrealized gain on available-for-sale marketable securities of $4.6 million, net of unrealized tax expenses of $1.7 million, in the investment in AudioCodes.

 

The Company’s equity in the net income of AudioCodes was $105,000 in the first quarter of 2001, $2,644,000 in 2000, and $2,475,000 in 1999. All shares and per share numbers with respect to AudioCodes have been adjusted to reflect the 2 for 1 Stock Split effected by AudioCodes in October 2000.

 

(2)  Tomen Corporation

 

In September 2000, the Company invested approximately $485,000 (50.0 million Yen) in shares of its Japanese distributor’s parent company, Tomen Corporation, as part of a long strategic relationship. Tomen’s shares are traded on the Japanese stock exchange, and are recorded in “Other Investments” on the balance sheets. The Company accounts for investments in debt and equity securities in accordance with FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities”.  Securities available for sale are carried at fair value, with the unrealized gains and losses, net of income taxes, reported as a separate component of stockholders’ equity, accumulated other comprehensive income (loss). Realized gains and losses on sales of investments, as determined on a specific identification basis, are included in the consolidated statement of income.

 

As of December 31, 2001, the fair market value of the Company’s investment in Tomen  was approximately $292,000.

 

The condensed consolidated balance sheets as of December 31 , 2001 include unrealized loss on available-for-sale marketable securities of $193,700.

 

Foreign Currency Translations

 

A majority of the revenues of the Company and its subsidiaries is generated in US dollars (“dollar”). In addition, a substantial portion of the Company’s and its subsidiaries costs are incurred in dollars.  The Company’s management believes that the dollar is the primary currency of the economic environment in which the Company and its subsidiaries operate. Thus, the functional and reporting currency of the Company and its subsidiaries is the dollar.

 

Accordingly, monetary accounts maintained in currencies other than the dollar are remeasured into U.S. dollars in accordance with SFAS No. 52 — “Foreign Currency Translations”. All transactions gains and losses of the remeasurement of monetary balance sheet items are reflected

 

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in the consolidated statements of income as financial income or expenses as appropriate, and have not been significant to date

 

Net Earnings Per Share

 

Basic net earnings per share is computed based on the weighted average number of shares of Common Stock outstanding during the year.  For the same periods, diluted net earnings per share further includes the effect of dilutive stock options outstanding during the year, all in accordance with SFAS No. 128, “Earnings per Share”.  The following table sets forth the computation of basic and diluted net earnings per share:

 

		2001			2000					1999
		(US dollars in thousands except per share amounts)
Numerator:
Net Income		$	21,916			$	49,835			$	54,579
Denominator:
Weighted average number of shares of Common Stock outstanding during the period used to compute basic net earnings per share		26,641				26,616				23,468
Incremental shares attributable to exercise of outstanding options (assuming proceeds would be used to purchase treasury stock)		965				2,053				1,974
Weighted average number of shares of Common Stock used to compute diluted net earnings per share		27,606				28,669				25,442
Basic net earnings per share		$	0.82			$		1.87		$		2.33
Diluted net earnings per share		$	0.79			$		1.74		$		2.15

 

Options outstanding to purchase approximately 2,670,000, 432,000 and 182,000  shares of Common Stock for the years ended December 31, 2001, 2000 and 1999, respectively, were not included in the computation of diluted net earning per share, because option exercise prices were greater than the average market price of the Common Stock and therefore, the effect would have been antidilutive.

 

Concentration of Credit Risk

 

Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents, marketable securities, short-term bank deposits and trade receivables.

 

The Company’s cash, cash equivalents and short term bank deposit are invested in major US and Israeli banks.  Such cash and cash equivalents and short term bank deposits in the United States may be in excess of insured limits and are not insured in other jurisdictions. Management

 

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believes that the financial institutions holding the Company’s investments are financially sound, the portfolio is well diversified, and accordingly, minimal credit risk exists with respect to these investments. The majority of the Company’s sales of products are to distributors who in turn sell to manufacturers of consumer electronics products.  The Company’s software licensing revenues are primarily from customers that have licensed rights to use the Company’s DSP Core microprocessor architectures and speech compression technology.  No collateral is required from the Company’s licensing customers; however, some of the customers pay using letters of credit. An allowance for doubtful accounts is determined with respect to those amounts that the Company has determined to be doubtful of collection.

 

The Company’s customers are located primarily in Japan, Europe and the United States. The Company performs ongoing credit evaluations of its customers.

 

Derivative instruments

 

SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, requires companies to recognize all of its derivative instruments as either assets or liabilities in the statement of financial position at fair value.

 

For derivative instruments that are designated and qualify as a cash flows hedge (i.e., hedging the exposure to variability in expected future cash flows that is attributable to a particular risk), the effective portion of the gain or loss on the derivative instrument is reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. The remaining gain or loss on the derivative instrument in excess of the cumulative change in the present value of future cash flows of the hedged item, if any, is recognized in current earnings during the period of change. For derivative instruments not designated as hedging instruments, the gain or loss is recognized in current earnings during the period of change.

 

To protect against the increase in value of forecasted foreign currency cash flows resulting from salary payments in NIS during the year, the Company has instituted a foreign currency cash flow hedging program. The Company hedges portions of the anticipated payroll of its Israeli subsidiary denominated in NIS for a period of two to ten months with forward contracts and put options.

 

These forward contracts and put options are designated as cash flow hedges, as defined by SFAS No. 133 and are all effective as hedges of these expenses.

 

As of December 31, 2001, the Company recorded a comprehensive loss amounting to $30.5 thousands which derives from its forward contracts in respect to anticipated payroll payments expected in the year 2002. Such amounts will be recorded into earnings in 2002.

 

Cash Equivalents

 

The Company considers all highly liquid investments which are readily convertible to cash with an original maturity of three months or less when purchased to be cash equivalents.

 

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Marketable Securities and Short Term Bank Deposits

 

Marketable Debt securities have been designated as held to maturity under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities”.  The amortized cost of held to maturity securities is adjusted for the amortization of premiums and accretion of discounts to maturity.  Such amortization is included in interest and other income.  The cost of securities matured is based on the specific identification method. Interest on securities classified as held to maturity are included in interest and other income.

 

Cash deposits originally purchased with a maturity of over three months are considered as short-term investments.

 

The following is a summary of held-to-maturity securities and short term bank deposits at December 31, 2001 and 2000 :

 

		Amortized Cost						Unrealized gains (losses)						Estimated fair value
		2001			2000			2001			2000			2001			2000
		(US dollars in thousands)
Obligations of states and political subdivisions		$	63,190		$	52,253		$	(152	)	$	(65	)	$	63,038		$	52,188
Corporate obligations		147,455			110,916			2,261			1,464			149,716			112,380
		$	210,645		$	163,169		$	2,109		$	1,399		$	212,754		$	164,568

 

Short term bank deposits amounted to $0 and $14,997 at December 31, 2001 and 2000, respectively.

 

At December 31, 2001 and 2000, the carrying amount of securities approximated the fair value and the amount of unrealized gain or loss was not significant.  Gross realized gains or losses for 2001, 2000, and 1999 were not significant. The amortized cost of held-to-maturity debt and securities at December 31, 2001, by contractual maturities, are shown below:

 

		Amortized Cost			Estimated fair value
		(US dollars in thousands)
Due in one year or less		$	70,893		$	72,641
Due after one year		139,752			140,113
		$	210,645		$		212,754

 

Severance Pay

 

The Company’s subsidiaries, DSP Group Ltd. and VoicePump, Inc., have liability for severance pay pursuant to Israeli law, based on the most recent monthly salary of the employees multiplied by the number of years of employment as of the balance sheet date for all employees.  The

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Company’s liability is fully provided by monthly deposits with severance pay funds and insurance policies.

 

The deposited funds include profits accumulated up to the balance sheet date.  The deposited funds may be withdrawn only upon the fulfillment of the obligation pursuant to Israeli severance pay law or labor agreements. The value of these policies is recorded as an asset in the Company’s balance sheet.

 

Severance expenses for the years ended December 31, 2001, 2000 and 1999, were approximately $875,000, $890,000, and $593,000, respectively.

 

Accounting for Stock-Based Compensation

 

The Company accounts for stock-based compensation in accordance with the provisions of Accounting Principles Board Opinion No. 25, (“APB-25”),  “Accounting for Stock Issued to Employees” and FASB interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation” (“FIN-44”) in accounting for its employee stock options. Under APB-25, when the exercise price of the employee’s options equals or is higher than the market price of the underlying Company stock on the date of grant, no compensation expense is recognized. The pro-forma information with respect to the fair value of the options is provided in accordance with the provisions of statement No. 123 “Accounting for Stock Based Compensation” (see Note 4).

 

New Accounting Pronouncements

 

In June 2001, the Financial SFAS No. 141, “Business Combinations”, and No. 142, “Goodwill and Other Intangible Assets”, effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill (and intangible assets deemed to have indefinite lives) will no longer be amortized but will be subject to annual impairment tests in accordance with the Statements. Other intangible assets will continue to be amortized over their useful lives.

 

The Company will apply the new rules on accounting for goodwill and other intangible assets beginning in the first quarter of 2002. Application of the nonamortization provisions of the Statements are expected to result in an increase in the net income of $1.033 million per year.

 

In August 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (FAS 144), which addresses financial accounting and reporting for the impairment or disposal of long-lived assets and supersedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of”, and the accounting and reporting provision of APB Opinion No. 30, “Reporting the Results of Operations for a disposal of a segment of a business”.  FAS 144 is effective for fiscal years beginning after December 15, 2001, with earlier application encouraged.  The Company expects to adopt FAS 144 as of January 1, 2002 and it does not expect that the adoption of FAS 144 will have a significant impact, if any, on the Company’s financial position and results of operations.

 

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Income Taxes

 

The Company and its subsidiaries accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes”.  This statement prescribes the use of the liability method, whereby deferred tax asset and liability account balances are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates that will be in effect when the differences are expected to reverse.  The Company and its subsidiaries provide a valuation allowance, if necessary, to reduce deferred tax assets to their estimated realizable value.

 

Research and Development Costs

 

Research and development costs are charged to the statement of operations as incurred.

 

Advertising expenses

 

Advertising expenses are carried to the statement of operations as incurred.

 

Reclassification

 

Certain amounts from prior years referring to held to maturity marketable securities in the balance sheet and to capital gains in the statements of cash flow have been reclassified to conform with current period presentation.

 

3.  Property And Equipment, Net

 

Composition of assets, grouped by major classifications, is as follows:

 

		December 31,
		2001				2000
		(US dollars in thousands)
Computers and peripheral equipment		$		19,395		$		15,229
Office furniture and equipment		1,138				1,076
Motor vehicles		717				1,145
Leasehold improvements		2,258				2,076
		23,508				19,526
Less accumulated depreciation		15,919				13,075
Depreciated cost		$	7,589			$	6,451

 

4.  Stockholders’ Equity

 

Preferred Stock

 

The Board of Directors has the authority, without any further vote or action by the stockholders, to provide for the issuance of up to 5,000,000 shares of Preferred Stock in one or more series with such designations, rights, preferences, and limitations as the Board of Directors may determine, including the consideration received, the number of shares comprising each series, dividend rates, redemption provisions, liquidation preferences, sinking fund provisions, conversion rights, and voting rights.

 

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