UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the Quarterly Period Ended September 30, 2004

OR

o

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

For the Transition Period from             to

Commission File Number 000-31803

TRANSMETA CORPORATION

3990 Freedom Circle, Santa Clara, CA 95054
(Address of principal executive offices, including zip code)

(408) 919-3000
(Registrant’s telephone number, including area code)

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

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No o

     There were 176,468,261 shares of the Company’s common stock, par value $0.00001 per share, outstanding on October 22, 2004.

TRANSMETA CORPORATION

FORM 10-Q
Quarterly Period Ended September 30, 2004

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements

TRANSMETA CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(See accompanying notes)

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TRANSMETA CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(See accompanying notes)

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TRANSMETA CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(See accompanying notes)

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TRANSMETA CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission and accounting principles generally accepted in the United States for interim financial information. However, certain information or footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed, or omitted, pursuant to such rules and regulations. The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements. Actual results could differ from those estimates. Significant estimates made in preparing the financial statements include license revenue recognition, inventory valuations, long-lived and intangible asset valuations, restructuring charges and loss contingencies. In the opinion of management, the statements include all adjustments (which are of a normal and recurring nature) necessary for the fair presentation of the results of the interim periods presented. These financial statements should be read in conjunction with our audited consolidated financial statements and the notes thereto included in the Company’s Form 10-K for the year ended December 31, 2003. The results of operations for the three months and nine months ended September 30, 2004 are not necessarily indicative of the operating results for the full fiscal year or any future period.

     The financial statements of the Company have been presented based on the assumption that the Company will continue as a going concern. The Company, however, has a history of substantial losses, and expects to incur future losses. The Company has historically reported negative cash flows from operations because the gross profit, if any, generated from its product and licensing revenues has not been sufficient to cover its operating cash requirements. The Company believes that its existing cash and cash equivalents and short-term investment balances and cash from operations will be insufficient to fund its operations, planned capital and R&D expenditures for the next 12 months on its current business model. Accordingly, the Company intends to raise during that time period additional funds through public or private equity or debt financing or by any other means available to the Company at that time. Additional funds may not be available on terms favorable to the Company or at all. In the event that the Company is unable to raise additional funds, it is positioned to modify its current business model, for example, by leveraging its intellectual property assets and by focusing on its strategy of licensing its advanced power management and other technologies to other companies and, in doing so, to substantially limit its operations and reduce costs related to aspects of the business other than intellectual property and technology licensing to permit it to continue to operate on a modified business model for a period that extends at least through September 30, 2005.

     The Company’s fiscal year ends on the last Friday in December, and each fiscal quarter ends on the last Friday of each calendar quarter. For ease of presentation, the accompanying financial information has been shown as of December 31 and calendar quarter ends for all annual and quarterly financial statement captions. The three-month periods ended September 24, 2004 and September 26, 2003 each consisted of 13 weeks. The first nine months of fiscal 2004 and 2003 each consisted of 39 weeks.

2. Net Loss per Share

     Basic and diluted net loss per share is presented in conformity with the Financial Accounting Standards Board’s (FASB) Statement of Financial Accounting Standards (SFAS) No. 128, “Earnings Per Share”, for all periods presented. Basic and diluted net loss per share has been computed using the weighted-average number of shares of common stock outstanding during each period, less weighted-average shares subject to repurchase.

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     The following table presents the computation of basic and diluted net loss per share:

     The Company has excluded all outstanding stock options and shares subject to repurchase from the calculation of basic and diluted net loss per share because these securities are antidilutive for all periods presented. Options and warrants to purchase 41,923,626 and 35,532,096 shares of common stock at September 30, 2004 and 2003, respectively, determined using the treasury stock method, were not included in the computation of diluted net loss per share because the effect would be antidilutive. These securities, had they been dilutive, would have been included in the computation of diluted net loss per share using the treasury stock method.

3. Revenue Recognition

     The Company recognizes revenue from products sold when persuasive evidence of an arrangement exists, the price is fixed or determinable, title of goods is transferred and collectibility is reasonably assured. The Company accrues for estimated sales returns, and other allowances at the time of shipment. Certain of the Company’s product sales are made to distributors under agreements allowing for price protection and/or right of return on unsold products. The Company defers recognition of revenue on these sales until the distributors sell the products. The Company may also sell certain products with “End of Life” status to its distributors under special arrangements without price protection or return privileges for which revenue is recognized upon transfer of title, typically upon shipment.

     The Company enters into license agreements, some of which may contain multiple elements, including technology license and support services, or non-standard terms and conditions. As a result, in accordance with Emerging Issues Task Force (EITF) Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” and the Securities and Exchange Commission’s Staff Accounting Bulletin No. 104, “Revenue Recognition”, significant interpretation on these agreements is sometimes required to determine the appropriate accounting, including whether deliverables specified in a multiple element arrangement should be treated as separate units of accounting for revenue recognition purposes, and if so, how the price should be allocated among the deliverable elements and when to recognize revenue for each element. The Company recognizes revenue from license agreements when earned, which generally occurs when agreed-upon deliverables are provided, or milestones are met and confirmed by licensees and relative fair values of multiple elements can be determined. Additionally, license revenues and maintenance and service revenues are recognized only if payments received are non-refundable and not subject to any future performance obligation by the Company. The Company recognizes revenue from maintenance agreements based on the fair value of such agreements ratably over the period in which such services are rendered.

     License and service revenue for the three and nine months ended September 30, 2004 were $3.7 million and $4.2 million, respectively. Through September 30, 2004, the Company has collected a total of $3.5 million for technology transfer fees and maintenance service fees related to an agreement with its initial LongRun2 licensing partner. The Company has recognized revenue in respect of this agreement upon receipt of payments which are non-refundable and not subject to any future performance obligation by the Company.

4. Stock Based Compensation

     The Company accounts for its stock options and equity awards in accordance with the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”, and related interpretations and has elected to follow the “disclosure only” alternative prescribed by SFAS 123, “Accounting for Stock-Based Compensation.” Expense associated with stock-based compensation is amortized on an accelerated basis over the vesting period of the individual award consistent with the method

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described in FASB Interpretation 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plan.” Accordingly, approximately 59% of the unearned deferred compensation is amortized in the first year, 25% in the second year, 12% in the third year, and 4% in the fourth year following the date of grant. Pursuant to SFAS 123, Transmeta discloses the pro forma effect of using the fair value method of accounting for its stock-based compensation arrangements. In December 2002, the FASB issued, and the Company adopted, SFAS 148, “Accounting for Stock-Based Compensation - Transition and Disclosure — an Amendment of FASB Statement No. 123”. SFAS 148 amends the disclosure requirements of FASB’s SFAS 123, “Accounting for Stock-Based Compensation”, to require more prominent disclosures in both annual and interim financial statements regarding the method of accounting for stock-based employee compensation and the effect of the method used on reported results.

     For purposes of pro forma disclosures, the estimated fair value of options is amortized to pro forma expense over the option’s vesting period using an accelerated graded method. Pro forma information follows:

     The fair value for the Company’s stock-based awards is estimated at the date of grant using a Black-Scholes option-pricing model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, the Black-Scholes option-pricing model requires the input of highly subjective assumptions, including expected stock price volatility. Because the Company’s stock-based awards have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its stock-based awards. The fair value of options granted was determined based on estimated stock price volatility. The weighted average assumptions used to determine fair value were as follows:

5. Net Comprehensive Loss

     Net comprehensive loss includes the Company’s net loss, as well as accumulated other comprehensive income/(loss) on available-for-sale investments and foreign currency translation adjustments. Net comprehensive loss for the three and nine month periods ended September 30, 2004 and 2003, respectively, is as follows (in thousands):

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     The components of accumulated other comprehensive income/(loss), net of taxes as of September 30, 2004 and December 31, 2003, respectively, is as follows (in thousands):

6. Inventories

     Inventories are stated at the lower of cost (first-in, first-out) or market. The components of inventories consist of the following (in thousands):

     In the third quarter of fiscal 2004, the Company recorded a $3.2 million charge related to inventory on hand, which resulted in a reduction of the carrying value of that inventory. The Company additionally recorded a $3.6 million charge during the period related to non-cancelable commitments for substrates and wafers on order with our third-party suppliers, as such contractual commitments were in excess of that inventory’s net realizable value. The charge for inventory on hand as well as the charge for inventory on order primarily related to the cost to manufacture our 130 nanometer and 90 nanometer Efficeon products exceeding the price at which we expect to be able to sell these products. Of the $7.5 million and $8.8 million of net inventory on hand at September 30, 2004 and December 31, 2003, respectively, $2.3 million and $2.6 million of net inventory, respectively, were stated at net realizable value. Accordingly, gross margin may be impacted from future sales of these parts to the extent that the associated revenue exceeds or fails to achieve their currently adjusted values. Benefits to gross margin as a result of products being sold at ASPs in excess of their previously written down values were $0.1 million and $0.3 million for the three and nine months ended September 30, 2004, respectively, compared to $0.2 million and $0.6 million for the same periods last year.

7. Restructuring Charges

     In the second quarter of fiscal 2002, Transmeta recorded a $10.6 million restructuring charge as a result of the Company’s decision to cease development and productization of the TM6000 microprocessor. The restructuring charge consisted primarily of lease costs, equipment write-offs and other costs as the Company identified a number of leased facilities as well as leased and owned equipment that were no longer required.

     During the fourth quarter of fiscal 2003, Transmeta reassessed the adequacy of the remaining accrual and adjusted the accrued restructuring costs as a result of an update in certain underlying assumptions.

     During the third quarter of fiscal 2004, Transmeta reassessed the adequacy of the remaining accrual and adjusted the accrued restructuring costs as a result of an update in certain underlying assumptions. In view of current market conditions, the Company has no assumptions of subleasing previously vacated space that remains unused as of September 30, 2004. As a result of this update in assumptions, the Company adjusted the accrued restructuring costs and recorded a charge of $0.9 million in restructuring charges.

     Accrued restructuring charges consist of the following at September 30, 2004 (in thousands):

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8. Related Party Transaction

     Transmeta entered into a trademark and technology licensing agreement during fiscal 2003 with Chinese 2 Linux (Holdings) Limited. In relation to this agreement, the Company became a 16.6% beneficial owner of the party with which the agreement was entered. In relation to this agreement, the Company recognized license revenue of $198,000 and $720,000 for the three and nine months ended September 30, 2004, respectively.

9. Recent Accounting Pronouncements

     In March 2004, the FASB issued a proposed Statement, “Share-Based Payment, an amendment of FASB Statements Nos. 123 and 95,” that addresses the accounting for share-based payment transactions in which a Company receives employee services in exchange for either equity instruments of the Company or liabilities that are based on the fair value of the Company’s equity instruments or that may be settled by the issuance of such equity instruments. The proposed statement would require all companies to measure compensation cost for all share-based payments at fair value. The effective date of the proposed standard is for periods beginning after June 15, 2005. The Company is currently evaluating the effect that the adoption of the proposed statement will have on its financial position and results of operations.

10. Legal Proceedings

     The Company is a party in one consolidated lawsuit. Beginning in June 2001, the Company, certain of its directors and officers, and certain of the underwriters for its initial public offering were named as defendants in three putative shareholder class actions that were consolidated in and by the United States District Court for the Southern District of New York in In re Transmeta Corporation Initial Public Offering Securities Litigation, Case No. 01 CV 6492. The complaints allege that the prospectus issued in connection with the Company’s initial public offering on November 7, 2000 failed to disclose certain alleged actions by the underwriters for that offering, and alleges claims against the Company and several of its officers and directors under Sections 11 and 15 of the Securities Act of 1933, as amended, and under Sections 10(b) and Section 20(a) of the Securities Exchange Act of 1934, as amended. Similar actions have been filed against more than 300 other companies that issued stock in connection with other initial public offerings during 1999-2000. Those cases have been coordinated for pretrial purposes as In re Initial Public Offering Securities Litigation, Master File No. 21 MC 92 (SAS). In July 2002, the Company joined in a coordinated motion to dismiss filed on behalf of multiple issuers and other defendants. In February 2003, the Court granted in part and denied in part the coordinated motion to dismiss, and issued an order regarding the pleading of amended complaints. Plaintiffs subsequently proposed a settlement offer to all issuer defendants, which settlement would provide for payments by issuers’ insurance carriers if plaintiffs fail to recover a certain amount from underwriter defendants. Although the Company and the individual defendants believe that the complaints are without merit and deny any liability, but because they also wish to avoid the continuing waste of management time and expense of litigation, they accepted plaintiffs’ proposal to settle all claims that might have been brought in this action. The Company and the individual Transmeta defendants expect that their share of the global settlement will be fully funded by their director and officer liability insurance. Although the Company and the Transmeta defendants have approved the settlement in principle, it remains subject to several procedural conditions, as well as formal approval by the Court. It is possible that the parties may not reach a final written settlement agreement or that the Court may decline to approve the settlement in whole or part. In the event that the parties do not reach agreement on the final settlement, the Company and the Transmeta defendants believe that they have meritorious defenses and intend to defend any remaining action vigorously.

11. Subsequent Events

     On October 19, 2004, the Company entered into an agreement with International Business Machines, or IBM, to add a second amendment to the Company’s amended technology license agreement with IBM, which second amendment relates solely to the terms of the Company’s final $16 million cash commitment payable to IBM in December 2004 pursuant to the amended technology license agreement. Specifically, the second amendment reschedules and amortizes over the next four fiscal quarters the Company’s final $16 million payment to IBM. Under the second amendment, the Company is now obligated, and currently expects, to pay $4.0 million cash to IBM in December 2004, and to pay the remaining $12.0 million of its cash commitment to IBM, with an imputed interest rate of 7.5%, during the first three quarters of fiscal 2005.

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     On October 26, 2004, the Company received from NEC Electronics, or NEC, a cash payment of $3.0 million, which payment constitutes a portion of the Company’s deliverable-based license fee for licensing to NEC the Company’s proprietary LongRun2 technologies for power management and transistor leakage control pursuant to the Company’s March 2004 licensing agreement with NEC. This $3.0 million payment was received during the fourth quarter of fiscal 2004 and will be recognized as revenue in that period.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Caution Regarding Forward-Looking Statements

     The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements and the related notes contained in this report and with the information included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 and subsequent reports filed with the Securities and Exchange Commission (SEC). The information contained in this report is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this report and in our other reports filed regularly with the SEC, some of which reports discuss our business in greater detail.

     This report contains forward-looking statements that are based upon our current expectations, estimates and projections about our industry, and that reflect our beliefs and certain assumptions based upon information made available to us at the time of this report. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “may,” “could,” “will” and variations of these words or similar expressions are intended to identify forward-looking statements. Such statements include, but are not limited to, statements concerning anticipated trends or developments in our business and the markets in which we operate, the competitive nature and anticipated growth of those markets, our expectations for our future performance and the market acceptance of our products, our ability to migrate our products to smaller process geometries, and our future gross margins, operating expenses and need for additional capital.

     Investors are cautioned that such forward-looking statements are only predictions, which may differ materially from actual results or future events. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Some of the important risk factors that may affect our business, results of operations and financial condition are set out and discussed below in the section entitled “Risks That Could Affect Future Results.” You should carefully consider those risks, in addition to the other information in this report and in our other filings with the SEC, before deciding to invest in our company or to maintain or change your investment. Investors are cautioned not to place reliance on these forward-looking statements, which reflect management’s analysis only as of the date of this report. We undertake no obligation to revise or update any forward-looking statement for any reason.

Overview

     We design, develop and sell highly efficient x86-compatible software-based microprocessors. Since the introduction of our first family of microprocessors, the Crusoe series, in January 2000, we have derived the majority of our revenue from the sale of these products. In October 2003, we introduced the Efficeon TM8000 family of microprocessors, which is our next family of x86-compatible processors. In September 2004, we began limited production of our Efficeon TM8800 processor on an advanced 90 nanometer manufacturing process. In fiscal 2003, and through the first nine months of fiscal 2004, we additionally have recognized revenue from technology and intellectual property license agreements. During the first quarter of fiscal 2004, we entered into a licensing agreement with NEC Electronics, or NEC, wherein NEC licensed our LongRun2 technologies for power management and transistor leakage control. The agreement with NEC includes deliverable-based license fees, maintenance service fees, and subsequent royalties payable to us once NEC begins production of products incorporating our technologies, which NEC currently expects to begin in late 2005. Through September 30, 2004, we have collected a total of $3.5 million in license fees and maintenance service fees related to our NEC agreement. These funds were recognized as revenue as certain predetermined milestones have been met and customer acceptance has been received. We expect in the near term that technology and intellectual property license revenues will contribute to our total revenue, and we will continue to explore additional opportunities for licensing our advanced power management and other technologies to other companies.

     Our total revenue, including product revenue and license and service revenue, for the three and nine months ended September 30, 2004, was $7.0 million and $18.2 million, respectively, compared to $2.7 million and $13.8 million for the corresponding periods last

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year. These increases were primarily due to increased license and service revenue, which totaled $3.7 million and $4.2 million for the three and nine months ended September 30, 2004, compared to $0.3 million and $0.9 million for the corresponding periods last year. Product revenue also increased 39% and 8%, respectively, for the three and nine months ended September 30, 2004, compared to the corresponding periods last year, primarily due to respective increases of 144% and 36% in net units shipped, consisting largely of our Crusoe products. Our average selling prices, or ASPs, for Crusoe product sales decreased, but we also reduced our Crusoe manufacturing costs for the three and nine months ended September 30, 2004 compared to the same periods last year.

     Our gross margin was negative 62.2% for the three months ended September 30, 2004, compared to negative 14.3% for the same period last year. We have historically reported negative cash flows from operations because the gross profit, if any, generated from our product and licensing revenues has not been sufficient to cover our operational cash requirements. We had total operating expenses of $24.4 million and $71.3 million for the three and nine months ended September 30, 2004, respectively, compared to $23.4 million and $67.8 million for the corresponding periods last year. Net loss was $28.6 million and $78.7 million for the three and nine months ended September 30, 2004, respectively, compared to $23.7 million and $65.7 million for the corresponding periods last year. Historically we have incurred significant losses, and as of September 30, 2004, we had an accumulated deficit of $621.2 million.

     We believe that our existing cash and cash equivalents and short-term investment balances and cash from operations will be insufficient to fund our operations, planned capital and R&D expenditures for the next twelve months on our current business model. Accordingly, we intend to raise during that time period additional funds through public or private equity or debt financing. If we are unable to do so, we are positioned to modify our current business model, for example, by leveraging our intellectual property assets and by focusing on our strategy of licensing our advanced power management and other technologies to other companies and, in doing so, to substantially limit our operations and reduce costs related to aspects of the business other than intellectual property and technology licensing to permit us to continue to operate on a modified business model for a period that extends at least through September 30, 2005.

     The majority of our sales have been to a limited number of customers. Additionally, we derive a significant portion of our revenue from customers located in Asia. The following table represents our sales to customers, each of which is located in Asia, that accounted for more than 10% of total revenue for the three and nine months ended September 30, 2004 and 2003:

     The following table represents balances from our customers that accounted for more than 10% of our accounts receivable balance at September 30, 2004 and December 31, 2003:

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     We began shipments in the fourth quarter of 2003 of our initial Efficeon TM8000 microprocessor, manufactured using a 130 nanometer complementary metal oxide semiconductor, or CMOS, process. We believe that we must successfully complete the transition of the manufacturing of our Efficeon TM8000 microprocessors to a 90 nanometer CMOS process in order to be able to achieve broad market acceptance of our Efficeon TM8000 microprocessors. We sampled our 90 nanometer Efficeon TM8800 processors in early April 2004 and we began limited production of these products in the third quarter of fiscal 2004.

     In the third quarter of fiscal 2004 we recorded a $6.8 million inventory-related charge. Of the $6.8 million charge, $3.2 million was for inventory on hand, the majority of which was for our Crusoe and 130 nanometer Efficeon processors. The remaining $3.6 million of the inventory charge was for substrates and wafers on order, the majority of which relates to both our 130 and 90 nanometer Efficeon processors, and which resulted in our recording an accrued liability for an equal amount. As of September 30, 2004, our expected costs to produce 130 and 90 nanometer Efficeon processors on hand and on order exceeded the average selling prices that we anticipated to be able to sell the related product. As a result, we have had to take charges related to this difference between cost and expected average selling prices, and accordingly anticipate that we will not see contributions to our gross profits as these products are sold. Our goal is to improve gross margins once unit sales of the 90 nanometer Efficeon product are substantial enough to drive down production costs as the product moves into a stage of substantial volume production.

Critical Accounting Policies

     The process of preparing financial statements requires the use of estimates on the part of our management. The estimates used by management are based on our historical experiences combined with management’s understanding of current facts and circumstances. Certain of our accounting policies are considered critical as they are both important to the portrayal of our financial condition and results and require significant or complex judgment on the part of management. For a description of what we believe to be our most critical accounting policies and estimates, refer to our Annual Report on Form 10-K for the year ended December 31, 2003 filed with the Securities and Exchange Commission on March 9, 2004. There have been no changes in any of our critical accounting policies since December 31, 2003.

Results of Operations

Changes to Previously Announced Financial Results for the Third Quarter of Fiscal 2004

     On October 20, 2004, we issued a press release and filed a current report on Form 8-K to announce our financial results for the third quarter of fiscal 2004. In conjunction with the filing of this quarterly report, we are required to reassess all significant estimates and judgments made in the financial statements for the period, as well as consider any relevant additional information that is available as of the filing date. This updated analysis includes information that had not been previously identified at the time we announced our financial results for the third quarter of fiscal 2004. In light of this information, as well as correcting for an error in calculations that was detected following October 20, 2004, we concluded that decreasing our inventory valuation by $1.1 million and recording related additional product cost of revenue of $1.1 million in the third quarter of fiscal 2004 was appropriate. Additionally, we concluded that reclassifying a $0.9 million charge related to non-cancelable commitments for goods and services from research and development expenses to cost of product revenue was appropriate.

     As a result of the $1.1 million adjustment, our fiscal third quarter 2004 net loss was $28.6 million, or a loss of $0.16 per share, compared to $27.5 million, or a loss of $0.16 per share, as previously announced.

Total Revenue

     We derive revenue from two sources: product revenue, and license and service revenue. Total revenue for each period presented is summarized in the following table:

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     Our products are targeted at a broad range of computing platforms, particularly battery-operated mobile devices and applications that need high performance, low power consumption and low heat generation. Such platforms include thin clients, notebook computers, embedded computers and blade servers, ultra-personal computers, or UPCs, and tablet PCs. Product revenue derived from each computing market segment as well as license and service revenue is presented as a percentage of total revenue in the following table:

     Total product revenue for the three and nine months ended September 30, 2004 was $3.3 million and $14.0 million, respectively, compared to $2.4 million and $12.9 million for the corresponding periods last year. The increase in product revenue is primarily due to an overall increase in net product shipped of 144% and 36%, respectively, for the three and nine months ended September 30, 2004 compared to the same periods last year. Contributing to this increase were the shipments of our Efficeon product, which began in the fourth quarter of 2003 and represented 13% and 20%, respectively, of total revenue for the three and nine months ended September 30, 2004. Partially offsetting this increase was the decrease of ASPs for our Crusoe processors.

     Pricing pressure on the TM5800 has increased and may continue to increase as the product has matured and continues to sell into market segments and geographies, such as China and Taiwan, that traditionally demand lower ASPs. We expect to continue to manufacture the TM5800 as that processor continues to sell into market segments such as the embedded and thin client markets, from which we expect the processor to derive the majority of its future revenue. The Efficeon TM8000 product is targeted at higher-volume notebook and other markets that demand low power consumption and low heat generation characteristics, such as the UPC and thin and light notebook markets.

     For the three and nine months ended September 30, 2004, we recognized license and service revenue of $3.7 million and $4.2 million, respectively. This revenue related to a license and service agreement that we entered into during fiscal 2003 and a licensing agreement with NEC Electronics for power management and transistor leakage control. We will continue to explore additional opportunities for licensing our advanced power management technologies to other companies. For example, we believe our proprietary LongRun2 leakage control technology could be valuable to the semiconductor industry and could generate significant future licensing revenues for us without impairing our microprocessor product business.

Gross Margin

     Our gross margin is comprised of the components displayed in the following table, shown as a percentage of total revenue:

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     Gross margin was negative 62.2% the third quarter of fiscal 2004 compared to negative 14.3% for the same period last year. In the third quarter of fiscal 2004, we recorded a $6.8 million inventory-related charge. Of the $6.8 million charge, $3.2 million was for inventory on hand, the majority of which was for our Crusoe and 130 nanometer Efficeon processors. The remaining $3.6 million of the inventory charge was for non-cancelable orders for substrates and wafers, the majority of which relates to both our 130 and 90 nanometer Efficeon processors. The majority of the Efficeon-related charges for inventory on hand and on order primarily related to the cost to manufacture our 130 nanometer and 90 nanometer Efficeon products exceeding the price at which we expect to be able to sell these products. Our 130 and 90 nanometer products have incurred higher than anticipated initial costs of production. Further, we believe that the initial availability of our first limited production 90 nanometer Efficeon processors in September 2004 had a greater than expected adverse effect on demand for our 130 nanometer Efficeon microprocessors, and, as a result, we have to take inventory-related charges for 130 nanometer product on hand and on order that are in excess of our anticipated demand for that product. We often must place our orders with third party suppliers in advance of expected purchase orders form our customers, and, as a result, we may have too much material for a particular product on hand or on order. Gross margin from our 130 and 90 nanometer parts on hand and on order may benefit from future sales only to the extent that the associated revenue exceeds their currently adjusted values. Similarly, our gross margins could be adversely affected if the products are sold at a price lower than our currently estimated market value. For the nine months ended September 30, 2004, we have taken a charge of $5.0 million for inventory on order. There were no similar charges related to purchase commitments in any other periods. We expect that we may incur similar charges in future periods related to our 90 nanometer Efficeon products until we are able to align product costs below expected ASPs, which should be achieved once unit sales of the product are substantial enough to drive down production costs as the product moves into a stage of substantial volume production.

     Gross margin was negative 44.1% for the first nine months of fiscal 2004 compared to 9.0% for the same period last year. As a percent of total revenue, our product costs decreased 0.2 percentage points, from 73.6% to 73.4%, which was the result of a decrease in average selling prices as well as a slight increase in the average dollar cost of products sold in the first nine months of fiscal 2004 compared to the same period last year. The initial product cost for our 130 nanometer and 90 nanometer Efficeon TM8000 processors is significantly higher than the product cost of a more mature product, as the first quarter of fiscal 2004 was our first full quarter of producing the 130 nanometer product while the third quarter of fiscal 2004 was the first quarter of producing the 90 nanometer product. Gross margin was additionally adversely affected in the third quarter of fiscal 2004 as a result of the $6.8 million inventory-related charge noted above, as well as from a $0.9 million charge related to non-cancelable obligations that we had made to third party suppliers for goods and services for which we currently do not anticipate seeing any economic benefits.

     Gross margin was adversely affected during both periods by unabsorbed overhead costs as our production-related infrastructure exceeded our needs. For the third quarter of fiscal 2004, these unabsorbed costs were $0.4 million, or 5.7% of total revenue, compared to $0.5 million, or 17.3% of total revenue, for the same period in the prior year. For the first nine months of fiscal 2004, these unabsorbed costs were $0.9 million, or 5.2% of total revenue, compared to $1.6 million, or 11.4% of total revenue, for the same period in the prior year. We expect to increase the utilization of our manufacturing overhead in coming periods as the volume of shipments of our Efficeon TM8000 products increase.

     Of the $7.5 million and $8.8 million net inventory on hand at September 30, 2004 and December 31, 2003, respectively, $2.3 million and $2.6 million of net inventory, respectively, were stated at net realizable value. Accordingly, gross margin may be impacted from future sales of these parts to the extent that the associated revenue exceeds or fails to achieve their currently adjusted values. Benefits to gross margin as a result of products being sold at ASPs in excess of their previously written down values were $0.1 million and $0.3 million for the three and nine months ended September 30, 2004, respectively, compared to $0.2 million and $0.6 million for the same periods last year.

Research and Development

     Research and development (R&D) expenses were $13.8 million and $40.2 million for the three and nine months ended September 30, 2004, respectively, compared to $12.5 million and $37.1 million for the corresponding periods last year. The increase in R&D expenses for the third quarter of fiscal 2004 compared to the same period last year was due to increases in non-recurring engineering charges of $1.0 million, headcount-related expenses of $0.7 million and other expenses of $0.4 million, partially offset by a decrease in consultant expenses of

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$0.4 million and depreciation expenses of $0.4 million. The increase in R&D expenses for the first nine months of fiscal 2004 compared to the same period last year was due to increases in non-recurring engineering charges of $1.8 million, headcount-related expenses of $2.0 million and other expenses of $0.4 million, partially offset by a decrease in depreciation expenses of $1.0 million. The increased engineering and headcount-related expenses through the first nine months of fiscal 2004 were primarily the result of our increased efforts devoted to the development of the 90 nanometer and 130 nanometer manufacturing technology for our Efficeon TM8000 family of microprocessors, as well as our LongRun2 power management technologies. Partially attributing to the increase in other expenses was a one time sales tax refund received in fiscal 2003. The decreases in depreciation expenses were primarily due to certain property and equipment being fully depreciated throughout the last fiscal year.

Selling, General and Administrative

     Selling, general and administrative (SG&A) expenses were $7.4 million and $21.6 million for the three and nine months ended September 30, 2004, respectively, compared to $6.0 million and $19.0 million for the corresponding periods last year. The increase in SG&A expenses for the third quarter of fiscal 2004 compared to the same period last year was due to increases in legal and accounting expenses of $0.5 million, headcount-related expenses of $0.4 million and consultant expenses of $0.4 million. The increase in SG&A expenses for the first nine months of fiscal 2004 compared to the same period last year was due to increases in headcount-related expenses of $1.1 million, building and facilities expenses of $0.9 million, travel and tradeshow expenses of $0.5 million and advertising expenses of $0.3 million, offset by decreases in depreciation expenses of $0.7 million and insurance expenses of $0.4 million. The increased headcount-related expenses, travel and tradeshow expenses and advertising expenses through the first nine months of fiscal 2004 were primarily the result of our continued efforts to hire additional personnel, to expand our presence in the Asia-Pacific market with new offices and to promote awareness of our Efficeon TM8000 processor. The increased building and facilities expenses were primarily the result of our increased building occupancy at our offices in Santa Clara. The increased legal expenses were primarily the result of higher expenditures for patent protection of our inventions. The increased accounting expenses were primarily due to costs incurred for compliance with Section 404 “Management’s Internal Controls and Procedures for Financial Reporting” of the Sarbanes Oxley Act of 2002.

Restructuring Charges

     As part of our quarterly reassessment of restructuring accruals, during the third quarter of fiscal 2004, we adjusted our accrued restructuring costs as a result of an update to certain underlying assumptions. We had previously anticipated subleasing our vacant facilities in future periods. In view of current market conditions, this assumption has been revised such that we no longer assume that we will be able to sublease our previously vacated space that remains unused as of September 30, 2004. As a result of this update in assumptions, we adjusted the accrued restructuring costs and recorded a charge of $0.9 million in restructuring charges.

Amortization of Deferred Charges, Patents and Patent Rights

     Amortization of deferred charges, patents and patent rights were $2.2 million and $7.0 million for the three and nine months ended September 30, 2004, respectively, compared to $2.6 million and $7.9 million for the corresponding periods last year. Amortization charges relate to various patents and patent rights acquired from Seiko Epson and others during fiscal 2001. Also included in the amortization charges are accretion expenses associated with the liability recorded from the acquisition of these patent and patent rights. The decreases can be attributed to a decrease in accretion expenses as a result of a reduction in payments due under our patent and patent rights and our technology license agreement with IBM, as amended. Amounts due under the agreements decreased from $30.5 million at September 30, 2003 to $16.0 million at September 30, 2004.

Stock Compensation

     Stock compensation was $0.1 million for the three months ended September 30, 2004 compared to $2.3 million for the same period last year, representing a decrease of $2.2 million. Stock compensation was $1.6 million for the nine months ended September 30, 2004 compared to $3.8 million for the same period last year, representing a decrease of $2.2 million. The two components of stock compensation were the amortization of deferred stock compensation and variable stock compensation.

     Net amortization of deferred stock compensation for the third quarter of fiscal 2004 was $0.1 million, compared to $0.3 million for the same period last year. For the first nine months of fiscal 2004, net amortization was $0.7 million, compared to $1.5 million for the same period last year. The decrease was primarily a result of amortizing the deferred charge on an accelerated method in accordance with our accounting policy, as well as a decrease in the number of outstanding options affecting the compensation charge as a result of cancellations. The amortization of the remaining $12,000 of deferred stock compensation will continue through the end of fiscal 2004.

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     Variable stock compensation is based on the excess, if any, of the current market price of our stock as of the period-end over the purchase price of the stock award, adjusted for vesting and prior stock compensation expense recognized on the stock award. Variable stock compensation for the third quarter of fiscal 2004 was a credit of $49,000, compared to a charge of $2.0 million for the same period last year. This decrease was the result of certain notes receivable from stockholders being fully paid toward the end of fiscal 2003. For the first nine months of fiscal 2004, variable stock compensation was $1.0 million, compared to $2.3 million for the same period last year. This decrease was the result of a lower market price of our stock as of September 30, 2004, compared to the same period in the prior year.

Interest Income and Other, Net and Interest Expense

     Interest income and other, net was $0.2 million and $0.7 million for the three and nine months ended September 30, 2004, respectively, compared to $0.2 million and $1.2 million for the corresponding periods last year. The decreases were due to lower average invested cash balances as we continued to use cash to fund operations, as well as a decrease in interest rates earned on investments during the period. The decrease in interest expense was primarily the result of lower average debt balances due to several lease-financing arrangements expiring during 2003, as well as decreases in certain accretion expenses related to our facilities lease commitments.

Liquidity and Capital Resources

Cash and Cash Flows

     We have historically reported negative cash flows from operations because the gross profit, if any, generated from our product and licensing revenues has not been sufficient to cover our operating cash requirements. We intend to rely on funds that we have received from financing activities until we are able to generate sufficient revenue and gross profit to cover operational expenses as well as anticipated increases in our working capital requirements. We believe that our existing cash and cash equivalents and short-term investment balances and cash from operations will be insufficient to fund our operations, planned capital and R&D expenditures for the next twelve months on our current business model because of significant risks and uncertainties as noted below. Accordingly, we intend to raise during that time period additional funds through public or private equity or debt financing. Additional funds may not be available on terms favorable to us or at all. In the event that we are unable to raise additional funds, we are positioned to modify our current business model, for example, by leveraging our intellectual property assets and by focusing on our strategy of licensing our advanced power management and other technologies to other companies and, in doing so, to substantially limit our operations and reduce costs related to aspects of the business other than intellectual property and technology licensing to permit us to continue to operate on a modified business model for a period that extends at least through September 30, 2005.

     For the period through September 30, 2005 and over the longer term, our capital requirements for our current business model will depend on many factors, including but not limited to general economic conditions, the rate of sales growth, market acceptance of our products, costs of securing access to adequate manufacturing capacity, the timing and extent of research and development projects and increases in our operating expenses. As we shift our product mix to our new 90 nanometer Efficeon TM8000 microprocessors, and as we continue to develop new or enhance existing products or services in line with our current business model, we expect that, as a result of an increased level of operations, we will need to increase our non-cash working capital, and accordingly, the net cash which we will use in our operating activities will increase.

     Our ability to increase sales of our Crusoe TM5800 products into additional market segments, to decrease manufacturing costs for our Crusoe TM5800 and Efficeon TM8000 products, to achieve market acceptance of our initial Efficeon TM8000 microprocessor manufactured using a 130 nanometer process and to transition successfully our Efficeon TM8000 microprocessor to a 90 nanometer process will be particularly critical in determining our cash needs. All of these factors are subject to significant risks and uncertainties.

     Although we are currently not a party to any agreement or letter of intent for a potential acquisition or business combination, we may enter into acquisitions or business combinations in the future, which also could require us to seek additional equity or debt financing. If adequate funds were not available or were not available on acceptable terms, our ability to fund our operations, take advantage of unanticipated opportunities, develop or enhance our products or otherwise respond to competitive pressures would be significantly limited.

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     As of September 30, 2004 we had $65.1 million in cash, cash equivalents and short-term investments compared to $120.8 million at December 31, 2003.

     The following comparison table summarizes our usage of cash and cash equivalents for the nine months ended September 30, 2004 and the nine months ended September 30, 2003:

     Net cash used in operating activities was $61.8 million for the nine months ended September 30, 2004, compared to $48.2 million for the corresponding period in fiscal 2003. Net cash used during the first nine months of fiscal 2004 was primarily the result of a net loss of $78.7 million, cash drawdowns in restructuring charges of $1.3 million and an increase in accounts receivable of $0.8 million. The net loss and changes in operating assets and liabilities were partially offset by non-cash charges related to amortization of patents and patent rights of $7.0 million, increases in accounts payable and accrued liabilities of $5.7 million, depreciation of $2.8 million, decrease in inventory of $1.3 million, stock compensation of $1.6 million and non cash change in restructuring charges of $0.9 million.

     Net cash used in investing activities was $19.4 million for the nine months ended September 30, 2004, compared to net cash provided by investing activities of $64.0 million for the corresponding period in fiscal 2003. This change was primarily due to $9.8 million in net purchases of available-for-sale investments for the first nine months of fiscal 2004, compared to net proceeds of $73.9 million from the maturity of available-for-sale investments for the same period last year. Additionally, we made scheduled payments for previously acquired patent and patent rights totaling $7.5 million during the first nine months of fiscal 2004, compared to $9.0 million in the same period last year. We have remaining payments to a development partner totaling $16.0 million that is due in four quarterly installments starting in December 2004. Additional cash used in investing activities included the purchase of property and equipment, which amounted to $2.0 million and $0.9 million for the first nine months in fiscals 2004 and 2003, respectively.

     Net cash provided by financing activities was $15.8 million for the nine months ended September 30, 2004, compared to $3.3 million for the corresponding period in fiscal 2003. This increase was primarily the result of our receipt of $10.2 million when our underwriters exercised their over-allotment option to purchase an additional 3.75 million shares of our common stock in relation to our December 2003 common stock offering. We also received $4.9 million in net proceeds from sales of common stock under our employee stock purchase and stock option plans for the first nine months of fiscal 2004, compared to $3.9 million for the same period last year. Additionally, we received $0.9 million for the repayment of notes from our stockholders in the first nine months of fiscal 2004. Since our inception, we have financed our operations primarily through sales of equity securities and, to a lesser extent, from lease financing. It is reasonably possible that we may continue to seek financing through these sources of capital as well as other types of financing, including, but not limited to, debt financing. Additional financing might not be available on terms favorable to us, or at all.

     At September 30, 2004, we had $18.4 million in cash and cash equivalents and $46.7 million in short-term investments. We lease our facilities under non-cancelable operating leases expiring in 2008, and we lease equipment and software under non-cancelable leases with terms ranging from 12 to 36 months.

Contractual Obligations

     At September 30, 2004, we had the following contractual obligations:

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Recent Accounting Pronouncements

     In March 2004, the FASB issued a proposed Statement, “Share-Based Payment, an amendment of FASB Statements Nos. 123 and 95,” that addresses the accounting for share-based payment transactions in which a Company receives employee services in exchange for either equity instruments of the Company or liabilities that are based on the fair value of the Company’s equity instruments or that may be settled by the issuance of such equity instruments. The proposed statement would require all companies to measure compensation cost for all share-based payments at fair value. The effective date of the proposed standard is for periods beginning after June 15, 2005. The Company is currently evaluating the effect that the adoption of the proposed statement will have on its financial position and results of operations.

Risks that Could Affect Future Results

     The factors discussed below are cautionary statements that identify important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements in this Form 10-K. If any of the following risks actually occurs, our business, financial condition and results of operations would suffer. In this case, the trading price of our common stock could decline and investors might lose all or part of their investment in our common stock.

We have a history of losses, expect to incur further significant losses and may never achieve or maintain profitability.

     We have historically reported negative cash flows from operations because the gross profit, if any, generated from our product and licensing revenues has not been sufficient to cover our operating cash requirements. Since our inception, we have incurred cumulative losses aggregating $621.2 million, including net losses of $78.7 million for the first nine months of fiscal 2004, $87.6 million in fiscal 2003 and $110.0 million in fiscal 2002, which have reduced stockholders’ equity to $70.4 million at September 30, 2004. We currently expect to continue to incur losses under our current business plan until at least September 30, 2005.

     We have financed our operations primarily through sales of equity securities and, to a lesser extent, from product and license revenue and lease financing. We believe that our existing cash and cash equivalents and short-term investment balances and cash from operations will be insufficient to fund our operations, planned capital and R&D expenditures for the next twelve months on our current business model. Accordingly, we intend to raise during that time period significant additional funds through public or private equity or debt financing. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources”. However, even if we are able to raise additional funds, our ability to continue to operate under our current business model until we achieve profitability may be affected by a variety of factors, which may include our ability to achieve market acceptance for our Efficeon TM8000 products, significant unexpected technical or manufacturing problems we may experience in transitioning our Efficeon TM8000 microprocessor to a 90 nanometer manufacturing process or any significant problems we may face in selling our TM5800 microprocessors in additional market segments. All of these factors are subject to significant risks and uncertainties.

We may not be able to raise further financing or it may only be available on terms unfavorable to us or our stockholders.

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     We intend to raise significant additional funds through public or private equity or debt financing in order to continue to operate under our current business model. Further, as we shift our product mix to our next family of microprocessors, the Efficeon TM8000, and as we continue to develop new or enhance existing products or services in line with our business model, we expect that, as a result of an increased level of operations, our cash expenditures will increase. In addition, we may begin to generate positive cash flow from operations later than anticipated or we may never generate positive cash flow from operations. A variety of other business contingencies could contribute to our need for funds in the future, including the need to:

	•		fund expansion;
	•		fund marketing expenditures;
	•		develop new products or enhance existing products;
	•		enhance our operating infrastructure;
	•		hire additional personnel;
	•		respond to customer concerns about our viability;
	•		respond to competitive pressures; or
	•		acquire complementary businesses or technologies.

     If we were to raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders would be reduced, and these newly issued securities might have rights, preferences or privileges senior to those of our then-existing stockholders. Additional financing might not be available on terms favorable to us, or at all. For example, in order to raise equity financing, we may decide to sell our stock at a discount of our then current trading price, which may have an adverse effect on our future trading price. If adequate funds were not available on acceptable terms or at all, we are positioned to modify our current business model, for example, by leveraging our intellectual property assets and by focusing on our strategy of licensing our advanced power management and other technologies to other companies and, in doing so, to substantially limit our operations and reduce costs related to aspects of the business other than intellectual property and technology licensing to permit us to continue to operate on a modified business model for a period that extends at least through September 30, 2005. If we are unable to raise significant additional funds or appropriately modify our business model, then we expect that our independent auditors will issue a going concern opinion that would raise substantial doubt about our ability to continue as a going concern. The uncertainty raised by a going concern opinion may cause our stock price to fall and impair our ability to raise additional capital. This uncertainty may create a concern among our current and future customers and vendors as to whether we will be able to fulfill our obligations or, in the case of customers, fulfill their future product or service needs. As a result, current and future customers may determine not to do business with us, or only do so on less favorable terms, which would cause our revenues to decline. Employee concern about the future of the business and their continued prospects for employment may cause them to seek employment elsewhere, depriving us of the human capital we need to be successful.

Our future operating results under our current business model will depend significantly on sales of our new Efficeon TM8000 products.

     Our future revenue and gross margins under our current business model will be influenced in large part by the level of sales of our new Efficeon TM8000 products. Therefore, our future operating results will depend on the demand for these products from future customers. We began shipment in the fourth quarter of 2003 of our initial Efficeon TM8000 microprocessor manufactured using a 130 nanometer complementary metal oxide semiconductor, or CMOS, process. In September 2004, we began limited production of our TM8800 Efficeon processor on an advanced 90 nanometer CMOS manufacturing process. If we experience delays in manufacturing sufficient quantities of microprocessors, our target customers could design a competitor’s microprocessor into their product, which would lead to lost sales and impede our ability to generate market interest in our new microprocessor. If these products are not widely accepted by the market due to performance, price, compatibility or any other reason, significant demand for our new products may fail to materialize.

     We are transitioning the manufacturing of our Efficeon TM8000 microprocessors to a 90 nanometer CMOS process, and we have achieved limited production on the new 90 nanometer process. We believe that successfully completing this transition will be

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important to our ability to achieve broad market acceptance of our Efficeon TM8000 microprocessors and to our ability to compete, particularly in market segments in which performance is a key competitive factor such as the notebook personal computer and blade server markets. The availability of our 90 nanometer Efficeon TM8000 appears to have reduced, and may continue to reduce, demand for our 130 nanometer Efficeon TM8000 microprocessor. We cannot be sure that we will successfully achieve volume production of the Efficeon TM8000 microprocessor using the 90 nanometer process.

We could encounter a variety of technical and manufacturing problems that could delay or prevent volume shipments of Efficeon TM8000 microprocessors manufactured using a 90 nanometer process.

     Transitioning our TM8000 microprocessors to a 90 nanometer manufacturing process involves a variety of technical and manufacturing challenges. We are using Fujitsu Microelectronics to manufacture our initial 90 nanometer Efficeon TM8000 microprocessors. Fujitsu Microelectronics has limited experience with the 90 nanometer CMOS process and, although we have achieved limited production of our Efficeon TM8800 product on the Fujitsu Microelectronics 90 nanometer CMOS process, we cannot be sure that Fujitsu Microelectronics’ 90 nanometer foundry will achieve production shipments on our planned schedule or that other manufacturing challenges might later arise. For example, during 2001 we experienced yield problems as we migrated our products to smaller geometries, which caused increases in our product costs, delays in product availability and diversion of engineering personnel. If we encounter problems with the manufacture of the Efficeon TM8000 microprocessors using the 90 nanometer process that are more significant or take longer to resolve than we anticipate, our ability to increase our revenue would suffer and we could incur significant expenses. If those problems prove to be more serious than expected and cannot be remedied on a timely basis and at a reasonable cost, our stock price would likely be very substantially reduced.

Our Crusoe TM5800 microprocessors are experiencing decreasing demand from notebook computer manufacturers and are experiencing declining average selling prices. If we are unable to sell the TM5800 microprocessors into additional market segments or reduce our costs of production, our operating results will suffer.

     As our Crusoe TM5800 microprocessors have matured, demand for the TM5800 microprocessors from notebook computer manufacturers has declined in that market segment. We have begun to sell the TM5800 microprocessors into additional market segments such as the thin client, ultra-personal computer, or UPC, and embedded computer market segments, many of which are only beginning to be developed. We cannot be sure that we will be successful in selling the TM5800 microprocessors into these markets or that these markets will experience significant growth. In addition, the average selling price of the TM5800 microprocessors has decreased, and we expect that pricing pressure on the TM5800 microprocessors will continue to increase as sales of these microprocessors increasingly derive from geographies and market segments that traditionally demand lower average selling prices. If we are unable to achieve sufficient reductions in our costs of products sold, this decline in prices will adversely affect our gross margins.

The growth of our business depends in part upon the development of emerging markets and our ability to meet the needs of these markets.

     The growth of our business depends in part on acceptance and use of our products in new classes of devices such as UPCs, high density servers and new embedded processor applications. We depend on the ability of our target customers to develop new products and enhance existing products for these markets that incorporate our products and to introduce and promote their products successfully. These new markets often rely on newly developed technologies, which will require extensive development and marketing before widespread acceptance is achieved, so the new markets may grow slowly, if at all. If the new markets do not grow as we anticipate, our target customers do not incorporate our products into theirs, or our products are not widely accepted by end users, our ability to increase our revenues would suffer. In addition, manufacturers within emerging markets may have widely varying requirements. To meet the requirements of different manufacturers and markets, we may be required to change our product design or features, sales methods or pricing policies. The costs of addressing these requirements could be substantial and could delay or prevent any improvement in our operating results.

Our future revenue depends in part upon our ability to penetrate additional segments of the notebook computer market.

     Historically, our sales in the notebook computer market have primarily been in the market segment consisting of thin and light notebook computers for which low heat generation and power consumption are particularly critical. Our ability to increase our revenues in the future will depend in significant part on our ability to market our new Efficeon TM8000 microprocessors in additional segments of the notebook computer market in which microprocessor performance is a more significant factor. These notebook market segments are intensely competitive and dominated by Intel. We have not succeeded in deriving significant revenues from sales of our

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microprocessors in these market segments in the past and cannot be sure that we will successfully market and sell our microprocessor products in these market segments in the future.

     Due to our software-based approach to microprocessor design, we have been required, and expect to continue to be required, to devote substantial resources to educate prospective customers in the notebook computer market about the benefits of our products and to assist potential customers with their designs. In addition, since computer products generally are designed to incorporate a specific microprocessor, original equipment manufacturers, or OEMs, must design new products to utilize different microprocessors such as our products. Given the complexity of these computer products and their many components, designing new products requires significant investments. For instance, OEMs may need to design new computer casings, basic input/output system, or BIOS, software and motherboards. Our target customers may not choose our products for technical, performance, packaging, novelty, design cost or other reasons. If our products fail to achieve widespread acceptance in the notebook computer market, our ability to increase our revenue would likely be seriously harmed.

We might not succeed if we choose to transition to a modified business model.

     In the event that we are unable to raise additional funds to cover operational expenses, planned capital and R&D expenditures, as well as anticipated increases in our working capital requirements, we are positioned to modify our current business model, for example, by leveraging our intellectual property assets and by focusing on our strategy of licensing our advanced power management and other technologies to other companies. There would be significant risks and costs inherent in any efforts that we may undertake under a modified business model. These include the risks that we may not be able to develop viable products or services, achieve market acceptance for our products or services, earn adequate revenues from the sale of our products or services, or achieve profitability. Employee concern about the future of the business and their continued prospects for employment might cause them to seek employment elsewhere, depriving us of the human capital we would need to be succeed. Since limited operating and financial information would be available relating to a modified business model, it would be difficult for us, as well as investors, to evaluate our performance and future prospects. Our prospects would need to be considered in light of the uncertainties and difficulties frequently encountered by companies in their early stages of development. The uncertainty raised by modifying our business model might cause our stock price to fall and impair our ability to raise additional capital.

We might not experience growth in our licensing revenues.

     Licensing revenue was $4.2 million for the first nine months of fiscal year 2004 and $1.1 million for fiscal year 2003. However, we may not recognize significant licensing revenue in the future. License transactions often have a long sales cycle and can result in additional liability, such as indemnification obligations. A portion of the revenue to which we might be entitled under some of our license transactions depends upon our provision of future deliverables to licensees. If we do not provide those deliverables in a timely and satisfactory manner, then we may not receive that portion of the revenue and we may strain our relationship with the licensee. In addition, the amount of revenue we recognize under some of our license transactions can depend significantly upon product sales by the licensees, over which we will have no control. While we anticipate that we will continue to license our technology to licensees, we cannot predict the timing or the extent of any future licensing revenue, and recent levels of license revenues may not be indicative of future periods.

We face intense competition in the x86-compatible microprocessor market. Many of our competitors are much larger than we are and have significantly greater resources. We may not be able to compete effectively.

     The market for microprocessors is intensely competitive. We may not be able to compete effectively against current and potential competitors, especially those with significantly greater resources and market leverage. Competition may cause price reductions, reduced gross margins and loss of market share, any one of which could significantly reduce our future revenue and increase our losses. For example, we may determine to lower the prices of our products in order to increase or maintain market share, which would likely increase our losses.

     Significant competitors in the x86-compatible microprocessor product market include Intel, Advanced Micro Devices and VIA Technologies. Our current and potential competitors have longer operating histories, significantly greater financial, technical, product development and marketing resources, greater name recognition and significantly larger customer bases than we do. Our competitors may be able to develop products comparable or superior to those we offer, adapt more quickly than we do to new technologies, evolving industry trends and customer requirements, and devote greater resources to the development, promotion and sale of their products than we can. Many of our competitors also have well-established relationships with our existing and prospective customers and suppliers. As a result of these factors, many of our competitors, either alone or with other companies, have significant influence in

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our target markets that could outweigh any advantage that we may possess. For example, negotiating and maintaining favorable customer and strategic relationships are and will continue to be critical to our business. If our competitors use their influence to negotiate strategic relationships on more favorable terms than we are able to negotiate, or if they structure relationships that impair our ability to form strategic relationships, our competitive position and our business would be substantially damaged.

     In particular, Intel has dominated the market for x86-compatible microprocessors for many years. We may be adversely affected by Intel’s pricing decisions, product mix and introduction schedules, marketing strategies and influence over industry standards and other market participants and the loyalty of consumers to the Intel brand. We cannot be sure that we can compete effectively against Intel even in the market segments that we intend to target.

     In 2003, Intel introduced a new microprocessor that is focused on the notebook computer market segment and designed to consume less power than its prior microprocessors. We expect that Intel, and potentially other microprocessor companies, will increasingly seek to offer microprocessors specifically targeted at many of the same market segments that we intend to serve, which could adversely affect our ability to compete successfully.

     Furthermore, our competitors may merge or form strategic relationships that might enable them to offer, or bring to market earlier, products that are superior to ours in terms of features, quality, pricing or other factors. We expect additional competition from other established and emerging companies and technologies.

We may experience manufacturing difficulties that could increase the cost and reduce the supply of our products.

     The fabrication of wafers for our microprocessors is a highly complex and precise process that requires production in a tightly controlled, clean room environment. Minute impurities, difficulties in the fabrication process, defects in the masks used to print circuits on a wafer or other factors can cause numerous die on each wafer to be nonfunctional. The proportion of functional die expressed as a percentage of total die on a wafer is referred to as product “yield.” Semiconductor companies frequently encounter difficulties in achieving expected product yields, particularly when introducing new products. Yield problems may not be identified and resolved until a product has been manufactured and can be analyzed and tested, if ever. As a result, yield problems are often difficult, time-consuming and expensive to correct. We have experienced yield problems in the past, and we may experience yield problems in the future that impair our ability to deliver our products to our customers, increase our costs, adversely affect our margins and divert the efforts of our engineering personnel. Difficulties in achieving the desired yields often occur in the early stages of production of a new product or in the migration of manufacturing processes to smaller geometries. We could experience difficulties in achieving desired yields or other manufacturing problems in the production of our Efficeon TM8000 products that could delay our ability to further introduce Efficeon TM8000 products in volume, adversely affect our costs and gross margins and harm our reputation. In addition, we could also experience these difficulties as we migrate the Efficeon TM8000 products to a 90 nanometer process technology, which poses significant technical challenges and in which neither we nor Fujitsu Microelectronics, which we intend to use to manufacture these products, has significant experience. Even with functional die, normal variations in wafer fabrication can cause some die to run faster than others. Variations in speed yield could lead to excess inventory of the slower, less valuable die, a resulting unfavorable impact on gross margins and an insufficient inventory of faster products, depending upon customer demand.

Our lengthy and variable sales cycles make it difficult for us to predict when and if a design win will result in volume shipments.

     We depend upon other companies designing our microprocessors into their products, which we refer to as design wins. Many of our targeted customers consider the choice of a microprocessor to be a strategic decision. Thus our targeted customers may take a long time to evaluate our products, and many individuals may be involved in the evaluation process. We anticipate that the length of time between our initial contact with a customer and the time when we recognize revenue from that customer will vary. We expect our sales cycles to range typically from six to 12 months, or more, from the time we achieve a design win to the time the customer begins volume production of products that incorporate our microprocessors. We do not have historical experience selling our products that is sufficient for us to determine accurately how our sales cycles will affect the timing of our revenue. Variations in the length of our sales cycles could cause our revenue to fluctuate widely from period to period. While potential customers are evaluating our products and before they place an order with us, we may incur sales and marketing expenses and expend significant management and engineering resources without any assurance of success. The value of any design win depends upon the commercial success of our customers’ products. If our customers cancel projects or change product plans, we could lose anticipated sales. We can offer no assurance that we will achieve further design wins or that the products for which we achieve design wins will ultimately be introduced or will, if introduced, be commercially successful.

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If we fail to forecast demand for our products accurately, we could lose sales and incur inventory losses.

     The demand for our products depends upon many factors and is difficult to forecast. Many shipments of our products may be made near the end of the fiscal quarter, which makes it difficult to estimate demand for our products. We expect that it will become more difficult to forecast demand as we introduce new products and as competition in the markets for our products intensifies. Significant unanticipated fluctuations in demand have caused, and in the future could cause, problems in our operations. The lead-time required to fabricate large volumes of wafers is often longer than the lead-time our customers provide to us for delivery of their product requirements. Therefore, we often must place our orders in advance of expected purchase orders from our customers. As a result, we have only a limited ability to react to fluctuations in demand for our products, which could cause us to have either too much or too little inventory of a particular product. If demand does not develop as we expect, we could have excess production. Excess production would result in excess inventories of product, which would use cash and could result in inventory write-downs and write-offs. For example, we recorded a $6.8 million inventory-related charge for the third quarter of fiscal 2004. We have limited capability to reduce ongoing production once wafer fabrication has commenced. Further, as we introduce product enhancements and new products, and improve our manufacturing processes, demand for our existing products decreases. Conversely, if demand exceeds our expectations, Taiwan Semiconductor Manufacturing Company, or TSMC, or Fujitsu Microelectronics might not be able to fabricate wafers as quickly as we need them. Also, Advanced Semiconductor Engineering, or ASE, might not be able to increase assembly functions in a timely manner. In that event, we would need to increase production and assembly rapidly or find, qualify and begin production and assembly at additional manufacturers or providers of assembly and test services, which may not be possible within a time frame acceptable to our customers. The inability of our product manufacturer or ASE to increase production rapidly enough could cause us to fail to meet customer demand. In addition, rapid increases in production levels to meet unanticipated demand could result in higher costs for manufacturing and other expenses. These higher costs could lower our gross margins.

We currently derive a substantial portion of our revenue from a small number of customers, and our revenue would decline significantly if any major customer were to cancel, reduce or delay a purchase of our products.

     Sales to three customers in the aggregate accounted for 70% of total revenue in the first nine months of fiscal 2004. These customers are located in Asia, which subjects us to economic cycles in that area as well as the geographic areas in which they sell their products containing our microprocessors. We expect that a small number of customers and distributors will continue to account for a significant portion of our revenue. Our future success will depend upon the timing and size of future purchase orders, if any, from these customers and new customers and, in particular:

	•		the success of our customers in marketing products that incorporate our products;
	•		the product requirements of our customers; and
	•		the financial and operational success of our customers.

     We expect that our sales to OEM customers will continue to be made on the basis of purchase orders rather than long-term commitments. In addition, customers can delay, modify or cancel orders without penalty. Many of our customers and potential customers are significantly larger than we are and have sufficient bargaining power to demand reduced prices and favorable nonstandard terms. The loss of any major customer, or the delay of significant orders from these customers, could reduce or delay our recognition of revenue.

     We have entered into distributor agreements and rely in part on distributors and stocking representatives for sales of our products in large territories, including Japan, Taiwan, Hong Kong, Europe, China, Korea and North America. These agreements do not contain minimum purchase commitments.

     Additionally, we have entered into agreements with manufacturers’ representatives in North America and Europe. Any distributor, stocking representative or manufacturers’ representative that fails to emphasize sales of our products, chooses to emphasize alternative products or devices or to promote products of our competitors might not sell a significant amount or any of our products.

If our customers are not able to obtain the other components necessary to build their systems, sales of our products could be delayed or cancelled.

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     Suppliers of other components incorporated into our customers’ systems may experience shortages, which could reduce the demand for our products. For example, from time to time, the computer and semiconductor industries have experienced shortages of some materials and devices, such as memory components, displays, and storage devices. Our customers could defer or cancel purchases of our products if they are not able to obtain the other components necessary to build their systems.

We rely on an independent foundry that has no obligation to provide us with fixed pricing or production capacity for the fabrication of our wafers, and our business will suffer if we are unable to obtain sufficient production capacity on favorable terms.

     We do not have our own manufacturing facilities and, therefore, must rely on third parties to manufacture our products. We currently rely on TSMC in Taiwan to fabricate the wafers for our current 130 nanometer products, and we rely on Fujitsu Microelectronics in Japan to manufacture our initial 90 nanometer Efficeon TM8000 products. As is common in the industry, we do not have a manufacturing contract with TSMC that guarantees any particular production capacity or any particular price, and although we have not yet entered into a definitive manufacturing agreement with Fujitsu Microelectronics, we cannot be assured that we will have any guaranteed production capacity with Fujitsu Microelectronics. The Fujitsu Microelectronics 90 nanometer foundry has relatively limited capacity and we cannot be sure that sufficient capacity will be available at that foundry to enable us to manufacture our initial 90 nanometer Efficeon TM8000 products in the quantities that we would desire if these products were to achieve rapid market acceptance.

     These foundries may allocate capacity to other companies’ products while reducing the capacity available to us on short notice. Foundry customers that are larger than we and have greater economic resources, that have long-term agreements with these foundries or that purchase in significantly larger volumes than we may cause these foundries to reallocate capacity to them, decreasing the capacity available to us. In addition, these foundries could, with little or no notice, refuse to continue to fabricate all or some of the wafers that we require. If these foundries were to stop manufacturing for us, we would likely be unable to replace the lost capacity in a timely manner. Transferring to another manufacturer would require a significant amount of time and money. As a result, we could lose potential sales and fail to meet existing obligations to our customers. These foundries could also, with little or no notice, change the terms under which they manufacture for us, which could cause our manufacturing costs to increase substantially.

Our reliance on TSMC and Fujitsu Microelectronics to fabricate our wafers limits our ability to control the production, supply and delivery of our products.

     Our reliance on third-party manufacturers exposes us to a number of risks outside our control, including the following:

	•		unpredictability of manufacturing yields and production costs;
	•		interruptions in shipments;
	•		inability to control quality of finished products;
	•		inability to control product delivery schedules;
	•		potential lack of access to key fabrication process technologies; and
	•		potentially greater exposure to misappropriation of our intellectual property.

We depend on ASE to provide assembly and test services. If ASE were to cease providing services to us in a timely manner and on acceptable terms, our business would suffer.

     We rely on ASE, which is located in Taiwan, for the majority of our assembly and test services. We do not have a contract with ASE for test and assembly services, and we typically procure these services from ASE on a per order basis. ASE could cease to perform all of the services that we require, or could change the terms upon which it performs services for us. If we were required to find and qualify alternative assembly or testing services, we could experience delays in product shipments, increased product costs or a decline in product quality. In addition, as a result of our reliance on ASE, we do not directly control our product delivery schedules. If ASE were not to provide high quality services in a timely manner, our costs could increase, we could experience delays in the delivery of our products and our product quality could suffer.

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If our products are not compatible with industry standards, hardware that our customers design into their systems or that is used by end-users or software applications or operating systems for x86-compatible microprocessors, market acceptance of our products and our ability to maintain or increase our revenues would suffer.

     Our products are designed to function as components of a system. If our customers experience system-level incompatibilities between our products and the other components in their systems, we could be required to modify our products to overcome the incompatibilities or delay shipment of our products until the manufacturers of other components modify their products or until our customers select other components. These events would delay purchases of our products, cause orders for our products to be cancelled or result in product returns.

     In addition, to gain and maintain market acceptance, our microprocessors must not have significant incompatibilities with software for x86-compatible microprocessors, and in particular, the Windows operating systems, or hardware used by end-users. Software applications, games or operating systems with machine-specific routines programmed into them can result in specific incompatibilities. If a particular software application, game or operating system is programmed in a manner that makes it unable to respond correctly to our microprocessor, it will appear to users of that software that our microprocessor is not compatible with that software. Software or hardware incompatibilities that are significant or are perceived to be significant could hinder our products from achieving or maintaining market acceptance and impair our ability to increase our revenues.

     In an effort to test and ensure the compatibility of our products with hardware and software for x86-compatible microprocessors, we rely on the cooperation of third-party hardware and software companies, including manufacturers of graphics chips, motherboards, BIOS software and other components. All of these third-party designers and manufacturers produce chipsets, motherboards, BIOS software and other components to support each new generation of Intel’s microprocessors, and Intel has significant leverage over their business opportunities. If these third parties were to cease supporting our microprocessor products, our business would suffer.

Our products may have defects that could damage our reputation, decrease market acceptance of our products, cause us to lose customers and revenue and result in liability to us.

     Highly complex products such as our microprocessors may contain hardware or software defects or bugs for many reasons, including design issues or defective materials or manufacturing processes. Often, these defects and bugs are not detected until after the products have been shipped. If any of our products contains defects, or has reliability, quality or compatibility problems, our reputation might be damaged significantly and customers might be reluctant to buy our products, which could result in the loss of or failure to attract customers. In addition, these defects could interrupt or delay sales. We may have to invest significant capital and other resources to correct these problems. If any of these problems is not found until after we have commenced commercial production of a new product, we might incur substantial additional development costs. If we fail to provide solutions to the problems, such as software patches, we could also incur product recall, repair or replacement costs. These problems might also result in claims against us by our customers or others. In addition, these problems might divert our technical and other resources from other development efforts. Moreover, we would likely lose, or experience a delay in, market acceptance of the affected product or products, and we could lose credibility with our current and prospective customers. This is particularly significant as we are a new entrant to a market dominated by large well-established companies.

We are subject to general economic and market conditions.

     Our business is subject to the effects of general economic conditions in the United States and worldwide and, in particular, market conditions in the semiconductor and computer industries. In 2001, 2002 and through parts of 2003, our operating results were adversely affected by unfavorable global economic conditions and reduced information technology spending, particularly in Japan, where we currently generate a substantial portion of our revenue. These adverse conditions resulted in decreased demand for notebook computers and, as a result, our products, which are components of notebook computers. Further, demand for our products decreases as computer manufacturers seek to manage their component and finished product inventory levels. If the economic conditions in Japan and worldwide do not improve, or worsen, we may continue to experience material adverse effects on our business, operating results and financial condition.

The cyclical nature of the semiconductor industry could create fluctuations in our operating results.

     The semiconductor industry has historically been cyclical and characterized by wide fluctuations in product supply and demand. From time to time, the industry has also experienced significant downturns, often in connection with, or in anticipation of, maturing product cycles and declines in general economic conditions. Industry downturns have been characterized by diminished product

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demand, production overcapacity and accelerated decline in average selling prices, and in some cases have lasted for more than a year. The industry experienced a downturn of this type in 1997 and 1998, and began experiencing a downturn again in 2001. Our revenue has decreased, in part due to industry-wide downturns, and could decrease further. In addition, we may determine to lower our prices of our products to increase or maintain market share, which would likely harm our operating results.

If we do not keep pace with technological change, our products may not be competitive and our revenue and operating results may suffer.

     The semiconductor industry is characterized by rapid technological change, frequent new product introductions and enhancements, and ongoing customer demands for greater performance. In addition, the average selling price of any particular microprocessor product has historically decreased substantially over its life, and we expect that trend to continue. As a result, our products may not be competitive if we fail to introduce new products or product enhancements that meet evolving customer demands. It may be difficult or costly for us, or we may not be able, to enhance existing products to fully meet customer demands. For instance, in order to meet the demands of our customers for enhancement of our existing products, we may incur manufacturing or other costs that would harm our operating margins and financial condition. Further, we may not achieve further design wins with current customers unless we continue to meet their evolving needs by developing new products. The development of new products is complex, and we may not be able to complete development in a timely manner, or at all. To introduce and improve products on a timely basis, we must:

	•		accurately define and design new products to meet market needs;
	•		design features that continue to differentiate our products from those of our competitors;
	•		transition our products to new manufacturing process technologies;
	•		identify emerging technological trends in our target markets;
	•		anticipate changes in end-user preferences with respect to our customers’ products;
	•		bring products to market on a timely basis at competitive prices; and
	•		respond effectively to technological changes or product announcements by others.

     We believe that we will need to continue to enhance our products and develop new products to keep pace with competitive and technological developments and to achieve market acceptance for our products. We may incur significant research and development, manufacturing or other costs that would harm our operating margins and financial conditions, in our development efforts. These efforts may not result in enhanced products, or in additional product sales. Accordingly, these investments may not provide us with an acceptable return, or any return at all.

Advances in battery design, cooling systems and power management systems could adversely affect our ability to achieve widespread market acceptance for our products.

     We believe that our ability to achieve widespread market acceptance for our products will depend in large part on whether potential purchasers of our products believe that the low power usage of our products is a substantial benefit. Advances in battery technology, or energy technologies such as fuel cell technologies, that offer increased battery life and enhanced power capacity, as well as the development and introduction of more advanced cooling systems, may make microprocessor power consumption a less important factor to our customers and potential customers. These developments, or developments in power management systems by third parties, may adversely affect our ability to market and sell our products and increase our revenues.

Our products may infringe the intellectual property rights of others, which may cause us to become subject to expensive litigation, cause us to incur substantial damages, require us to pay significant license fees or prevent us from selling our products.

     Our industry is characterized by the existence of a large number of patents and frequent claims and related litigation regarding patent and other intellectual property rights. We cannot be certain that our products do not and will not infringe issued patents, patents that may be issued in the future, or other intellectual property rights of others. In addition, leading companies in the semiconductor industry have extensive intellectual property portfolios with respect to semiconductor technology. From time to time, third parties,

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including these leading companies, may assert exclusive patent, copyright, trademark and other intellectual property rights to technologies and related methods that are important to us. We expect that we may become subject to infringement claims as the number of products and competitors in our target markets grows and the functionality of products overlaps. We have received, and may in the future receive, communications from third parties asserting patent or other intellectual property rights covering our products. Litigation may be necessary in the future to defend against claims of infringement or invalidity, to determine the validity and scope of the proprietary rights of others, to enforce our intellectual property rights, or to protect our trade secrets. We may also be subject to claims from customers for indemnification. Any resulting litigation, regardless of its resolution, could result in substantial costs and diversion of resources.

     If it were determined that our products infringe the intellectual property rights of others, we would need to obtain licenses from these parties or substantially reengineer our products in order to avoid infringement. We might not be able to obtain the necessary licenses on acceptable terms, or at all, or to reengineer our products successfully. Moreover, if we are sued for infringement and lose the suit, we could be required to pay substantial damages or be enjoined from licensing or using the infringing products or technology. Any of the foregoing could cause us to incur significant costs and prevent us from selling our products.

If we are unable to protect our proprietary rights adequately, our competitors might gain access to our technology and we might not compete successfully in our markets.

     We believe that our success will depend in part upon our proprietary technology. We rely on a combination of patents, copyrights, trademarks, trade secret laws and contractual obligations with employees and third parties to protect our proprietary rights. These legal protections provide only limited protection and may be time consuming and expensive to obtain and enforce. If we fail to protect our proprietary rights adequately, our competitors might gain access to our technology. As a result, our competitors might offer similar products and we might not be able to compete successfully in our market. Moreover, despite our efforts to protect our proprietary rights, unauthorized parties may copy aspects of our products and obtain and use information that we regard as proprietary. Also, our competitors may independently develop similar, but not infringing, technology, duplicate our products, or design around our patents or our other intellectual property. In addition, other parties may breach confidentiality agreements or other protective contracts with us, and we may not be able to enforce our rights in the event of these breaches. Furthermore, we expect that we will increase our international operations in the future, and the laws of many foreign countries do not protect our intellectual property rights to the same extent as the laws of the United States. We may be required to spend significant resources to monitor and protect our intellectual property rights.

     Our pending patent and trademark applications may not be approved. Our patents, including any patents that may result from our patent applications, may not provide us with any competitive advantage or may be challenged by third parties. If challenged, our patents might not be upheld or their claims could be narrowed. We may initiate claims or litigation against third parties based on our proprietary rights. Any litigation surrounding our rights could force us to divert important financial and other resources from our business operations.

We might not be able to execute on our business plan if we lose key management or technical personnel, on whose knowledge, leadership and technical expertise we rely.

     Our success depends heavily upon the contributions of our key management and technical personnel, whose knowledge, leadership and technical expertise would be difficult to replace. Many of these individuals have been with us for several years and have developed specialized knowledge and skills relating to our technology and business. For instance, Svend-Olav Carlsen, who had joined Transmeta in October 2000 and was promoted to be our Chief Financial Officer in June 2002, resigned in June 2004. Others have joined us in senior management roles only recently. In September 2004, Mark R. Kent joined us as our Chief Financial Officer. All of our executive officers and key personnel are employees at will. We have no employment contracts and do not maintain key person insurance on any of our personnel. We might not be able to execute on our business plan if we were to lose the services of any of our key personnel. If any of these individuals were to leave our company unexpectedly, we could face substantial difficulty in hiring qualified successors and could experience a loss in productivity while any such successor develops the necessary training and experience.

We will not be able to grow our business if we are unable to hire, train and retain sales, marketing, operations, engineering and finance personnel.

     To grow our business successfully and maintain a high level of quality, we will need to recruit, train, retain and motivate highly skilled sales, marketing, operations, engineering and finance personnel. We will need to develop our sales and marketing

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organizations in order to increase market awareness of our products and to increase revenue. In addition, as a company focused on the development of complex products, we will need to hire skilled engineering staff of various experience levels in order to meet our product roadmap. We may not be able to hire on a timely basis a sufficient number of skilled employees, which could lead to delays in product deliveries or the development of new products. Competition for skilled employees, particularly in the San Francisco Bay Area, is intense. We may have difficulty recruiting potential employees and retaining our key personnel if prospective or current employees perceive the equity component of our compensation package to be less valuable than that of other employers.

The evolution of our business could place significant strain on our management systems, infrastructure and other resources, and our business may not succeed if we fail to manage it effectively.

     Our ability to implement our business plan in a rapidly evolving market requires effective planning and management process. Changes in our business plans could place significant strain on our management systems, infrastructure and other resources. In addition, we expect that we will continue to improve our financial and managerial controls and procedures. We will also need to expand, train and manage our workforce worldwide. Furthermore, we expect that we will be required to manage an increasing number of relationships with suppliers, manufacturers, customers and other third parties. If we fail to manage change effectively, our employee-related costs and employee turnover could increase and our business may not succeed.

We have significant international operations and plan to expand our international operations, which exposes us to risk and uncertainties.

     We believe that we must expand our international sales and distribution operations to be successful. We have sold, and in the future we expect to sell, most of our products to customers in Asia. In addition, TSMC and ASE are located in Taiwan, and the Fujitsu Microelectronics foundry we use for our initial 90 nanometer product is located in Japan. As part of our international expansion, we have personnel in Japan, Taiwan, China, Korea and Europe who provide sales and customer support. We have appointed distributors, stocking representatives and manufacturers’ representatives to sell products in Japan, Taiwan, Hong Kong, Europe, China, Korea and North America. In addition, we generally ship our products from a third-party warehouse facility located in Hong Kong. In attempting to conduct and expand business internationally, we are exposed to various risks that could adversely affect our international operations and, consequently, our operating results, including:

	•		difficulties and costs of staffing and managing international operations;
	•		fluctuations in currency exchange rates;
	•		unexpected changes in regulatory requirements, including imposition of currency exchange controls;
	•		longer accounts receivable collection cycles;
	•		import or export licensing requirements;
	•		problems in the timeliness or quality of product deliveries;
	•		potentially adverse tax consequences;
	•		major health concerns, such as SARS;
	•		political and economic instability, for example as a result of tensions between Taiwan and the People’s Republic of China; and
	•		potentially reduced protection for intellectual property rights.

Our operating results are difficult to predict and fluctuate significantly. A failure to meet the expectations of securities analysts or investors could result in a substantial decline in our stock price.

     Our operating results fluctuate significantly from quarter to quarter, and we expect that our operating results will fluctuate significantly in the future as a result of one or more of the risks described in this section or as a result of numerous other factors. You should not rely on quarter-to-quarter comparisons of our results of operations as an indication of our future performance. Our stock

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price has declined substantially since our stock began trading publicly. If our future operating results fail to meet or exceed the expectations of securities analysts or investors, our stock price would likely decline from current levels.

     A large portion of our expenses, including rent and salaries, is fixed and difficult to reduce. Our expenses are based in part on expectations for our revenue. If our revenue does not meet our expectations, the adverse effect of the revenue shortfall upon our operating results may be acute in light of the fixed nature of our expenses. We often make many shipments of our products at or near the end of the fiscal quarter, which makes it difficult to estimate or adjust our operating activities quickly in response to a shortfall in expected revenue.

The price of our common stock has been volatile and is subject to wide fluctuations.

     The market price of our common stock has been volatile and is likely to remain subject to wide fluctuations in the future. Many factors could cause the market price of our common stock to fluctuate, including:

	•		variations in our quarterly results;
	•		market conditions in our industry, the industries of our customers and the economy as a whole;
	•		announcements of technological innovations by us or by our competitors;
	•		introductions of new products or new pricing policies by us or by our competitors;
	•		acquisitions or strategic alliances by us or by our competitors;
	•		recruitment or departure of key personnel;
	•		the gain or loss of significant orders;
	•		the gain or loss of significant customers; and
	•		changes in the estimates of our operating performance or changes in recommendations by securities analysts.

     In addition, the stock market generally and the market for semiconductor and other technology-related stocks in particular experienced a decline during 2000, 2001 and through 2002, and could decline from current levels, which could cause the market price of our common stock to fall for reasons not necessarily related to our business, results of operations or financial condition. The market price of our stock also might decline in reaction to events that affect other companies in our industry even if these events do not directly affect us. Accordingly, you may not be able to resell your shares of common stock at or above the price you paid. Securities litigation is often brought against a company following a period of volatility in the market price of its securities, and we have been subject to such litigation in the past. Any such lawsuits in the future will divert management’s attention and resources from other matters, which could also adversely affect our business and the price of our stock.

Our California facilities and the facilities of third parties upon which we rely to provide us critical services are located in regions that are subject to earthquakes and other natural disasters.

     Our California facilities, including our principal executive offices, are located near major earthquake fault lines. If there is a major earthquake or any other natural disaster in a region where one of our facilities is located, our business could be materially and adversely affected. In addition, TSMC, upon which we currently rely to fabricate our wafers, and ASE, upon which we currently rely for the majority of our assembly and test services, are located in Taiwan. Fujitsu Microelectronics, which we expect will fabricate a significant amount of our wafers in the future, is located in Japan. Taiwan and Japan have experienced significant earthquakes and could be subject to additional earthquakes in the future. Any earthquake or other natural disaster in these areas could materially disrupt our manufacturer’s production capabilities and ASE’s assembly and test capabilities and could result in our experiencing a significant delay in delivery, or substantial shortage, of wafers and possibly in higher wafer prices.

Our certificate of incorporation and bylaws, stockholder rights plan and Delaware law contain provisions that could discourage or prevent a takeover, even if an acquisition would be beneficial to our stockholders.

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     Provisions of our certificate of incorporation and bylaws, as well as provisions of Delaware law, could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. These provisions include:

	•		establishing a classified board of directors so that not all members of our board may be elected at one time;
	•		providing that directors may be removed only “for cause” and only with the vote of 66 2/3% of our outstanding shares;
	•		requiring super-majority voting to amend some provisions in our certificate of incorporation and bylaws;
	•		authorizing the issuance of “blank check” preferred stock that our board could issue to increase the number of outstanding shares and to discourage a takeover attempt;
	•		limiting the ability of our stockholders to call special meetings of stockholders;
	•		prohibiting stockholder action by written consent, which requires all stockholder actions to be taken at a meeting of our stockholders; and
	•		establishing advance notice requirements for nominations for election to our board or for proposing matters that can be acted upon by stockholders at stockholder meetings.

     In addition, the stockholder rights plan, which we implemented in 2002, and Section 203 of the Delaware General Corporation Law may discourage, delay or prevent a change in control.

Our reported financial results may be adversely affected by changes in accounting principles generally accepted in the United States.

     Generally accepted accounting principles in the United States are subject to interpretation by the Financial Accounting Standards Board (FASB), the American Institute of Certified Public Accountants, the Securities and Exchange Commission (SEC) and various bodies formed to promulgate and interpret appropriate accounting principles. A change in these principles or interpretations could have a significant effect on our reported financial results, and could affect the reporting of transactions completed before the announcement of a change. For example, we currently are not required to record stock-based compensation charges if an employee’s stock option exercise price is equal to or exceeds the deemed fair value of our common stock at the date of grant. However, several companies have recently elected to change their accounting policies and begun to record the fair value of stock options as an expense. The FASB published in March 2004 an exposure draft that would require us to record expense for the fair value of stock options granted. The effective date of the proposed standard is for periods beginning after June 15, 2005. Our reported earnings and/or loss would be harmed if we were required to change our current accounting policy.

We have identified material weaknesses in our internal control over financial reporting, which contributed to our need to amend our financial statements for the second quarter of fiscal 2004. Further, we may be unable to assess on a timely basis the effectiveness of our internal control over financial reporting as required by Section 404 of the Sarbanes-Oxley Act of 2002.

     In the course of preparing our financial statements for the third quarter of fiscal 2004, material weaknesses, as defined in Public Company Accounting Oversight Board Standard No. 2, were identified in our internal control over financial reporting. Specifically, material weaknesses were identified with respect to our financial statement close process and our contract administration.

     These material weaknesses contributed to post-closing adjustments and the resulting need to amend our financial statements for the second quarter of fiscal 2004. By amending our previously released financial statements, we could suffer a loss of public confidence in the reliability of our financial statements, which could harm our business and our publicly traded stock price. In addition, we cannot assure you that we will not in the future identify further material weaknesses or significant deficiencies in our internal control over financial reporting that we have not discovered to date.

     In order to comply with the Sarbanes-Oxley Act of 2002, we are currently performing the system and process evaluation and testing (and any necessary remediation) required in an effort to allow our management to assess the effectiveness of our system of internal control as of December 31, 2004, the end of our current fiscal year. Our independent auditors must then attest to and report on that assessment by our management. We have been notified by our independent auditors that we may not be able to complete, on a timely basis, our assessment in compliance with Section 404. If we fail to timely complete our evaluation and testing in order to

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allow for this assessment by our management, or if our independent auditors cannot timely attest to our management’s assessment, we could be subject to regulatory scrutiny and a loss of public confidence in our internal controls, which could harm our business and our publicly traded stock price. Further, if our independent auditors are not satisfied with our internal control over financial reporting or with the level at which it is documented, designed, operated or reviewed, they may decline to attest to management’s assessment or may issue a qualified report identifying a material weakness in our internal controls. This could result in significant additional expenditures responding to the Section 404 internal control audit, a diversion of management attention and potentially an adverse reaction to our publicly traded stock price.

Changes in securities laws and regulations have increased our costs.

     The Sarbanes-Oxley Act of 2002 has required and will require changes in some of our corporate governance, public disclosure and compliance practices. The Act also requires the SEC to promulgate new rules on a variety of subjects. In addition to final rules and rule proposals already made by the SEC, the National Association of Securities Dealers has adopted revisions to its requirements for companies, such as us, that are listed on the Nasdaq National Market. These developments have increased our legal and financial compliance costs and have made some activities, such as SEC reporting requirements, more difficult. Additionally, we expect these developments to make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These developments could make it more difficult for us to attract qualified executive officers and attract and retain qualified members of our board of directors, particularly to serve on our audit committee. We are presently evaluating and monitoring regulatory developments and cannot estimate the timing or magnitude of additional costs we may incur as a result.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

     Interest Rate Risk. Our cash equivalents and available-for-sale investments are exposed to financial market risk due to fluctuations in interest rates, which may affect our interest income. Over the past few years, we have experienced significant reductions in our interest income due in part to declines in interest rates. These declines have led to interest rates that are low by historical standards and we do not believe that further decreases in interest rates will have a material impact on the interest income earned on our cash equivalents and short-term investments held at September 30, 2004.

     Foreign Currency Exchange Risk. All of our sales and substantially all of our expenses are denominated in U.S. dollars. As a result, we have relatively little exposure to foreign currency exchange risk. We do not currently enter into forward exchange contracts to hedge exposures denominated in foreign currencies or any other derivative financial instruments for trading or speculative purposes. However, in the event our exposure to foreign currency risk increases, we may choose to hedge those exposures.

Item 4. Controls and Procedures

     We maintain a set of disclosure controls and procedures designed to ensure that information required to be disclosed by us in the reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified by the rules and forms of the Securities and Exchange Commission. Disclosure controls and procedures are also designed with the objective of ensuring that this information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.

     In the course of preparing our financial statements for the third quarter of fiscal 2004, material weaknesses, as defined in Public Company Accounting Oversight Board, or PCAOB, Standard No. 2, were identified in our internal control over financial reporting. As used by the PCAOB, a material weakness is a significant deficiency, or a combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. Specifically, material weaknesses with were identified with respect to our financial statement close process and our contract administration.

     The material weakness with respect to our financial statement close process affected our inventory for the second and third quarters of fiscal 2004 and accrued restructuring costs for the third quarter of fiscal 2004. In respect of our financial statements for the second quarter of fiscal 2004, we did not properly record an inventory charge because we had not identified our contractual obligation to purchase materials from a third-party supplier. We identified that contractual obligation after we filed on August 4, 2004 our quarterly report on Form 10-Q for the quarterly period ended June 30, 2004, and a charge for those materials in excess of our anticipated needs as of June 30, 2004 is now reflected in our amended financial statements included in the amendment of that quarterly report which we filed on November 8, 2004. In respect of our financial statements for the third quarter of fiscal 2004, we initially made inappropriate

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and inconsistent assumptions with respect to certain inventory valuations and accrued restructuring costs and initially misapplied accounting principles with respect to the impairment of certain manufacturing related equipment. Management and Ernst & Young LLP, our independent auditors, identified these inaccuracies, and the correct charges are reflected in the financial statements included in this quarterly report.

     The material weakness with respect to our contract administration contributed to our failure to identify our contractual obligation to purchase materials from a third-party supplier described above.

     We also recently experienced transitions in the oversight of our finance and accounting personnel. In June 2004, Svend-Olav Carlsen, who had served as our chief financial officer since June 2002, resigned. In September 2004, we hired Mark R. Kent as our new chief financial officer. During a portion of the interim period, our general counsel served as our chief financial officer.

     Our management evaluated, with the participation of our chief executive officer and our chief financial officer, the effectiveness of our disclosure controls and procedures as of September 30, 2004, the end of the period covered by this report. As a consequence of the material weaknesses described above that existed at September 30, 2004, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were not effective as of September 30, 2004.

     Our management and audit committee have assigned a high priority to the short-term and long-term improvement of our internal control over financial reporting. Specific initiatives with respect to our disclosure controls and procedures and actions to address the material weaknesses described above that we have undertaken through the end of the fiscal year ended December 31, 2004 include the revision and implementation of our policies regarding:

	•		who at the company is authorized to sign contracts;
	•		confirmation that only authorized company employees have signed contracts;
	•		provision of appropriate signed contracts to our finance group; and
	•		determination of our assumptions used to calculate inventory valuation by the finance group integrating in a more comprehensive manner the sales and inventory forecasting processes.

     Our management and audit committee intend to closely monitor the implementation of our remediation plan. Although we have undertaken the foregoing initiatives, the existence of a material weakness is an indication that there is more than a remote likelihood that a material misstatement of our financial statements will not be prevented or detected in a future period. In addition, we cannot assure you that we will not in the future identify further material weaknesses or significant deficiencies in our internal control over financial reporting that we have not discovered to date. We are taking steps to address the material weaknesses that have been identified and to refine our internal controls and procedures to meet the internal control reporting requirements of Section 404 of the Sarbanes-Oxley Act and the rules adopted thereunder although these initiatives may not be concluded by December 31, 2004. The effectiveness of the steps we have taken to date and the steps we are still in the process of completing is subject to continued management review, as well as audit committee oversight, and we may make additional changes to our internal control over financial reporting.

     Other than the foregoing initiatives, during the third quarter of fiscal 2004, there have been no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

     The Company is a party in one consolidated lawsuit. Beginning in June 2001, the Company, certain of its directors and officers, and certain of the underwriters for its initial public offering were named as defendants in three putative shareholder class actions that were consolidated in and by the United States District Court for the Southern District of New York in In re Transmeta Corporation Initial Public Offering Securities Litigation, Case No. 01 CV 6492. The complaints allege that the prospectus issued in connection with the Company’s initial public offering on November 7, 2000 failed to disclose certain alleged actions by the underwriters for that offering, and alleges claims against the Company and several of its officers and directors under Sections 11 and 15 of the Securities Act of 1933, as amended, and under Sections 10(b) and Section 20(a) of the Securities Exchange Act of 1934, as amended. Similar actions have been filed against more than 300 other companies that issued stock in connection with other initial public offerings during 1999-2000. Those cases have been coordinated for pretrial purposes as In re Initial Public Offering Securities Litigation, Master File No. 21 MC 92 (SAS). In July 2002, the Company joined in a coordinated motion to dismiss filed on behalf of multiple issuers and other defendants. In February 2003, the Court granted in part and denied in part the coordinated motion to dismiss, and issued an order regarding the pleading of amended complaints. Plaintiffs subsequently proposed a settlement offer to all issuer defendants, which settlement would provide for payments by issuers’ insurance carriers if plaintiffs fail to recover a certain amount from underwriter defendants. Although the Company and the individual defendants believe that the complaints are without merit and deny any liability, but because they also wish to avoid the continuing waste of management time and expense of litigation, they accepted plaintiffs’ proposal to settle all claims that might have been brought in this action. The Company and the individual Transmeta defendants expect that their share of the global settlement will be fully funded by their director and officer liability insurance. Although the Company and the Transmeta defendants have approved the settlement in principle, it remains subject to several procedural conditions, as well as formal approval by the Court. It is possible that the parties may not reach a final written settlement agreement or that the Court may decline to approve the settlement in whole or part. In the event that the parties do not reach agreement on the final settlement, the Company and the Transmeta defendants believe that they have meritorious defenses and intend to defend any remaining action vigorously.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

     Not Applicable.

Item 3. Defaults upon Senior Securities

     Not Applicable.

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

     Not Applicable.

Item 5. Other Information

     Not Applicable.

Item 6. Exhibits

     (a) Exhibits.

     The following exhibits are filed herewith:

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     * As contemplated by SEC Release No. 33-8212, these exhibits are furnished with this quarterly report on Form 10-Q and are not deemed filed with the Securities and Exchange Commission and are not incorporated by reference in any filing of Transmeta Corporation under the Securities Act of 1933 or the Securities Exchange Act of 1934, including this quarterly report, whether made before or after the date hereof and irrespective of any general incorporation language in any filings.

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SIGNATURES

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

	TRANSMETA CORPORATION
	By:	/s/ MARK R. KENT
		Mark R. Kent
		Chief Financial Office (Principal Financial Officer and Duly Authorized Officer)

Date: November 8, 2004

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EXHIBIT INDEX

     * As contemplated by SEC Release No. 33-8212, these exhibits are furnished with this quarterly report on Form 10-Q and are not deemed filed with the Securities and Exchange Commission and are not incorporated by reference in any filing of Transmeta Corporation under the Securities Act of 1933 or the Securities Exchange Act of 1934, including this quarterly report, whether made before or after the date hereof and irrespective of any general incorporation language in any filings.