SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

OR

Commission file number: 0-29939

OMNIVISION TECHNOLOGIES, INC.

1341 Orleans Drive, Sunnyvale, California 94089-1136
(Address of Principal Executive Offices) (Zip Code)

Registrant’s telephone number, including area code: (408) 542-3000

     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 and Exchange Act of 1934 during the preceding 12 months (or for 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 þ No o

     Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes þ No o

     At December 8, 2004, 56,628,182 shares of common stock of the Registrant were outstanding.

OMNIVISION TECHNOLOGIES, INC.

INDEX

2

PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

OMNIVISION TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements (unaudited).

3

OMNIVISION TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED INCOME STATEMENTS

*

As restated in the Quarterly Report on Form 10-Q/A for the quarter ended October 31, 2003.

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements (unaudited).

4

OMNIVISION TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

*

As restated in the Quarterly Report on Form 10-Q/A for the quarter ended October 31, 2003.

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements (unaudited).

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OMNIVISION TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
For the Three and Six Months Ended October 31, 2004 and 2003
(unaudited)

Note 1 — Basis of Presentation

     Overview

          The accompanying interim unaudited condensed consolidated financial statements as of October 31, 2004 and April 30, 2004 and for the three and six months ended October 31, 2004 and 2003 have been prepared by OmniVision Technologies, Inc. and its subsidiaries (“OmniVision” or the “Company”) in accordance with the rules and regulations of the Securities and Exchange Commission. The amounts as of April 30, 2004 are derived from the Company’s annual audited financial statements. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted in accordance with such rules and regulations. In the opinion of management, the accompanying unaudited financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position of the Company and its results of operations and cash flows as of and for the periods presented. These financial statements should be read in conjunction with the annual audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended April 30, 2004, as amended (the “Form 10-K”).

          The results of operations for the three and six months ended October 31, 2004 are not necessarily indicative of the results that may be expected for the year ending April 30, 2005 or any other future period.

          The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The Company bases its estimates and judgments on its historical experience, knowledge of current conditions and beliefs of what could occur in the future considering available information. Actual results could differ from those estimates.

     Restatement of Previous Quarterly Financial Statements

          On June 23, 2004, the Company issued a press release and filed a Current Report on Form 8-K announcing that the Company was restating its financial results for its quarters ended July 31, 2003, October 31, 2003 and January 31, 2004.

          The restatements arose out of an internal review which was initiated in response to issues raised by an employee. The management of the Company notified the Audit Committee of the Board of Directors of the issues raised, and the Audit Committee, with assistance from special legal counsel, conducted its own independent investigation. As a result of the internal review and the independent investigation, management and the Audit Committee determined that certain errors had occurred which principally affected the timing of revenue recognition for certain sales. The independent investigation concluded that there was no evidence of wrongdoing in connection with these errors.

          The restatement of the Company’s financial results for the first three quarters of fiscal 2004 related primarily to two issues identified as part of the internal review and independent investigation. First, beginning in the second half of fiscal 2003 and continuing through the first nine months of fiscal 2004, certain distribution sales, for which the Company recognizes revenue on a “sell-through” basis, were not reported to the Company by one of its distributors in a timely manner. Additionally, in the second and third quarters of fiscal 2004, during the transition of testing operations and certain international sales functions to overseas locations, some shipments made to customers late in the quarter were incorrectly classified as transferring title upon delivery as opposed to upon shipment, and therefore revenue was not recognized when product was shipped. Both of these issues resulted in delayed revenue recognition.

Note 2 — Summary of Significant Accounting Policies

     Revenue Recognition

          For shipments to original equipment manufacturers (“OEMs”), value added resellers (“VARs”) and distributors without agreements that allow for returns or credits, the Company recognizes revenue using the “sell-in” method,

6

OMNIVISION TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
For the Three and Six Months Ended October 31, 2004 and 2003
(unaudited)

which shipments represented approximately 80.4% and 81.4% of revenues for the three and six months ended October 31, 2004, respectively. Under this method, the Company recognizes revenue upon the shipment of products to the customer provided that the Company has received a signed purchase order, the price is fixed or determinable, title and risk of loss has transferred to the customer, collection of resulting receivables is considered reasonably assured, product returns are reasonably estimable, there are no customer acceptance requirements and there are no remaining material obligations. The Company provides for future returns based on historical experience at the time revenue is recognized. For shipments to distributors under agreements allowing for returns or credits, revenue is recognized using the “sell-through” method under which revenue is deferred until the distributor actually resells the product to the end-user customer and the Company is notified in writing by the distributor of such sale. These sales represented approximately 19.6% and 18.6% of revenues for the three and six months ended October 31, 2004, respectively. Deferred income on shipments to distributors represents the amount billed less the cost of inventory shipped to but not yet sold by distributors.

          In addition, the Company recognizes revenue from the provision of engineering assistance to a limited number of its customers. The Company recognizes the associated revenue only upon the completion of and acceptance by the customer of the services performed. The revenue is based on a fixed fee which is agreed upon prior to initiation of the engineering assistance. Historically, revenue generated from such arrangements has been immaterial.

     Restricted Cash

          Restricted cash represents cash that has been set aside as a result of court proceedings in which the parties stipulated to the filing of a bond that the Company posted with the San Diego County Superior Court. As of October 31, 2004, restricted cash of approximately $1.1 million was posted to secure the bond. Restricted cash is classified in current assets on the consolidated balance sheet. The Company maintains its restricted cash with a commercial bank. As a result of the settlement of the related litigation in November 2004, the Company expects the restricted cash will be released before the end of January 2005. (See Note 9 and Note 10.)

     Short-Term Investments

          The Company’s short-term investments, which are classified as available-for-sale, are invested in high-grade corporate securities and government bonds maturing in twelve months or less from the date of purchase. These investments are reported at fair value at October 31, 2004 and April 30, 2004. Unrealized gains or losses are recorded in stockholders’ equity and included in other comprehensive income (losses). Declines in value judged to be other than temporary, if any, are recorded in operations as incurred. Unrealized gains or losses were not significant during any period presented in these financial statements.

     Intangible Assets

          In the three months ended October 31, 2004, the Company purchased certain intellectual property rights that have been recorded in Other non-current assets. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” the Company recognizes as expense the cost of such acquired intellectual property rights will be amortized over a period of up to five years.

     Research and Development

          In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 2, “Accounting for Research and Development Costs,” the Company recognizes as expense when incurred the associated costs of the internal development of these intellectual property rights, including patent, copyright, trademark and trade secrets.

     Warranty Reserve for Defective Products

          The Company accounts for its warranty reserve for defective products as a portion of the sales return reserve. The Company warrants to its customers that its products will work in accordance with their respective specifications. If a product is defective, the customer is required to notify the Company and return the defective product to the Company. The Company then sends replacement products to the customer. Owing to cost and other complexities associated with the products, the Company does not repair any defective products.

     Land Use Right Acquired in China

          In December 2000, the Company established a Chinese subsidiary to conduct testing operations in China. Subsequently, the Company constructed a manufacturing facility in Shanghai owned by the Chinese subsidiary. This manufacturing facility was places in service in July 2003. However, the Chinese subsidiary does not own the land that underlies the facility; rather, it holds a “land use right” that was acquired from the local Chinese government in December 2000 for approximately $0.8 million, which entitles the Company to use the land for 50 years. The cost of this land use right was recorded as a portion of property, plant and equipment and is being depreciated over the useful life of the right.

7

OMNIVISION TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
For the Three and Six Months Ended October 31, 2004 and 2003
(unaudited)

     Stock-Based Compensation

          The Company accounts for stock-based employee compensation arrangements using the intrinsic value method in accordance with the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and the Financial Accounting Standards Board (“FASB”) Interpretation 44, “Accounting for Certain Transactions Involving Stock Compensation” (“FIN 44”), and complies with the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), as amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure—An Amendment of FASB Statement No. 123” (“SFAS 148”). Under APB 25, compensation cost is recognized based on the difference, if any, on the date of grant between the fair value of the Company’s stock and the amount an employee must pay to acquire the stock. Deferred stock-based compensation is then amortized over the vesting period of the option on an accelerated basis using the multiple option approach as defined in paragraph 24 of FIN 28. SFAS 123 describes a “fair value” based method of accounting for an employee stock option or similar equity instrument. The following table illustrates the effect on net income and net income per share as if the Company had applied the fair value recognition provisions of SFAS 123 and SFAS 148 to stock-based employee grants compensation and is referenced to in this Note as “as adjusted” (in thousands, except per share amounts):

8

OMNIVISION TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
For the Three and Six Months Ended October 31, 2004 and 2003
(unaudited)

          The Company accounts for stock issued to non-employees in accordance with the provisions of SFAS 123 and Emerging Issues Task Force Consensus No. 96-18, "Accounting for Equity Instruments that are Offered to Other than Employees for Acquiring or in Conjunction with Selling Goods or Services” (“EITF 96-18”). Under SFAS 123 and EITF 96-18, stock option awards issued to non-employees are accounted for at their fair value, determined using the Black-Scholes option pricing model. The amount of compensation expense for certain stock option awards issued to consultants for services is accounted for using the variable accounting method.

     Recent Accounting Pronouncements

          The Financial Accounting Standards Board (“FASB”) has issued FASB Statement No. 151, “Inventory Costs, an Amendment of ARB No. 43, Chapter 4” (“FAS No. 151”). The amendments made by FAS No. 151 are intended to improve financial reporting by clarifying that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges and by requiring the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities.

          FAS No. 151 is the result of a broader effort by the FASB to improve the comparability of cross-border financial reporting by working with the International Accounting Standards Board (“IASB”) toward development of a single set of accounting standards. The FASB and the IASB noted that ARB 43, Chapter 4 and International Accounting Standard No. 2, “Inventories,” (“IAS 2”) are both based on the principle that the primary basis of accounting for inventory is cost. Both of these accounting standards also require that abnormal amounts of idle freight, handling costs, and wasted materials be recognized as period costs; however, the Boards noted that differences in the wording of the two standards could lead to inconsistent application of essentially similar requirements. The FASB concluded that clarifying the existing requirements in ARB 43 by adopting language similar to that used in IAS 2 is consistent with its goals of improving financial reporting in the United States and promoting convergence of accounting standards internationally.

          The guidance is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal years beginning after November 23, 2004. The provisions of FAS No. 151 will be applied prospectively. The Company does not expect the adoption of FAS No. 151 to have a material impact on its consolidated financial position, results of operations or cash flows.

9

OMNIVISION TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
For the Three and Six Months Ended October 31, 2004 and 2003
(unaudited)

Note 3 — Balance Sheet Accounts (in Thousands)

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OMNIVISION TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
For the Three and Six Months Ended October 31, 2004 and 2003
(unaudited)

Note 4 — Inventory Write-Off

          During the three months ended January 31, 2001, the Company wrote off $18.1 million of inventory due to a significant imbalance in the PC camera market. The following table summarizes the activity in the original $18.1 million of previously written-off inventory (in thousands):

          As of October 31, 2004 and April 30, 2004, the Company held inventories with an original cost of $3.9 million and $4.3 million, respectively, that were written off in fiscal 2001. No inventory was scrapped during the three and six months ended October 31, 2004 and 2003.

Note 5 — Long-term Investments

          In April 2003, the Company purchased approximately 11% of the common stock of a privately held company based in Taiwan for a total of $2.8 million in cash. During fiscal 2004, the Company’s equity participation in this privately held company declined to approximately 9% due to additional rounds of financing obtained by the Taiwanese company. The Taiwanese company provides chip-scale packaging services. The Company does not have the ability to exercise significant influence over the operating and financial policies of this company. As a result, the Company accounts for this investment using the cost method.

          In June 2003, the Company purchased approximately 27% of another privately held company based in Taiwan for a total of $2.0 million in cash. This Taiwanese company provides plastic packaging services. In November 2003, the Company made an additional cash contribution in the amount of approximately $0.8 million to maintain its equity ownership percentage in this company. During fiscal 2004, the Company’s equity participation in this privately held company declined to approximately 23% due to additional rounds of financing obtained by this Taiwanese company. The Company accounts for this investment using the equity method. The Company recorded an equity loss of $0.3 million and $0.6 million for its portion of the net loss for the three and six months ended October 31, 2004, respectively, recorded by the company in which it had invested.

          In October 2003, the Company entered into an agreement with TSMC to form VisEra, a joint venture in Taiwan, for the purpose of providing manufacturing services and automated final testing services. The Company and TSMC both have equal interests in VisEra. The Company has committed to invest $23.5 million in VisEra which becomes due in stages as VisEra’s business and service capabilities develop over a number of years. In November 2003, the Company made a $1.5 million cash investment in VisEra. The Company accounts for this investment using the equity method. The Company recorded equity income of $0.2 million for its portion of the net income for the three and six months ended October 31, 2004, respectively, recorded by VisEra.

          In May 2004, the Company entered into an agreement with Powerchip Semiconductor Corporation (“PSC”) to establish a joint venture in Taiwan. The purpose of the joint venture is to conduct manufacturing, marketing and selling of certain of the Company’s legacy products. In connection with this joint venture, the Company entered into licensing and manufacturing agreements with PSC. The Company’s capital commitment to the joint venture is approximately $2.1 million in exchange for an ownership percentage of approximately 49%. The Company’s cash contributions are to be made in two phases. In the first phase, the Company made a cash investment in an amount equal to approximately $1.5 million in this joint venture in May 2004. The first phase concluded prior to the scheduled December 31, 2004 date by mutual consent between the Company and the joint venture company. In the

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OMNIVISION TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
For the Three and Six Months Ended October 31, 2004 and 2003
(unaudited)

second phase, which commenced immediately following the conclusion of the first phase and continues until the termination of the agreement, the Company will contribute an additional amount equal to approximately $0.6 million in cash to the joint venture. The Company accounts for this investment using the equity method. The Company recorded an equity loss of $0.2 million for its portion of the net loss for the three and six months ended October 31, 2004 recorded by the joint venture.

Note 6 — Net Income Per Share

          Basic net income per share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed according to the treasury stock method using the weighted average number of common and potentially dilutive common shares outstanding during the period. Potentially dilutive common shares include the effect of stock options. For the three and six months ended October 31, 2004, 5,414,775 and 5,164,775 shares of common stock subject to outstanding options were not included in the calculation of diluted net income per share as they were considered antidilutive (i.e., the per share exercise price for such options exceeded the trading price of the Company’s common stock as reported on The Nasdaq Stock Market), respectively. For the six months ended October 31, 2003, 601,750 shares of common stock subject to outstanding options were not included in the calculation of diluted net income per share as they were considered antidilutive. There were no antidilutive shares for the three months ended October 31, 2003.

          The following table sets forth the computation of basic and diluted income per share attributable to common stockholders for the periods indicated (in thousands, except per share data):

Note 7 — Segment, Product Line and Geographic Information

          The Company identifies its operating segments based on business activities, management responsibility and geographic location. For all periods presented, the Company operated in a single business segment.

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OMNIVISION TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
For the Three and Six Months Ended October 31, 2004 and 2003
(unaudited)

          Revenues from the Company’s two product lines, digital and analog image sensors, were as follows (in thousands):

          The Company sells its image-sensor products either directly to OEMs and VARs or indirectly through distributors. The following table illustrates the percentage of revenues from sales to OEMs and VARs as compared to distributors in the three and six months ended October 31, 2004 and 2003:

          The Company sells its products primarily to customers in the Asia Pacific region. Revenues by geographic location are not necessarily representative of the geographic distribution of sales to end-user markets, as the Company’s customers sell their products globally. The revenues by geographic location in the following table are based on the country or region in which the customers are located (in thousands):

          In December 2000, the Company formed a subsidiary to conduct testing operations and other processes associated with the manufacturing of its products in China. The registered capital of this subsidiary was initially $12.0 million, of which $3.8 million was funded by the Company in fiscal 2001, as required by Chinese law. The Company funded an additional $3.7 million during fiscal 2002. In August 2002, the Company increased the registered capital to $30.0 million and funded an additional $3.2 million and $4.0 million during fiscal 2004 and fiscal 2003, respectively. A total of $14.7 million of the $30.0 million of registered capital of the subsidiary had been funded as of October 31, 2004 from the Company’s available working capital. The remaining $15.3 million of registered capital must be funded by January 2005 unless the Chinese government agrees to an extension. The $14.7 million invested through October 31, 2004 was used primarily for partial payment to building contractors for the construction of the facility and the purchase of equipment.

13

OMNIVISION TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
For the Three and Six Months Ended October 31, 2004 and 2003
(unaudited)

          The Company’s long-lived assets are located in the following countries (in thousands):

Note 8 — Employee Stock Option and Stock Purchase Plans

     Employee Stock Option Grants

          Options to purchase 1,052,000 and 3,213,550 shares of common stock were granted to employees during the three and six months ended October 31, 2004, respectively. Options to purchase 601,750 and 3,444,600 shares of common stock were granted to employees during the three and six months ended October 31, 2003, respectively. As of October 31, 2004, options to purchase 10,077,228 shares of common stock were outstanding.

     2000 Employee Stock Purchase Plan

          As of October 31, 2004, 1,487,717 shares had been purchased under the 2000 Employee Stock Purchase Plan (the “2000 Purchase Plan”).

     Fair Value Disclosures

          Information regarding net income and net income per share, as adjusted, is required by SFAS 123, which also requires that the information be determined as if the Company had accounted for its employee stock options granted under the fair value method. The fair value for these options was estimated using the Black-Scholes option pricing model. The per share weighted average estimated fair value for employee options granted was $9.15 and $15.46 during the three months ended October 31, 2004 and 2003, respectively. The per share weighted average estimated fair value for employee options granted was $14.98 and $13.12 during the six months ended October 31, 2004 and 2003, respectively. The Black-Scholes model was developed for use in estimating the fair value of traded options that have no restrictions and are fully transferable and negotiable in a freely traded market. Black-Scholes does not consider the employment, transfer or vesting restrictions that are inherent in the Company’s employee options. The usage of an option valuation model, as required by SFAS 123, includes highly subjective assumptions based on long-term predictions, including the expected stock price volatility and average life of each option grant. Because the Company’s employee options have characteristics significantly different from those of freely traded options, and because changes in the subjective input assumptions can materially affect the Company’s estimate of the fair value of those options, it is the Company’s opinion that the existing valuation models, including Black-Scholes, are not reliable single measures and may misstate the fair value of the Company’s employee options.

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OMNIVISION TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
For the Three and Six Months Ended October 31, 2004 and 2003
(unaudited)

          The following weighted average assumptions are included in the estimated fair value calculations for stock option grants in the three and six months ended October 31, 2004 and 2003:

          Using Black-Scholes, the per share weighted average estimated fair value of rights issued pursuant to the Company’s 2000 Purchase Plan during the three and six months ended October 31, 2004 was $3.60 and $4.70, respectively. Using Black-Scholes, the per share weighted average estimated fair value of rights issued pursuant to the Company’s 2000 Purchase Plan during the three and six months ended October 31, 2003 was $15.97 and $12.47, respectively.

          The following weighted average assumptions are included in the estimated grant date fair value calculations for rights to purchase stock under the 2000 Purchase Plan:

Note 9 — Commitments and Contingencies

     Litigation

          From time to time, the Company has been subject to legal proceedings and claims with respect to such matters as patents, product liabilities and other actions arising out of the normal course of business.

          On November 29, 2001, a complaint captioned McKee v. OmniVision Technologies, Inc., et. al., Civil Action No. 01 CV 10775, was filed in the United States District Court for the Southern District of New York against OmniVision, some of the Company’s directors and officers, and various underwriters for the Company’s initial public offering. Plaintiffs generally allege that the named defendants violated federal securities laws because the prospectus related to the Company’s offering failed to disclose, and contained false and misleading statements regarding, certain commissions purported to have been received by the underwriters, and other purported underwriter practices in connection with their allocation of shares in the Company’s offering. The complaint seeks unspecified damages on behalf of a purported class of purchasers of the Company’s common stock between July 14, 2000 and December 6, 2000. Substantially similar actions have been filed concerning the initial public offerings for more than 300 different issuers, and the cases have been coordinated as In re Initial Public Offering Securities Litigation, 21 MC 92. Claims against the Company’s directors and officers have been dismissed without prejudice pursuant to a stipulation. On February 19, 2003, the Court issued an order dismissing all claims against the Company except for a claim brought under Section 11 of the Securities Act of 1933. A proposed stipulation of settlement as a release of claims against the issuer defendants, including the Company, has been submitted for preliminary approval by the Court. The settlement is subject to Court approval and a number of other conditions. If the settlement does not occur and litigation against the Company continues, the Company believes that it has meritorious defenses and intends to defend the case

15

OMNIVISION TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
For the Three and Six Months Ended October 31, 2004 and 2003
(unaudited)

vigorously. The Company further believes that the settlement is not expected to have any material adverse affect on its financial condition, results of operations or cash flows.

          On August 21, 2002, the Company initiated a patent infringement action in Taiwan, R.O.C. against IC Media Corporation of San Jose, CA for infringement of Taiwan patent NI-139439 that had been issued to the Company related to the integration of certain computer interfacing technology in system designs. The patent infringement action seeks damages and injunctive relief from IC Media Corporation. In response to the Company’s patent infringement action, on October 2, 2002, IC Media Corporation initiated a cancellation proceeding in the Taiwan Intellectual Property Office with respect to the Company’s Taiwan patent NI-139439. On July 23, 2003, the Taiwan Intellectual Property Office made an initial determination to grant the cancellation of Taiwan patent NI-139439, which decision was upheld by the Taiwan Ministry of Economic Affairs on November 21, 2003. On January 20, 2004, the Company filed an action with the High Administrative Court of Taiwan to reverse the grant of cancellation.

          On October 11, 2002, the Company filed a complaint against IC Media Corporation in Superior Court of California, Santa Clara County (Case No. CV 811866). In its complaint, the Company alleged misappropriation of trade secrets, unfair competition and other business torts, and sought damages and injunctive relief. IC Media Corporation answered the complaint by denying the allegations and raising various defenses. In accordance with the Alternative Dispute Resolution practices of the Court, this matter was submitted for mediation on April 1, 2004, and a settlement agreement was ultimately executed on May 7, 2004. The settlement, whose terms are confidential, resulted in dismissal of the lawsuit in October 2004. The settlement did not have a significant impact on its financial condition, results of operations or cash flows.

          On July 14, 2003, Sunex, Inc. (“Sunex”) filed a complaint against the Company in San Diego County Superior Court. Sunex was a supplier of optical lenses and lens holders for one of the Company’s cell phone products. Under its complaint, Sunex sought to recover approximately $1.8 million plus interest and attorney’s fees. Sunex’s complaint related to parts delivered by Sunex to the Company in the fiscal quarters ended January 31, 2003 and April 30, 2003 and the Company’s cancellation in that quarter of additional purchase orders it had previously placed with Sunex. In October 2003, the Superior Court granted Sunex’s request for a prejudgment writ of attachment. The parties stipulated to the filing of a bond in lieu of an attachment, which the Company posted with the Superior Court in the approximate amount of $1.1 million. In September 2004, the Company settled its cross-complaint against Sunex, Inc. for the payment of approximately $0.1 million by Sunex to the Company. In November 2004, the Company settled the complaint filed by Sunex for the payment of approximately $0.9 million by the Company to Sunex. The settlement of the complaint and cross-complaint completely and fully resolved any and all claims related to the above matters by the Company and Sunex in their entirety. The settlement did not have a significant impact on the Company’s financial condition, results of operations or cash flows.

          On June 10, 2004, the first of several putative class actions filed against the Company and certain of its present and former directors and officers in federal court on behalf of investors who purchased the Company’s common stock at various times from February 2003 through June 9, 2004. Those actions were consolidated under the caption In re OmniVision Technologies, Inc., No. C-04-2297-SC, and a consolidated complaint was filed. The consolidated complaint asserts claims on behalf of purchasers of the Company’s common stock between June 11, 2003 and June 9, 2004, and seeks unspecified damages. The consolidated complaint generally alleges that defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 by allegedly engaging in improper accounting practices that purportedly led to the Company’s financial restatement. The Company believes that these lawsuits are without merit and intends to defend the cases vigorously.

          Beginning on June 14, 2004, various shareholder derivative complaints were filed in state and federal courts in California. The first of the complaints filed in state court was captioned Gantt v. Winn, No. 1:04-CV-021453 (Super. Ct., Santa Clara Cty.). The first of the complaints filed in federal court was captioned Torriani v. Hong, No. C-04-2443 CRB (N.D. Cal.). The complaints generally sought unspecified damages and equitable relief based on causes of action against various of the Company’s present and former directors and officers for purported breach of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets, unjust enrichment and violations of California Corporations Code. These complaints appeared to be based upon the same allegations contained in the

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OMNIVISION TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
For the Three and Six Months Ended October 31, 2004 and 2003
(unaudited)

securities class actions. The Company was named solely as a nominal defendant against whom no monetary recovery was sought.

          In state court, following orders requiring plaintiffs to furnish security for their derivative actions plaintiffs filed voluntary dismissals. In federal court, defendants’ motion to dismiss the federal derivative complaints were granted with thirty days’ leave to amend. Plaintiffs in the federal action did not file amended complaints within the time required by the Court.

     Commitments

          In December 2000, the Company formed a subsidiary to conduct testing operations and other processes associated with the manufacturing of its products in China. The Company’s remaining $15.3 million of registered capital must be funded by January 2005 unless the Chinese government agrees to an extension. (See Note 5.)

          In October 2003, the Company entered into a Shareholders’ Agreement with Taiwan Semiconductor Manufacturing Company, or TSMC, pursuant to which the Company agreed with TSMC to form VisEra Technology Company, or VisEra, a joint venture in Taiwan, for the purposes of providing manufacturing services and automated final testing services. The Company has committed with TSMC and certain employees and affiliates of VisEra to provide an aggregate of $50.0 million in total capital to VisEra, which commitments may be made in the form of cash or asset contributions. The Company and TSMC have equal interests in VisEra. The Company’s share of this capital commitment to VisEra is $23.5 million and becomes due in stages as VisEra’s business and service capabilities develop over a number of years. The Company’s net cash commitment to VisEra is approximately $4.5 million, of which $3.5 million remains to be paid. In November 2003, the Company made a $1.5 million cash investment in this joint venture. The Company will also contribute approximately $19.0 million of assets to the joint venture, including technology, plant and equipment currently owned by the Company or to be purchased with funds for existing commercial commitments. (See Note 5.)

Note 10 — Subsequent Event

          In November 2004, the Company settled the complaint filed by Sunex for the payment of approximately $0.9 million by the Company to Sunex. The settlement of the complaint and cross-complaint completely and fully resolved any and all claims related to the above matters by the Company and Sunex in their entirety. (See Note 1 and Note 9.)

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

You should read the following discussion in conjunction with our unaudited condensed interim financial statements and the notes thereto included in Item 1 of this Quarterly Report on Form 10-Q. The following discussion contains forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors that include, but are not limited to, the risks discussed in “Factors Affecting Future Results.” These forward-looking statements include, but are not limited to, statements including the words “may,” “will,” “plans,” “seeks,” “expects,” “anticipates,” “outlook,” “intends,” “believes” and words of similar import as well as the negative of those terms. These forward-looking statements are based on current expectations and entail various risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Such risks and uncertainties are set forth below under “Factors Affecting Future Results” and elsewhere in this Quarterly Report and in other documents we file with the U.S. Securities and Exchange Commission.

Overview

          We design, develop and market high performance, highly integrated and cost efficient semiconductor image sensor devices. Our main product, an image-sensing device called the CameraChip™, is used to capture an image electronically and is used in a number of consumer and commercial mass market applications. Our CameraChips are designed to use the complementary metal oxide semiconductor, or CMOS, fabrication process. We have designed our CameraChip as a single chip solution that integrates several distinct functions including image capture, image processing, color processing, signal conversion and output of a fully processed image or video stream. We believe that our highly integrated CameraChips enable camera device manufacturers to build high quality camera products that are smaller, less complex, more reliable, lower cost and more power efficient than cameras using either traditional charge-coupled devices, or CCDs, or multiple chip CMOS image sensors.

          In August 2004, we announced the introduction of our advanced OmniPixel™ technology. OmniPixel technology represents a global redesign that features a new pixel architecture, a new circuit design, new embedded algorithms, new materials and new process technology. In September 2004, we introduced our first small-scale, CMOS image sensor with five megapixels. This 5-megapixel sensor’s new architecture is based on our recently launched OmniPixel technology. The sensor’s 2.775-micron pixels allowed us to design a 5-megapixel device with an optical format (footprint) of just 1/1.8 inches, making the new five-megapixel sensor small enough to meet the increasing demand for smaller, low-cost cameras with high performance. OmniPixel also comes with support for features such as auto-focus, zooming, panning and mechanical shutter control.

          In November 2004, we demonstrated a prototype of our new Smart Sensor™ image sensor that is capable of storing and subsequently identifying unique images for applications such as character recognition and facial recognition.

          Our image-sensor products are currently used in a number of consumer applications including digital still and video cameras, cell phones, personal computers and toys and games such as interactive video games.

          Our image-sensor products are sold to customers who incorporate them in either digital or analog mass market applications. Some examples of digital mass market applications that currently incorporate our image-sensor products are cell phone cameras, digital still cameras and personal computer camera applications. Some examples of analog applications that currently incorporate our image-sensor products are security and surveillance cameras and toy cameras.

          We sell our products worldwide directly to original equipment manufacturers, or OEMs, which include branded customers and contract manufacturers, and value added resellers, or VARs, and indirectly through distributors.

          We currently outsource the wafer fabrication, color filter application and packaging of our image-sensor products. This approach allows us to focus our resources on the design, development and marketing of our products and significantly reduces our capital requirements.

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

	We have relocated a substantial portion of our automated image testing equipment from the United States to China. We completed the majority of this transition in fiscal 2004 and completed the remainder of this transition early in fiscal 2005. We also expect to expand testing capabilities with additional automated testing equipment, which will also be located in China.

          In October 2003, we entered into a Shareholders’ Agreement, or the VisEra Agreement, with Taiwan Semiconductor Manufacturing Company, or TSMC, pursuant to which we agreed with TSMC to form VisEra Technology Company, or VisEra, a joint venture in Taiwan. VisEra’s mission is to provide manufacturing services and automated final testing services. In connection with the formation of VisEra, we and TSMC have separately agreed to enter into nonexclusive license agreements with VisEra pursuant to which both parties will license certain intellectual property to VisEra relating to manufacturing services and automated final testing services. Once VisEra has the capability to deliver high quality manufacturing services and automated final testing services, we have committed to direct a substantial portion of our requirements in these areas to VisEra, subject to pricing and technology requirements. We and TSMC have also committed not to compete directly or indirectly in the future with VisEra in the fields of certain manufacturing services and automated final testing services.

          Historically, we have relied upon TSMC to provide us with a substantial proportion of our wafers. As a part of the VisEra Agreement, TSMC has agreed to commit substantial wafer manufacturing capacity to us in exchange for our commitment to purchase a substantial portion of our wafers from TSMC, subject to pricing and technology requirements.

          In May 2004, we entered into an agreement with Powerchip Semiconductor Corporation, or PSC, under which we established a joint venture in Taiwan. The purpose of the joint venture is to conduct manufacturing, marketing and selling of certain of our legacy products. In connection with this joint venture, we entered into licensing and manufacturing agreements with PSC. Our capital commitment to the joint venture is approximately $2.1 million in exchange for an ownership percentage of approximately 49%. Our cash contributions are to be made in two phases. In the first phase, we made a cash investment in an amount equal to approximately $1.5 million in this joint venture in May 2004. The first phase concluded prior to the scheduled December 31, 2004 by mutual consent between us and the joint venture company. In the second phase, which commenced immediately following the conclusion of the first phase and continues until the termination of the agreement, we will contribute an additional amount equal to approximately $0.6 million in cash to the joint venture.

          As of October 31, 2004, we had approximately $230.6 million in cash and cash equivalents and approximately $50.8 million in short-term investments. To mitigate market risk related to short-term investments, we have an investment policy designed to preserve the value of capital and to generate interest income from these investments without material exposure to market fluctuations. Market risk is the potential loss due to the change in value of a financial instrument as a result of changes in interest rates or bond prices. Our policy is to invest in financial instruments with short durations, limiting interest rate exposure, and to measure performance against comparable benchmarks. We maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including both government and corporate obligations with ratings of A or better and money market funds.

     Restatement

          We restated our financial statements for the first, second and third quarters of fiscal 2004. We filed Form 10-Q/As for each of these quarters to reflect the restatement of the financial information for such periods.

          The restatements arose out of an internal review which was initiated in response to issues raised by an employee. We notified the Audit Committee of the Board of Directors of the issues raised, and the Audit Committee, with assistance from special legal counsel, conducted its own independent investigation. As a result of the internal review and the independent investigation, management and the Audit Committee determined that certain errors had occurred which principally affected the timing of revenue recognition for certain sales. The independent investigation concluded that there was no evidence of wrongdoing in connection with these errors.

          The restatement of our financial results for the first three quarters of fiscal 2004 related primarily to two issues identified as part of the internal review and independent investigation. First, beginning in the second half of

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

fiscal 2003 and continuing through the first nine months of fiscal 2004, certain distribution sales, for which we recognize revenue on a “sell-through” basis, were not reported to us by one of our distributors in a timely manner. Additionally, in the second and third quarters of fiscal 2004, during the transition of testing operations and certain international sales functions to overseas locations, some shipments made to customers late in the quarter were incorrectly classified as transferring title upon delivery as opposed to upon shipment, and therefore revenue was not recognized when product was shipped. Both of these issues resulted in delayed revenue recognition. Both management and the Audit Committee determined that the errors did not have material effects on quarterly or annual financial statements for fiscal 2003 and, consequently, decided not to restate the quarterly or annual financial results for such periods.

          All financial data contained in this Quarterly Report on Form 10-Q for the quarter ended October 31, 2003 are as provided in the Quarterly Report on Form 10-Q/A for the quarter ended October 31, 2003.

          In connection with its independent investigation, the Audit Committee together with its special counsel informed the Securities and Exchange Commission, or SEC, of the matters reviewed during the independent investigation, including the matters relating to the Company’s accounting, its internal accounting controls and the reporting of its financial results. The SEC is conducting an inquiry with respect to these matters. The Company is continuing to cooperate with the SEC.

     The Current Economic Environment

          We operate in a challenging economic environment that has undergone significant changes in technology and global trade. We strive to remain a leader in the development and marketing of image sensing devices based on the CMOS fabrication process and have benefited from the growing market demand for and acceptance of this emerging technology. The shift in global fabrication to Asia has introduced a range of cost pressures on domestic manufacturers. In response to these pressures, and in order to be closer to our primary customer base and our sources of offshore fabrication, we relocated a substantial portion of our testing operations to China during fiscal 2004.

          Since our inception, we have shipped more than 130 million image sensors, including approximately 42 million in the six months ended October 31, 2004, which demonstrated the capabilities of our production system, including our sources of offshore fabrication. To enhance our production capabilities, we have initiated partnerships with a number of vendors, including TSMC, one of the largest wafer fabrication companies in Asia.

          Due to the fact that we generate a large portion of our product sales through VARs and distributors, we cannot accurately confirm the distribution of our revenues across specific product categories and can only estimate the percentages of our products by market segment. Our estimated sales to the digital still camera market reflected an increase in the three months ended October 31, 2004 from the levels achieved in the previous quarter as a result, in part, of the introduction of a new 3-megapixel chip based on our recently announced OmniPixel technology. This increase reversed a decline for the previous two consecutive quarters which was due to seasonal fluctuations, price competition from CCD manufacturers and possible deferral of customer orders in anticipation of the introduction of our new OmniPixel technology. We benefited from growth in shipments for camera phones on a year-over-year basis, driven by increased demand for our 1.3-megapixel image sensors.

          The digital still camera market demonstrates a continuing a trend toward higher resolution products, with a growing acceptance of CMOS based image sensors. We have continued to benefit from a shift in product mix toward higher resolution products. We believe that this shift in product mix will continue through fiscal 2005. In anticipation of this market trend, we developed and introduced in September 2004 our first small-scale, CMOS image sensor with five megapixels. This 5-megapixel sensor’s new architecture is based on our recently launched OmniPixel technology. However, concurrent with this transition to higher resolution products, we have seen increased competition in the 3-megapixel market with resulting pressures on product pricing. We believe that excess capacity on the part of CCD manufacturers has lead to aggressive price reductions in the 3-megapixel product category.

          We believe camera phones are still in the early stages of adoption and that the opportunity presented by this market is still large. We also believe that, like the digital still camera market, camera phone demand will continue to shift toward higher resolutions. As a result, we released our quarter-inch 1.3 megapixel image sensor designed

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

specifically for camera phones and are currently in mass production with this product. Currently, we believe that video graphics array (“VGA”) resolution will account for a large portion of the volume shipments in handsets during calendar 2005, with an increasing transition to higher resolutions.

          As the markets for image sensors have grown, we have experienced increased competition from manufacturers of CMOS and CCD image sensors. In particular, we have experienced increased competition from companies such as Hynix, Micron and Sony in the market for CMOS image sensors for digital still cameras. In addition, we expect to see continued price competition in the image sensor market for digital cameras and mobile phones as those markets continue to grow. Although we believe that we currently compete effectively in those markets, our competitive position could be impaired by companies that have greater financial, technical, marketing, manufacturing, distribution and other resources, broader product lines, better access to large customer bases, greater name recognition, longer operating histories and more established strategic and financial relationships than we do. Such companies may be able to adapt more quickly to new or emerging technologies and customer requirements or devote greater resources to the promotion and sale of their products.

          As a result of the increase in competition and the growth of various consumer-product applications for image sensors, we have experienced a shortening in the life cycle of some image-sensor products. For example, although in the security and surveillance market we continue to sell CameraChips introduced more than four years ago, in the digital camera market the product life cycle of image sensors appears to be three years or less. One issue related to the shortening of product life cycles is that it will be increasingly difficult to accurately forecast customer demand for our products. As a result, we face the risk of being unable to fulfill customer orders if we underestimate market demand and the risks of excess inventory and product obsolescence if we overestimate market demand for our products. The shortening of product life cycles also increases the importance of having short product development cycles and being accurate in the prediction of market trends in the design of new products.

          Many of the products using our CameraChip and OmniPixel image sensors, such as digital still and video cameras, mobile phones and cameras for toys and games, are consumer electronics goods that have particular seasonal cycles. Historically, demand from OEMs and distributors that serve such consumer product markets has been stronger in the second and third quarters of our fiscal year and weaker in the first and fourth quarters of our fiscal year. As these consumer product applications for image sensors grow, we expect to witness increased seasonality in our business, which could cause our results of operations to fluctuate from period to period.

          In August 2004, we announced the introduction of our advanced OmniPixel technology. In September 2004, we introduced our first small-scale, CMOS image sensor with five megapixels based on our new OmniPixel technology. And in November 2004, we demonstrated a prototype of our new Smart Sensor image sensor technology. Certain risks are inherent in the introduction of such new products and technology. During the early stages of production, the production yields and gross margins for new products are typically lower than those of established products. In addition, in preparation for new product introductions, we are gradually ramping down production of established products. With our 100-day production cycle, it will be extremely difficult to predict precisely how many units of established products we will need. It will also be difficult to accurately predict the speed of the ramp of new products. Because of these circumstances, it is possible that we could suffer from shortages for certain products and also build inventories in excess of demand for other products.

     Sources of Revenues

          We generate our revenue by selling our products directly to OEMs and VARs and indirectly through distributors. In addition, we derive a minimal portion of our revenue by providing engineering assistance to a limited number of our customers. We treat sales to OEMs and VARs as one source of revenue, and distributors as another. Our revenue recognition policies between the two groups are different.

          For shipments to OEMs, VARs and distributors without agreements that allow for returns or credits, we recognize revenue using the “sell-in” method. Under this method, we recognize revenue when tile passes to the customer provided that we have received a signed purchase order, the price is fixed or determinable, risk of loss has transferred to the customer, collection of resulting receivables is considered reasonably assured, product returns are reasonably estimable, there are no customer acceptance requirements and there are no remaining material

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

obligations. We provide for future returns based on historical experience at the time we recognize revenue. For shipments to distributors under agreements allowing for returns or credits, we recognize revenue using the “sell-through” method under which we defer revenue until the distributor actually resells the product to the end-user customer and notifies us in writing of such sale. Deferred margin on shipment to distributors represents the amount billed less the cost of inventory shipped to but not yet sold by distributors.

          In addition, we recognize revenue from the provision of engineering assistance to a limited number of our customers from time to time. We recognize the associated revenue only upon the completion of, and acceptance by, the customer of the services performed. The revenue is based on a fixed fee, which is agreed upon prior to initiation of the engineering assistance. Historically, revenue generated from such arrangements has been immaterial.

          In order to determine whether collection is probable, we assess a number of factors, including past transaction history with the customer and the creditworthiness of the customer. If we determine that collection is not reasonably assured, we defer the recognition of revenue until collection becomes reasonably assured, which is generally upon receipt of payment.

     Critical Accounting Policies

          For a discussion of the critical accounting policies, please see the discussion in our Annual Report on Form 10-K for the fiscal year ended April 30, 2004, as amended.

Results of Operations

          The following table sets forth the results of our operations as a percentage of revenues. Our historical operating results are not necessarily indicative of the results for any future period.

Three and Six Months Ended October 31, 2004 as Compared to Three and Six Months Ended October 31, 2003

Revenues

          We derive revenues from the sale of our image-sensor products for use in a wide variety of consumer and commercial mass market applications including cell phones, digital still cameras, video game consoles and security and surveillance cameras. Revenues for the three months ended October 31, 2004 increased 8.3% to approximately $84.4 million from $78.0 million for the three months ended October 31, 2003. Revenues for the six months ended October 31, 2004 increased 46.8% to approximately $183.2 million from $124.8 million for the six months ended October 31, 2003. These increased revenues are primarily due to an increase in unit sales of our image-sensor products for digital applications, principally camera phones and digital still cameras, during the three and six months ended October 31, 2004 from the levels recorded in the prior year.

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

Revenues from Sales of Image-Sensor products for Digital as Compared to Analog Applications

          Our image-sensor products are sold to customers who incorporate them into either digital or analog applications. Examples of digital applications that incorporate our image-sensor products are camera phones, digital still cameras, personal computer camera applications and digital toy cameras. Examples of analog applications that incorporate our image-sensor products are security and surveillance cameras and analog toy cameras. We sell a large portion of our products through VARs and distributors, and often we do not know the identity of the manufacturers who ultimately embed our image-sensor products into their products. As a result of our sales to VARs and distributors and because our image-sensor products can be used in a wide variety of digital or analog products, we cannot accurately confirm the distribution of our revenues across specific product categories. However, we are able to confirm the distribution of our revenues by digital and analog product categories, and they are as follows (in thousands):

          Digital Revenues. Revenues from sales of image-sensor products for digital applications increased 5.6% to approximately $75.0 million for the three months ended October 31, 2004 from $71.0 million for the three months ended October 31, 2003. Revenues from sales of image-sensor products for digital applications represented 88.9% and 91.1% of revenues for the three months ended October 31, 2004 and 2003, respectively. Revenues from sales of image-sensor products for digital applications increased 49.0% to approximately $163.2 million for the six months ended October 31, 2004 from $109.5 million for the six months ended October 31, 2003. Revenues from sales of image-sensor products for digital applications represented 89.0% and 87.7% of revenues for the six months ended October 31, 2004 and 2003, respectively. The year-over-year increase in revenues from sales of image-sensor products for digital applications for the three months ended October 31, 2004 was primarily due to an increase in unit sales of approximately 7.7 million, or 69.7%. This increase in unit sales was led by an increase of approximately 5.9 million, or 85.4%, in unit sales of lower resolution image-sensor products used primarily in cell phone and toy applications, which carry a lower average sales price than image-sensor products used for digital still camera applications. The year-over-year increase in unit sales for the three months ended October 31, 2004 also benefited from an increase of approximately 1.8 million, or 43.0%, in unit sales of higher resolution image-sensor products used primarily for digital still camera applications. The increase in unit sales was partially offset by a decline in average sales prices for the three months ended October 31, 2004. The year-over-year increase in revenues from sales of image-sensor products for digital applications for the six months ended October 31, 2004 was primarily due to an increase in unit sales of approximately 22.7 million, or 138.5%. This increase in unit sales was led by an increase of approximately 18.2 million, or 187.7%, in unit sales of lower resolution image-sensor products used primarily in cell phone and toy applications, which carry a lower average sales price than image-sensor products used for digital still camera applications. We believe that demand in the cell phone market continued to reflect increased requirements from service providers to include camera functionality on handsets as consumers upgrade their cell phones. The year-over-year increase in unit sales for the six months ended October 31, 2004 also benefited from an increase of approximately 4.4 million, or 66.7%, in unit sales of higher resolution image-sensor products used primarily for camera phone and digital still camera applications. The increase in unit sales was partially offset by a decline in average sales prices for the six months ended October 31, 2004 resulting from the intensely competitive nature of the image sensor market. Our image-sensor products face competition from a number of sources, including companies that sell CCD image sensors, as well as other companies that sell CMOS image sensors. This competition has resulted in rapid technological change, evolving standards, reductions in product sales prices and rapid product obsolescence.

          Analog Revenues. Revenues from sales of image-sensor products for analog applications increased 35.3% to approximately $9.4 million in the three months ended October 31, 2004 from $7.0 million for the three months ended October 31, 2003 and represented 11.1% and 8.9% of our revenues in the three months ended October 31, 2004 and 2003, respectively. Revenues from sales of image-sensor products for analog applications increased 31.0%

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

to approximately $20.1 million in the six months ended October 31, 2004 from $15.3 million for the six months ended October 31, 2003 and represented 11.0% and 12.3% of our revenues in the six months ended October 31, 2004 and 2003, respectively. We believe the increase in revenues from sales of image-sensor products for analog applications for the three months ended October 31, 2004 primarily was due to an increase of approximately 0.4 million, or 35.6%, in unit sales. We believe the increase in revenues from sales of image-sensor products for analog applications for the six months ended October 31, 2004 primarily was due to an increase of approximately 0.9 million, or 37.5%, in unit sales. The slight decline in analog revenues as a percentage of revenues in the six months ended October 31, 2004 resulted from the proportionately greater increase in digital revenues during the period. Such image-sensor products for analog applications are used primarily in cameras for security applications and toys and games.

     Revenues from Sales to OEMs and VARs as Compared to Distributors

          We sell our image-sensor products either directly to OEMs and VARs or indirectly through distributors. The following table illustrates the percentage of revenues from sales to OEMs and VARs as compared to distributors in the three and six months ended October 31, 2004 and 2003:

          OEMs and VARs. In the three months ended October 31, 2004, one customer accounted for approximately 26.5% of our revenues. In the six months ended October 31, 2004, two customers accounted for approximately 19.7% and 11.2% of our revenues, respectively. In the three months ended October 31, 2003, one customer accounted for approximately 11.7% of revenues. In the six months ended October 31, 2003, one customer accounted for approximately 10.7% of revenues. No other OEM or VAR customer accounted for 10% or more of revenues during any of these periods.

          Distributors. In the three months ended October 31, 2004, one distributor customer accounted for approximately 10.6% of our revenues. In the three months ended October 31, 2003, one distributor customer accounted for approximately 21.8% of our revenues. In the six months ended October 31, 2004 and 2003, one distributor customer accounted for 10.2% and 24.3% of our revenues, respectively. No other distributor accounted for 10% or more of revenues during any of these periods.

     Revenues from Domestic Sales as Compared to Foreign Sales

          The following table presents the percentage of our revenues derived from sales of our image-sensor products to domestic customers as compared to foreign customers for the three and six months ended October 31, 2004 and 2003:

          We derive the majority of our foreign sales from customers in Asia and, to a lesser extent, in Europe. Over time, our sales to Asia-Pacific customers have increased primarily as a result of the continuing trend of outsourcing production to Asian manufacturers and facilities. Because of the preponderance of Asia-Pacific manufacturers and the fact that virtually all products incorporating our image-sensor products are sold globally, we believe that such figures do not accurately reflect geographic distribution of sales of our products into end-user markets.

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

Gross Profit

     Gross margins for the three months ended October 31, 2004 and 2003 were 45.3% and 37.9% of revenues, respectively. Gross margins for the six months ended October 31, 2004 and 2003 were 42.5% and 37.6% of revenues, respectively. The increase in gross margins for the three and six months ended October 31, 2004, as compared to the corresponding period in the prior year, was due in part to improved efficiency in our production sequence, particularly in product testing. In addition, our gross margins in the quarter were favorably impacted by a one-time $1.4 million credit to cost of goods sold pursuant to settlement of a dispute regarding the late cancellation of an order from one of our customers; without the credit, our gross margin would have been 43.6%. For the three months ended October 31, 2004, an additional approximately $3.5 million of gross profit was attributable to the sale of inventory which had been substantially reserved in prior periods. Excluding the additional gross profit from the sale of previously substantially reserved inventory, the gross margin for the three months ended October 31, 2004 would have been approximately 40.8% of revenues, as compared to 37.9% of revenues during the comparable period in the prior year. For the six months ended October 31, 2004, an additional approximately $3.7 million of gross profit was attributable to the sale of previously substantially reserved inventory. Excluding the gross profit from the sale of substantially reserved inventory, the gross margin for the six months ended October 31, 2004 would have been approximately 40.5% of revenues, as compared to 37.6% of revenues during the comparable period in the prior year.

Research and Development

          Research and development expenses consist primarily of compensation and personnel related expenses and costs for purchased materials, designs, tooling, depreciation of computers and workstations, and amortization of computer aided design software, some of which may fluctuate significantly from period to period as a result of our product development cycles. Research and development expenses for the three months ended October 31, 2004 increased 110.5% to approximately $6.7 million from $3.2 million for the three months ended October 31, 2003. As a percentage of revenues, research and development expenses for the three months ended October 31, 2004 and 2003 represented 7.9% and 4.1%, respectively. Research and development expenses for the six months ended October 31, 2004 increased 75.4% to approximately $11.8 million from $6.8 million for the six months ended October 31, 2003. As a percentage of revenues, research and development expenses for the six months ended October 31, 2004 and 2003 represented 6.5% and 5.4%, respectively.

          The increase in research and development expenses of approximately $3.5 million, or 110.5%, for the three months ended October 31, 2004 from the corresponding period in the prior year resulted primarily from a $2.5 million increase in expenses related to new product development to improve our current product line and

25

ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

support new product introductions such as our product lines based on the new OmniPixel and Smart Sensor technology, a $0.5 million increase in salary and payroll-related expenses associated with additional personnel and $0.2 million in software expenses. Examples of new product development expenses include tape-out and prototype runs with our wafer manufacturers. The increase in research and development expenses of approximately $5.0 million, or 75.4%, for the six months ended October 31, 2004 from the corresponding period in the prior year resulted primarily from a $3.6 million increase in expenses related to new product development to improve our current product line and support new product introductions, a $0.8 million increase in salary and payroll-related expenses associated with additional personnel and $0.4 million in software expenses. The increase in research and development as a percentage of revenues for the three and six months ended October 31, 2004 was primarily due to the substantial increase in expenses required to support our new product introductions. We anticipate that our research and development expenses will continue to increase in fiscal 2005 as we develop our OmniPixel and Smart Sensor technology.

Selling, General and Administrative

          Selling, general and administrative expenses consist primarily of compensation and personnel related expenses, commissions paid to distributors and manufacturers’ representatives and insurance and legal expenses. Selling, general and administrative expenses for the three months ended October 31, 2004 increased 19.4% to approximately $7.1 million from $5.9 million for the three months ended October 31, 2003. As a percentage of revenues, selling, general and administrative expenses for the three months ended October 31, 2004 and 2003 represented 8.4% and 7.6%, respectively. Selling, general and administrative expenses for the six months ended October 31, 2004 increased 36.4% to approximately $14.2 million from $10.4 million for the six months ended October 31, 2003. As a percentage of revenues, selling, general and administrative expenses for the six months ended October 31, 2004 and 2003 represented 7.7% and 8.3%, respectively.

          The increase in selling, general and administrative expenses of approximately $1.2 million, or 19.4%, for the three months ended October 31, 2004 from the corresponding period in the prior year resulted primarily from a $0.6 million increase in commissions associated with increased revenues, a $0.5 million increase in employment expenses, a $0.3 million increase in legal and accounting expenses, a $0.3 million increase in third party services and a $0.2 million increase in travel expenses, partially offset by a $1.0 million decrease in bad debt expenses. The increase in selling, general and administrative expenses of approximately $3.8 million, or 36.4%, for the six months ended October 31, 2004 from the corresponding period in the prior year resulted primarily from a $1.8 million increase in commissions associated with increased revenues, a $1.1 million increase in legal and accounting expenses, a $0.9 million increase in employment expenses, a $0.6 million increase in third party service expenses and a $0.3 million increase in travel expense, partially offset by a $1.4 million decrease in bad debt expenses. Selling, general and administrative expenses remained relatively stable as a percentage of revenues in the three and six months ended October 31, 2004 as compared to the corresponding period in the prior year. We anticipate that our future selling, general and administrative expenses will increase in absolute dollars due to anticipated securities litigation expenses, compliance with Sarbanes-Oxley regulations and continued expansion of our organization.

Stock-based compensation

          Stock-based compensation consists primarily of stock options issued to consultants in exchange for services. The stock-based compensation expense for the three months ended October 31, 2004 and 2003 was approximately $0.4 million and $0.1 million, respectively. As a percentage of revenues, stock-based compensation expense for the three months ended October 31, 2004 and 2003 represented 0.4% and 0.1%, respectively. Stock-based compensation expense for the six months ended October 31, 2004 and 2003 was approximately $0.6 million and $0.2 million, respectively. As a percentage of revenues, stock-based compensation expense for the six months ended October 31, 2004 and 2003 represented 0.3% and 0.2%, respectively.

Interest Income

          Our cash, cash equivalents and short-term investments are invested in interest-bearing accounts consisting primarily of money market accounts, high-grade corporate securities and government bonds maturing approximately twelve months or less from the date of purchase. Interest income increased for the three months ended October 31, 2004 from the corresponding period in the prior year to approximately $0.9 million from $0.5 million. Interest

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

income increased for the six months ended October 31, 2004 from the corresponding period in the prior year to approximately $1.6 million from $0.8 million. Increased interest income for the three and six months ended October 31, 2004 resulted from increased investments in interest-bearing accounts resulting from approximately $113.0 million in net proceeds from the issuance of common stock in our follow-on public offering in July 2003 and cash provided by operating activities.

Other Loss

          Other loss for the three and six months ended October 31, 2004 consisted of our portion of the losses recorded by two companies in which we hold a minority interest and which we account for using the equity method, partially offset by $0.1 million in other income. We did not record any other loss in the three and six months ended October 31, 2003.

Provision for Income Taxes

          We generated approximately $24.7 million and $20.9 million in income before income taxes for the three months ended October 31, 2004 and 2003, respectively. We recorded provisions for income taxes for the three months ended October 31, 2004 and 2003 of approximately $6.9 million and $7.1 million, respectively. We recorded provisions for income taxes for the six months ended October 31, 2004 and 2003 of approximately $14.6 million and $10.3 million, respectively. For the three and six months ended October 31, 2004 and 2003, the effective tax rates were 28.0% and 34.0%, respectively. The decrease in the effective tax rate in the three and six months ended October 31, 2004 was due to the anticipated combination of income between domestic and foreign entities for the current fiscal year. We anticipate the effective tax rate for fiscal 2005 will decrease as compared to fiscal 2004 and will be less than the combined federal and state statutory rate for fiscal 2005. Achieving an effective tax rate in fiscal 2005 that is less than the combined federal and state statutory rates is principally contingent upon the proportion of our total pre-tax income generated by foreign affiliates.

Liquidity and Capital Resources

          Principal sources of liquidity at October 31, 2004 consisted of cash, cash equivalents and short-term investments of $281.3 million.

          Our working capital increased by approximately $37.2 million to $309.1 million as of October 31, 2004 from $271.9 million as of April 30, 2004. The increase was primarily attributable to a $33.6 million increase in short-term investments, a $32.5 million increase in cash and cash equivalents and a $2.1 million increase in accounts receivable, net, due to an increase in days of sales outstanding, partially offset by a $15.6 million increase in accrued expenses and other current liabilities, a $14.0 million decrease in inventories and a $5.3 million increase in accounts payable, resulting from inventory purchases at the end of the quarter. The decrease in inventories resulted from our reduction of inventories of established products in anticipation of the launch of our new OmniPixel product line.

          For the six months ended October 31, 2004, net cash provided by operating activities totaled approximately $68.6 million as compared to $17.2 million for the corresponding period in the prior year, primarily due to net income of approximately $37.6 million for the six months ended October 31, 2004, a $15.6 million increase in accrued expenses and other current liabilities, a $14.0 million decrease in inventories and a $5.3 million increase in accounts payable, which were partially offset by a $2.1 million increase in accounts receivable, net, a $3.9 million decrease in deferred income and a $0.9 million increase in prepaid expenses and other assets. The $2.1 million increase in accounts receivable, net, reflects an increase in days of sales outstanding from 48 days as of April 30, 2004 to 61 days as of October 31, 2004. The $14.0 million decrease in inventories was attributable to our reduction of inventories of established products in anticipation of the introduction of our new OmniPixel products. Inventory turns increased to 7.5 as of October 31, 2004 as compared to 6.1 as of April 30, 2004. Accounts payable increased with the increased inventory purchases late in the three months ended October 31, 2004. Accrued liabilities increased primarily due to an increase in our accrued taxes as a consequence of our increase in income before taxes, partially offset by a reduction in our effective tax rate to 28.0% for the six months ended October 31, 2004 from 34.0% for the prior year period. For the six months ended October 31, 2003, net cash provided by operating activities totaled approximately $17.2 million, primarily due to net income of approximately $20.0 million for the six months ended October 31, 2003, a $27.5 million increase in accounts payable, a $3.1 million increase in accrued expenses and

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

other liabilities and a $1.2 million decrease in refundable and deferred income taxes, which were partially offset by a $26.6 million increase in accounts receivable, net, a $11.9 million increase in inventories to support future sales and a $0.5 million increase in prepaid expenses and other assets.

          For the six months ended October 31, 2004, our cash used in investing activities increased to approximately $37.8 million from $11.0 million for the corresponding prior year period, due to $33.7 million in net purchases of short-term investments, $1.5 million in purchases of long-term investments, $1.5 million in purchases of intangible property and $1.2 million in purchases of property, plant and equipment. For the six months ended October 31, 2003, our cash used in investing activities totaled approximately $11.0 million due to $6.6 million in purchases of property, plant and equipment, $3.3 million in purchases of short-term and long-term marketable investments and a $1.1 million increase in restricted cash. The $1.2 million and $6.6 million increases in property, plant and equipment in the six months ended October 31, 2004 and 2003, respectively, were due principally to additional investment in buildings, building improvements, machinery and other equipment to support the expanding operations of our subsidiary in China.

          For the six months ended October 31, 2004, net cash provided by financing activities decreased to approximately $1.6 million from $117.2 million for the corresponding period in the prior year and resulted from primarily due to approximately $113.2 million in net proceeds in the six months ended October 31, 2003 resulting from our follow-on public offering of common stock in July 2003. In addition, proceeds from the exercise of stock options and employee purchases through our employee stock purchase plan declined to approximately $1.6 million as compared to $4.0 million for the corresponding period in the prior year.

          In December 2000, we formed a subsidiary to conduct testing operations and other processes associated with the manufacturing of our products in China. A total of $14.7 million of the $30.0 million of the subsidiary’s registered capital, as required by Chinese law, had been funded as of October 31, 2004 from our available working capital. The remaining $15.3 million of registered capital must be funded by January 2005 unless the Chinese government agrees to an extension. We expect to fund the capital commitment to our Chinese subsidiary and to our joint ventures with TSMC and PSC from our available working capital.

          We currently expect our available cash, cash equivalents and short-term investments, together with cash that we anticipate to be generated from business operations, to be sufficient to satisfy our foreseeable working capital requirements. Our ability to generate cash from operations is subject to substantial risks described below under the caption “Factors Affecting Future Results.” We encourage you to review these risks carefully.

Contractual Obligations and Commercial Commitments

          The following summarizes our contractual obligations and commercial commitments as of October 31, 2004 and the effect such obligations and commitments are expected to have on our liquidity and cash flows in future periods (in thousands):

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

Factors Affecting Future Results

          This Quarterly Report on Form 10-Q, including Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements. These forward-looking statements are subject to substantial risks and uncertainties that could cause our future business, financial condition or results of operations to differ materially from our historical results or currently anticipated results, including those set forth below.

Risks Related to Our Business

If we are unable to strengthen our internal controls, there could be a material adverse effect on our operations or financial results.

          We restated our financial statements for the first, second and third quarters of fiscal 2004. We filed Form 10-Q/As for each of these quarters to reflect the restatement of the financial information for such periods. The restatements arose out of an internal review which was initiated in response to issues raised by an employee. We notified the Audit Committee of the Board of Directors of the issues raised, and the Audit Committee, with assistance from special legal counsel, conducted its own independent investigation. As a result of the internal review and the independent investigation, management and the Audit Committee determined that certain errors had occurred which principally affected the timing of revenue recognition for certain sales. The independent investigation concluded that there was no evidence of wrongdoing in connection with these errors.

          The restatement of our financial results for the first three quarters of fiscal 2004 related primarily to two issues identified as part of the internal review and independent investigation. First, beginning in the second half of fiscal 2003 and continuing through the first nine months of fiscal 2004, certain distribution sales, for which we recognize revenue on a “sell-through” basis, were not reported to us by one of our distributors in a timely manner. Additionally, in the second and third quarters of fiscal 2004, during the transition of testing operations and certain international sales functions to overseas locations, some shipments made to customers late in the quarter were incorrectly classified as transferring title upon delivery as opposed to upon shipment, and therefore revenue was not recognized when product was shipped. Both of these issues resulted in delayed revenue recognition. We have been working with the distributor on the issue regarding the reporting of resales to help ensure that we will receive

29

ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

sell-through data from such distributor for the full quarterly period. We have also worked on training our financial reporting and accounting staff to be more alert to this issue. In addition, we have conducted training to help ensure that all members of our accounting and financial reporting staff are aware of the importance of title transfer verification.

          Partly in connection with the restatement of our financial statements for the first, second and third quarters of fiscal 2004, our Independent Registered Public Accounting Firm identified material weaknesses in our internal controls and procedures relating to errors in our recognition of revenue resulting from incorrectly reviewing distributor reports and from incorrectly applying revenue recognition policies in accordance with title transfer, risk of loss and related shipping terms. Our Independent Registered Public Accounting Firm also noted a material weakness related to our need to increase our financial reporting and accounting staffing levels to ensure that we can meet our financial reporting obligations given the significant growth in our business in recent periods. In addition, our Independent Registered Public Accounting Firm reported additional observations and recommendations with respect to our financial reporting and internal controls. Correcting the identified material weaknesses and addressing the other issues identified by our Independent Registered Public Accounting Firm, responding to the findings of the internal review and the independent investigation and continuously strengthening our internal controls and financial reporting capabilities are some of our highest priorities. We believe that we have addressed the specific accounting issues identified in the internal review and independent investigation. In addition, we believe we have improved, and are in the process of further improving, our infrastructure, personnel, processes and controls to help ensure that we are able to produce accurate financial statements on a timely basis. In particular, we are focused on increasing our financial reporting and accounting staffing levels in the immediate future. However, our growth in operations will continue to place a strain on our management systems, controls and resources. To address these issues, we will need to continue to improve our financial and managerial controls, reporting systems and procedures in the future and will need to continue to expand, train and manage our work force company-wide, including the size of our accounting and financial reporting staff. If we are unable to maintain an adequate level of financial processes and controls, we may not be able to report our financial performance accurately or on a timely basis and this would materially harm our business and stock price.

          In connection with its independent investigation, the Audit Committee together with its special counsel informed the SEC of the matters reviewed during the independent investigation, including the matters relating to the Company’s accounting, its internal accounting controls and the reporting of its financial results. The SEC is conducting an inquiry with respect to these matters. The Company is continuing to cooperate with the SEC.

In connection with the documentation of and testing of our internal controls under Section 404 of the Sarbanes-Oxley Act, there will likely be areas for attention or improvement identified as part of this process.

          In addition to efforts to strengthen our internal controls as a result of the matters identified in connection with the independent investigation and internal review discussed above as well as those identified by our Independent Registered Public Accounting Firm, we are in the process of documenting our internal controls in accordance with Section 404 of the Sarbanes-Oxley Act, which requires annual management assessments of the effectiveness of our internal controls over financial reporting and a report by our Independent Registered Public Accounting Firm addressing these assessments. Both we and our Independent Registered Public Accounting Firm will be testing our internal controls in connection with the requirements of Section 404 and expect that as part of the documentation and testing of our internal controls there could be areas identified for further attention or improvement. We also could identify areas to be addressed where failure to strengthen internal controls could adversely affect our ability to report on our operating results and financial condition accurately or on a timely basis, which could adversely affect our stock price.

We have been named as defendant in certain litigation matters that could have a material adverse impact on our operating results and financial condition.

          We are currently a defendant in ongoing litigation matters as described in Part II, Item 1 – “Legal Proceedings.” We are currently unable to estimate the possible loss or possible range of loss, if any, associated with the resolution of these litigation matters. If we do not prevail in these matters, such failure could have a material adverse effect on our consolidated financial position, results of operations, or cash flows in the future. In addition,

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

the results of litigation are uncertain, and the litigation process may utilize a portion of our cash resources and divert management’s attention from the day-to-day operations of our company, all of which could harm our business.

Our success depends on the timely development, introduction, marketing and selling of new CMOS image sensors, which we might not be able to achieve.

          Our failure to successfully develop new products that achieve market acceptance in a timely fashion would adversely affect our ability to grow our business and our operating results. In February 2004, we introduced 1.3 megapixel, 2.0 megapixel and 1/7-inch CMOS image sensors for camera phones and in August 2004, we announced the introduction of our new OmniPixel technology. In September 2004, we introduced in our first small-scale, CMOS image sensor with five megapixels based on our recently launched OmniPixel technology. In November 2004, we demonstrated a prototype of our new Smart Sensor image sensor that is capable of storing and subsequently identifying unique images for applications such as character recognition and facial recognition. We also plan to introduce several new image sensor products in calendar 2005. The development, introduction and market acceptance of products such as these are critical to our ability to sustain and grow our business. Any failure to successfully develop, introduce, market and sell new products could materially adversely affect our business and operating results. The development of new products is highly complex, and we have in the past experienced delays in completing the development and introduction of new products. As our products integrate new and more advanced functions, they become more complex and increasingly difficult to design and debug. Successful product development and introduction depend on a number of factors, including:

•

accurate prediction of market requirements and evolving standards, including pixel resolution, output interface standards, power requirements, optical lens size, input standards and operating systems for personal computers and other platforms;

•

development of advanced technologies and capabilities;

•

definition, timely completion and introduction of new CMOS image sensors that satisfy customer requirements;

•

development of products that maintain a technological advantage over the products of our competitors, including our advantages with respect to the functionality and pixel capability of our image-sensor products and our proprietary testing processes; and

•

market acceptance of the new products.

          Accomplishing all of this is time consuming and expensive. We may be unable to develop new products or product enhancements in time to capture market opportunities or achieve a significant or sustainable acceptance in new and existing markets. In addition, our products could become obsolete sooner than anticipated because of a rapid change in one or more of the technologies related to our products or the reduced life cycles for consumer products.

We face intense competition in our markets from more established CCD and CMOS image sensor manufacturers, and if we are unable to compete successfully we may not be able to maintain or grow our business.

          The image sensor market is intensely competitive, and we expect competition in this industry to continue to increase. This competition has resulted in rapid technological change, evolving standards, reductions in product sales prices and rapid product obsolescence. If we are unable to successfully meet these competitive challenges, we may be unable to maintain and grow our business. Any inability on our part to compete successfully would also adversely affect our results of operation and impair our financial condition.

          Our image-sensor products face competition from a number of sources, including companies that sell CCD image sensors, as well as other companies that sell CMOS image sensors. Many of our competitors have longer operating histories, greater presence in key markets, greater name recognition, larger customer bases, more established strategic and financial relationships and significantly greater financial, sales and marketing, manufacturing, distribution, technical and other resources than we do. As a result, they may be able to adapt more quickly to new or emerging technologies and customer requirements or devote greater resources to the promotion and sale of their products. Our competitors include CCD image sensor manufacturers such as Matsushita, NEC, Sanyo, Sharp, Sony and Toshiba, as well as established CMOS image sensor manufacturers such as Agilent, Canon,

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

ESS, Fujitsu, Hynix, Micron, Mitsubishi Electronic, National Semiconductor, Philips, Samsung, Sharp, Sony, STMicroelectronics and Toshiba. In addition, we compete with a large number of smaller CMOS manufacturers including Foveon, IC Media Corporation, PixArt and Zoran. Competition with these and other companies may force us to reduce our prices. For instance, we have seen increased competition in the 3-megapixel market with resulting pressures on product pricing. Downward pressure on pricing could result in decreased revenues and gross margins, which would adversely affect our profitability.

          We released a 1.3-megapixel and 2.0-megapixel CMOS image sensor, as well as a 1/7-inch low-resolution CMOS image sensor, for camera phone manufacturers in February 2004, and in August 2004, we announced the introduction of our new OmniPixel technology. Our new products compete against CCD image sensors, but we cannot guarantee that existing or new customers will adopt and purchase these new products. We also cannot guarantee the growth of end-user markets that will require these new image sensors. If our enhanced products and technologies do not gain market acceptance, we may not be able to maintain our market share.

          Our competitors may acquire or enter into strategic or commercial agreements or arrangements with foundries or providers of color filter processing, assembly or packaging services. These strategic arrangements between our competitors and third party service providers could involve preferential or exclusive arrangements for our competitors. As a result, these strategic alliances could impair our ability to secure sufficient capacity from foundries and service providers to meet our demand for wafer manufacturing, color filter processing, assembly or packaging services, adversely affecting our ability to meet customer demand for our products. In addition, competitors may enter into exclusive relationships with distributors, which could reduce available distribution channels for our products and impair our ability to sell our products and grow our business. Further, some of our customers may also be developers of image sensors, and this could potentially adversely affect our results of operations, business and prospects.

Declines in our average sales prices may result in declines in our revenues and gross margin.

          We have experienced and expect to continue to experience pressure to reduce the sales prices of our products, and our average sales prices have declined as a result. Competition in our product markets is intense and as this competition continues to intensify, we anticipate that these pricing pressures will increase as well. We expect that the average sales prices for many of our products will continue to decline over time. Declines in our average sales prices could result in reduced revenues unless we can increase unit sales to offset these price declines. Unless we can reduce costs to compensate, reductions in our selling prices will cause a decline in our gross margin and could materially and adversely affect our operating results and impair our financial condition. We have and intend to continue to increase our research and development expenses in an attempt to accelerate the development of our next generation of image sensor products in fiscal 2005. However, if we are unable to timely introduce new products that incorporate more advanced technology and include more advanced features that can be sold at higher average sales prices, our financial results could be adversely affected.

If we do not forecast customer demand correctly, our business could be impaired and our stock price may decline.

          Our sales are generally made on the basis of purchase orders rather than long-term purchase commitments, and we manufacture products and build inventory based on our estimates of customer demand. Accordingly, we must rely on multiple assumptions about forecasted customer demand. We are continually working to improve our sales forecasting procedures. If we overestimate customer demand, we may manufacture products that we may be unable to sell, or we may have to sell our products to other customers at lower prices. This could materially and adversely affect our results of operation and financial condition. In addition, our customers may cancel or defer orders at any time. We have experienced problems with accurately forecasting customer demand in the past. For example, beginning in the third quarter of fiscal 2001, the demand for our image-sensor products for use in PC cameras decreased significantly and one of our significant OEM customers unexpectedly canceled its purchase orders. Recently, our customers have increasingly pushed to have us fill orders quickly. This results in a smaller backlog of orders and requires us to more accurately predict customer demand because we have to make commitments to have products manufactured before we receive firm purchase orders from our customers. If we underestimate customer demand, we may be unable to manufacture sufficient products quickly enough to meet actual demand, causing us to lose customers and impairing our ability to grow our business. In preparation for new product introductions, we are gradually ramping down production of established products. With our 100-day production cycle, it will be extremely difficult to predict precisely how many units of established products we will need. It will also be difficult to

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

accurately predict the speed of the ramp of new products and the impact on inventory levels presented by the shorter life cycles of newer products. The shorter product life cycle is a result of an increase in competition and the growth of various consumer-product applications for image sensors. For example, although in the security and surveillance market we continue to sell image-sensor products introduced more than four years ago, in the digital camera market the product life cycle of image sensors appears to be three years or less. Under these circumstances, it is possible that we could suffer from shortages for certain products and, if we underestimate market demand, we face the risk of being unable to fulfill customer orders. We also face the risk of excess inventory and product obsolescence if we overestimate market demand for our products and build inventories in excess of demand. Our ability to accurately forecast sales is also a critical factor in our ability to meet analyst expectations for our quarterly and annual operating results. Any failure to meet these expectations would likely lead to a substantial decline in our stock price.

Historically, our revenues have been dependent upon a few key customers, the loss of one or more of which could significantly reduce our revenues.

          Historically, a relatively small number of original equipment manufacturers, or OEMs, value added resellers, or VARs, and distributors have accounted for a significant portion of our revenues. Any material delay, cancellation or reduction of purchase orders from one of our major customers or distributors could result in our failure to achieve anticipated revenue for the period. If we are unable to retain one or more of our largest OEM, distributor or VAR customers, or if we are unable to maintain our current level of revenues from one or more of these significant customers, our business and results of operation would be impaired and our stock price could decrease, potentially significantly. In the six months ended October 31, 2004, two OEMs, Foundate and Nam Tai, accounted for approximately 20% and 11% of our revenues, respectively. In fiscal 2004, our only distributor customer that accounted for more than 10% of our revenues was World Peace which accounted for approximately 10.2% of our revenues. Our business, financial condition, results of operations and cash flows will continue to depend significantly on our ability to retain our current key customers and attract new customers, as well as on the financial condition and success of our OEMs, VARs and distributors.

Failure to obtain design wins could cause our market share and revenues to decline and could impair our ability to grow our business.

          Our future success is dependent upon manufacturers designing our image-sensor products into their products. To achieve design wins, which are decisions by those manufacturers to design our products into their systems, we must define and deliver cost effective and innovative semiconductor solutions. Our ability to achieve design wins is subject to numerous risks including competitive pressures as well as technological risks. If we do not achieve a design win with a prospective customer, it may be difficult to sell our image-sensor products to such prospective customer in the future because once a manufacturer has designed a supplier’s products into its systems, the manufacturer may be reluctant to change its source of components due to the significant costs, time, effort and risk associated with qualifying a new supplier. Accordingly, if we fail to achieve design wins with key camera device manufacturers that embed image sensors in their products, our market share or revenues could decrease. Furthermore, to the extent that our competitors secure design wins, our ability to expand our business in the future will be impaired.

Sales of our image-sensor products for camera phones have accounted for an increasing portion of our revenues from digital applications on an annual basis, and any decline in sales to the camera phone market or failure for this market to continue to grow as expected could adversely affect our results of operations.

          Sales to the camera phone market have accounted for an increasing portion of our revenues from digital applications. Although we can only estimate the percentages of our products that are used in the camera phone market due to the significant amount of our image-sensor products that are sold through distributors and value added resellers, we believe that the camera phone market accounted for approximately 45% of our revenue in fiscal 2004 and approximately 75% of our revenue in the six months ended October 31, 2004. Our sales to the camera phone market increased in the six months ended October 31, 2004 due to a continuing shift toward higher resolutions and increased requirements from service providers to include camera functionality on handsets. We expect that revenues from sales of our image-sensor products to the camera phone market will continue to account for a significant portion of our revenues during the remainder of fiscal 2005. Any factors adversely affecting the demand for our image sensors in this market could cause our business to suffer and adversely affect our results of operations. The

33

ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

digital image sensor market for camera phones is extremely competitive, and we expect to face increased competition in this market in the future. If we fail to continue to receive design wins with key camera phone manufacturers, our market share or revenues could decrease. In addition, camera phone manufacturers typically purchase digital image sensors through distributors, and we do not have contracts with any distributors that obligate them to sell our products. Such distributors may also sell products of our competitors. We may not be able to successfully increase or maintain the rate of sales of our image-sensor products for camera phones through distributors in the future. The image sensor market for camera phones is also subject to frequent technology change. In order to compete successfully in this market, we will have to correctly forecast customer demand for technological improvements and be able to deliver such products on a timely basis at competitive costs. If we fail to do this, our results of operation, business and prospects would be materially adversely affected. In the past, we have experienced problems accurately forecasting customer demand in other markets. If sales to the digital still camera market continues to decline and sales to the camera phone market do not increase, our results of operation, business and prospects would be materially adversely affected.

Problems with wafer manufacturing yields could result in higher operating costs and could impair our ability to meet customer demand for our products.

          If the foundries manufacturing the wafers used in our products cannot achieve the yields we expect, we will incur higher per unit costs and reduced product availability. Foundries that supply our wafers have experienced problems in the past achieving acceptable wafer manufacturing yields. Wafer yields are a function of both our design technology and the particular foundry’s manufacturing process technology. Low yields may result from design errors or manufacturing failures in new or existing products. Unlike many other semiconductor products, optical products can be effectively test only when they are complete. Accordingly we perform a final test of our products only after they are assembled. As a result, yield problems may not be identified until our products are well into the production process. The risks associated with low yields are exacerbated because we rely on third party offshore foundries for our wafers, which increases the effort and time required to identify, communicate and resolve manufacturing yield problems. Any of these potential problems with wafer manufacturing yields could result in a reduction in our ability to timely deliver products to customers, which could adversely affect our customer relations and make it more difficult to sustain and grow our business.

We depend on a limited number of third party wafer foundries, which reduces our ability to control our manufacturing process.

          We do not own or operate a semiconductor fabrication facility. Instead, we primarily rely on TSMC, Powerchip Semiconductor Company, or PSC, and other subcontract foundries to produce substantially all of our wafers. Historically, we have relied upon TSMC to provide us with a substantial majority of our wafers. As a part of our joint venture with TSMC, TSMC has agreed to commit substantial wafer manufacturing capacity to us in exchange for our commitment to purchase a substantial portion of our wafers from TSMC, subject to pricing and technology requirements.

          We do not have long-term supply agreements with any other foundries. As a result, we have to secure manufacturing availability on a purchase order basis. These other foundries have no obligation to supply products to us for any specific period, in any specific quantity or at any specific price, except as set forth in a particular purchase order. In general, our reliance on third party foundries involves a number of significant risks, including:

•

reduced control over delivery schedules, quality assurance, manufacturing yields and production costs;

•

lack of guaranteed production capacity or product supply;

•

unavailability of, or delayed access to, next generation or key process technologies; and

•

financial difficulties or disruptions in the operations of third party foundries due to causes beyond our control.

          If TSMC or any of our other foundries were unable to continue manufacturing our wafers in the required volumes, at acceptable quality, yields and costs, and in a timely manner, we would have to identify and qualify substitute foundries, which would be time consuming and difficult, and could increase our costs or result in unforeseen manufacturing problems. In addition, if competition for foundry capacity increases we may be required to

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

pay increased amounts for manufacturing services. We are also exposed to additional risks if we transfer our production of semiconductors from one foundry to another, as such transfer could interrupt our manufacturing process. Further, some of our foundries may also be developers of image sensor products. If one or more of our other foundries were to decide not to fabricate our interface chips for competitive or other reasons, we would have to identify and qualify other sources for these products.

We rely on third party service providers for color filter application and packaging services, which reduces our control over delivery schedules, product quality and cost, and could adversely affect our ability to deliver products to customers.

          We rely on TSMC and Toppan for the color filter processing of our completed wafers. In addition, we rely on ASE, Kyocera, Sun Yang Digital Image, or SYDI, and Impac for substantially all of our ceramic chip packages. We rely on a single service provider for our plastic chip packages. We rely on yet other service providers for chip scale packages, which are generally used in our products designed for the smallest form factor applications. We do not have long-term agreements with any of these service providers and typically obtain services on a purchase order basis. If for any reason one or more of these service providers becomes unable or unwilling to continue to provide color filter processing or packaging services of acceptable quality, at acceptable costs and in a timely manner, our ability to deliver our products to our customers could be severely impaired. We would have to identify and qualify substitute service providers, which could be time consuming and difficult and could result in unforeseen operational problems. Substitute service providers might not be available or, if available, might be unwilling or unable to offer services on acceptable terms.

          In addition, if competition for color filter processing or packaging capacity increases, we may be required to pay or invest significant amounts to secure access to these services, which could adversely impact our operating results. The number of companies that provide these services is limited and some of them have limited operating histories and financial resources. In the event our current providers refuse or are unable to continue to provide these services to us, we may be unable to procure services from alternate service providers. Furthermore, if customer demand for our products increases, we may be unable to secure sufficient additional capacity from our current service providers on commercially reasonable terms, if at all. Moreover, our reliance on a limited number of third party service providers to provide color filter processing services subjects us to reduced control over delivery schedules, quality assurance and costs. This lack of control may cause unforeseen product shortages or may increase our costs of manufacturing, assembling or testing our products, which would adversely affect our operating results.

We depend on the increased acceptance of CMOS technology for mass-market image sensor applications, and any delay in the acceptance of this technology could adversely affect our ability to grow our business and increase our revenues.

          Our business strategy depends in large part on the continued growth of various markets into which we sell our image-sensor products, including the markets for digital still and video cameras, cell phones, personal digital assistants, personal computers, toys and games, including interactive video games, and commercial and home security and surveillance applications. Our ability to sustain and grow our business also depends on the emergence of new markets for our products such as cameras for automotive applications, personal identification systems, medical imaging devices and embedded applications for personal computers. If these current and new markets do not grow and develop as anticipated, we may be unable to sustain or grow the sales of our products.

          Although CMOS technology has been available for over 30 years, CMOS technology has been used in image sensors only relatively recently. Along with the other risk factors described in this section, the following are examples of factors that may delay the adoption of the CMOS fabrication process and our single chip technology for mass market image sensor applications:

•

the failure of the emergence of a universal platform for imaging solutions for computers and the Internet;

•

improvements in or price reductions for CCD image sensors, which could slow the adoption of CMOS image sensors in markets already dominated by CCD image sensors or prevent or delay the adoption of CMOS image sensors in emerging markets;

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

•

the failure of manufacturers that have been using CCD products to adopt our CMOS image-sensor products; and

•

the failure to develop easy to use and affordable products using CMOS image sensors.

          The occurrence of any of these or other factors could adversely affect our ability to sustain and grow our business and increase our revenues and earnings.

          In addition, the market price of our common stock may be adversely affected if certain of these new markets do not emerge or develop as expected, such as the markets for image sensor products in automobiles and personal identification systems. Securities analysts may have already factored revenue from such new markets into their future estimates of our financial performance and any failure of such markets to develop as expected by such security analysts may adversely affect the trading price of our common stock.

Our ability to deliver products that meet customer demand is dependent upon our ability to meet new and changing requirements for color filter application and sensor packaging.

          We expect that as we develop new products to meet technological advances and new and changing industry and customer demands, our color filter application and ceramic, plastic and chip-scale packaging requirements will also evolve. Our ability to continue to profitably deliver products that meet customer demand is dependent upon our ability to procure third party services that meet these new requirements on a cost-effective basis. We have historically relied exclusively on third parties to provide these services. There can be no assurances that any of these parties will be able to develop enhancements to the services they provide to us to meet these new and changing industry and customer requirements. Furthermore, even if these service providers are able to develop their services to meet new and evolving requirements, these services may not be available at a cost that enables us to sustain profitability.

Our customers experience fluctuating product cycles and seasonality, which could cause our results of operations to fluctuate from period to period.

          Many of the products using our image sensors, such as digital still cameras, cell phone cameras, personal computer cameras and cameras for toys and games, are consumer electronics goods. These mass market camera devices generally have seasonal cycles which historically have caused the sales of our customers to fluctuate quarter-to-quarter. As a result, we are also increasingly experiencing fluctuations in our quarterly sales. These seasonal demand patterns could, in turn, cause our results of operations to fluctuate from period to period. Historically, demand from OEMs and distributors that serve such consumer product markets has been stronger in the second and third quarters of our fiscal year and weaker in the first and fourth quarters of our fiscal year. Partly due to the seasonality of the digital still camera market, Our estimated sales to the digital still camera market reflected an increase in the three months ended October 31, 2004 as a result, in part, of the introduction of a new 3-megapixel chip based on our recently announced OmniPixel technology. If we fail to predict accurately and respond appropriately to this consumer demand on a timely basis to meet seasonal fluctuations, or if there is any disruption of consumer buying habits during these key periods, our business and operating results would be harmed.

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

Fluctuations in our quarterly operating results make it difficult to predict our future performance and may result in volatility in the market price of our common stock.

          Our quarterly operating results have varied significantly from quarter to quarter in the past and are likely to vary significantly in the future based on a number of factors, many of which are beyond our control. These factors and other industry risks, many of which are more fully discussed in our other risk factors, include:

•

our ability to accurately forecast demand for our products;

•

our ability to achieve acceptable wafer manufacturing yields;

•

the gain or loss by us of a large customer;

•

our ability to manage our product transitions;

•

the availability of production capacities at the semiconductor foundries that manufacture our products or components of our products;

•

the growth of the market for products and applications using CMOS image sensors;

•

the timing and size of orders from our customers;

•

the volume of our product returns;

•

the seasonal nature of customer demand for our products;

•

the deferral of customer orders in anticipation of new products, product designs or enhancements by us; and

•

the announcement and introduction of products and technologies by our competitors.

          In addition, our introduction of new products and our product mix have affected and may continue to affect our quarterly operating results. Changes in our product mix could adversely affect our operating results, because some products provide higher margins than others. We typically experience lower yields when manufacturing new products through the initial production phase, and consequently our gross margins on new products have historically been lower than our gross margins on our more established products. We also anticipate that the rate of orders from our customers may vary significantly from quarter to quarter. Our expenses, including our future capital commitments to our Chinese subsidiary and our joint venture with TSMC, and our inventory levels are based on our expectations of future revenues and are relatively fixed. Consequently, if we do not achieve revenues in any quarter as expected, expenses and inventory levels could be disproportionately high, and our operating results for that quarter, and potentially future quarters, may be harmed.

          Any one or more of these factors is difficult to forecast and could result in fluctuations in our quarterly operating results. Our operating results in a given quarter could be substantially less than anticipated, and, if we fail to meet market analyst expectations, a substantial decline in our stock price could result. Fluctuations in our quarterly operating results could adversely affect the price of our common stock in a manner unrelated to our long-term operating performance.

We maintain a backlog of customer orders that is subject to cancellation or delay in delivery schedules, and any cancellation or delay may result in lower than anticipated revenues.

          Our sales are generally made pursuant to standard purchase orders. We include in our backlog only those customer orders for which we have accepted purchase orders and assigned shipment dates within the upcoming 12 months. Although our backlog is typically filled within two to four quarters, orders constituting our current backlog are subject to cancellation or changes in delivery schedules, and backlog may not necessarily be an indication of future revenue. Any cancellation or delay in orders which constitute our current or future backlog may result in lower than expected revenues.

We may never achieve the anticipated benefits from our operations in China.

          In December 2000, we established a Chinese subsidiary as part of our efforts to streamline our manufacturing process and reduce the costs and working capital associated with the testing of our image-sensor products. We have relocated a substantial portion of our automated image testing equipment from the United States to China. We

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

completed the majority of this transition by the end of fiscal 2004 and anticipate that we will complete the remainder of this transition prior to the end of calendar 2004. In addition, we also expect to expand testing capabilities with additional automated testing equipment, which will also be located in China. However, there are significant administrative, legal and governmental risks to operating in China that could result in increased operating expenses or that could prevent us from achieving our objectives in operations. Consequently, we may never achieve the anticipated cost savings from the transition of testing operations to China. If our operations in China do not result in offsetting gains in the form of operating cost reductions, whether because of risks and difficulties entailed by foreign operations or for any other reasons, our business and financial condition could be adversely affected. The substantial risks from operating in China that could increase our operating expenses and adversely affect our operating results, financial condition and ability to deliver our products and grow our business include, without limitation:

•

difficulties in staffing and managing foreign operations, particularly in attracting and retaining personnel qualified to design, sell and support CMOS image sensors;

•

difficulties in coordinating our operations in China with those in California;

•

diversion of management attention;

•

difficulties in maintaining uniform standards, controls, procedures and policies across our global operations, including inventory management and financial consolidation;

•

political and economic instability, which could have an adverse impact on foreign exchange rates in Asia and could impair our ability to conduct our business in China; and

•

inadequacy of the local infrastructure to support our needs.

We may never achieve the anticipated benefits from our joint venture with TSMC.

          In October 2003, we entered into an agreement with TSMC pursuant to which we agreed with TSMC to form VisEra, a joint venture in Taiwan, for the purposes of providing manufacturing services and automated final testing services. We expect that VisEra will eventually be able to provide us with a committed supply of high quality manufacturing services and automated final testing services at competitive prices. However, there are significant legal, governmental and relationship risks to forming and developing VisEra, and we cannot ensure that we will be able to receive the expected benefits from this joint venture. For example, VisEra may not be able to provide manufacturing services or automated testing services that have competitive technology or prices, which could adversely affect our product offerings and our ability to meet customer requirements for our products. In addition, the formation of VisEra provides us with an additional source for certain manufacturing services which, in the future, may also make it more difficult for us to secure dependable services from competing merchant vendors who provide similar manufacturing services. We are required to account for our investment in VisEra under the equity method, and any loss that VisEra incurs will negatively impact our reported earnings.

Our operations in China and our joint venture with TSMC will require substantial capital expenditures.

          We must meet certain minimal capital requirements applicable to our Chinese subsidiary and our joint venture with TSMC. Our Chinese subsidiary has $30.0 million in registered capital, $14.7 million of which had been funded as of October 31, 2004. The remaining $15.3 million must be funded by January 2005 unless this funding requirement is postponed with the consent of the Chinese authorities. In addition, we must meet certain financial requirements with regard to VisEra, our joint venture with TSMC. We have committed with TSMC and certain employees and affiliates of VisEra to provide an aggregate of $50.0 million in total capital to VisEra, which commitments may be made in the form of cash or asset contributions. Our share of this capital commitment to VisEra is $23.5 million and becomes due in stages as VisEra’s business and service capabilities develop over a number of years. Our net cash investment in the joint venture will be approximately $4.5 million. We will also contribute approximately $19.0 million of assets to the joint venture, including technology, plant and equipment currently owned by us or to be purchased with funds for existing commercial commitments. Our cash and net asset contributions to VisEra will be made in three phases. In the first phase, we contributed $1.5 million in cash to VisEra and granted a non-exclusive license to certain of our manufacturing and automated final testing technologies and patents. In the second phase, we will contribute $9.5 million in cash to VisEra and grant a non-exclusive license to certain of our manufacturing and automated final testing technologies and patents. In the third phase, we will

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

contribute $12.5 million in cash and assets to VisEra and receive back from VisEra an aggregate cash payment of $17.5 million. Our remaining net cash commitment to VisEra is $3.5 million.

          We expect to fund the capital commitment to our Chinese subsidiary and to our joint venture with TSMC through a combination of funds from our available working capital, investments from third parties, or equity or debt financing. Third party financing may not be available to us when and as required or on terms that are favorable to our stockholders and us. In addition, Chinese law may limit the sources that may be eligible to invest in our Chinese subsidiary. In the event we are unable to obtain financing from third parties, the issuance of our equity securities, including securities convertible into our equity securities, would dilute the ownership interests of our existing stockholders, and the issuance of debt securities could increase the risk or the perceived risk of our business.

          Issuance of debt securities could also impair our financial condition, and interest payments could have an adverse effect on our results of operation.

We may not achieve the anticipated benefits of our alliances with, and strategic investments in, third parties.

          We expect to develop our business partly through forming alliances or joint ventures with and making strategic investments in other companies, some of which may be companies at a relatively early stage of development. For example, in April 2003 we completed an investment in a chip-scale packaging service company, and in June 2003 we completed an investment in another packaging service company. In addition, we entered into an agreement with TSMC in October 2003 to form a joint venture in Taiwan, which will provide manufacturing services and automated final testing services. In May 2004, we entered into an agreement with PSC under which a joint venture was established as a company incorporated under the laws of Taiwan. We will contribute up to $2.1 million in exchange for an ownership percentage of approximately 49%. The purpose of the joint venture is to conduct the business of manufacturing, marketing and selling of certain of our legacy products. Our investment in these companies may negatively impact our operating results, as we are required to recognize our portion of the loss recorded by each of these companies. In the six months ended October 31, 2004, we recognized a loss of approximately $0.8 million as our portion of the losses recorded by two companies in which we had invested and which we have accounted for using the equity method. We expect to continue to utilize partnerships, strategic alliances and investments, particularly those that enhance our manufacturing capacity and those that provide manufacturing services and testing capability. These investments and partnering arrangements are crucial to our ability to grow our business and meet the increasing demands of our customers. However, we cannot ensure that we will achieve the benefits expected as a result of these alliances. For instance, we may not be able to receive acceptable quality and/or wafer manufacturing yields from these companies, which could result in higher operating costs and could impair our ability to meet customer demand for our products. In addition, certain of these investments or partnering relationships may place restrictions on the scope of our business, the geographic areas in which we can sell our products and the types of products that we can manufacture and sell. For example, our agreement with TSMC provides that we may not engage in business that will directly compete with the business of VisEra. This type of non-competition provision may impact our ability to grow our business and to meet the demands of our customers. We also may be required to account for some of these investments under the equity method or to consolidate them into our operating results. Under such circumstances, losses that such companies incur could also adversely affect our operating results. Several of these companies are at a relatively early stage of development and consequently they may continue to incur losses on a quarterly and annual basis for an extended period.

We may be unable to adequately protect our intellectual property and therefore we may lose some of our competitive advantage.

          We rely on a combination of patent, copyright, trademark and trade secret laws as well as nondisclosure agreements and other methods to protect our proprietary technologies. We have been issued patents and have a number of pending United States and foreign patent applications. However, we cannot provide assurance that any patent will be issued as a result of any applications or, if issued, that any claims allowed will be sufficiently broad to protect our technology. It is possible that existing or future patents may be challenged, invalidated or circumvented. For example, on August 21, 2002 we initiated a patent infringement action in Taiwan, R.O.C. against IC Media Corporation of San Jose, California for infringement of Taiwan patent NI-139439 that had been issued to us. The patent infringement action seeks damages and injunctive relief against IC Media Corporation. In response to our patent infringement action, on October 2, 2002, IC Media Corporation initiated a cancellation proceeding

39

ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

(Cancellation No. 089123560N01) in the Taiwan Intellectual Property Office with respect to our Taiwan patent NI-139439. On July 23, 2003, the Taiwan Intellectual Property Office made an initial determination to grant the cancellation of Taiwan patent NI-139439, which decision was upheld by the Taiwan Ministry of Economic Affairs in November 2003. In January 2004, we filed an action with the High Administrative Court of Taiwan to reverse the grant of cancellation. If IC Media is ultimately successful, we may lose or suffer diminished rights in the challenged patent. In addition, if we are not successful in suits in which we claim that third parties infringe our patents or other intellectual property, our competitive position may be adversely affected.

          Furthermore, it may be possible for a third party to copy or otherwise obtain and use our products or technology without authorization, develop corresponding technology independently or design around our patents. Effective patent, copyright, trademark and trade secret protection may be unavailable or limited in foreign countries. Any disputes over our intellectual property rights may result in costly and time-consuming litigation or the license of additional elements of our intellectual property for little or no compensation.

Litigation regarding intellectual property could divert management attention, be costly to defend and prevent us from using or selling the challenged technology.

          In recent years, there has been significant litigation in the United States involving intellectual property rights, including in the semiconductor industry. We have in the past, are currently, and may in the future be subject to legal proceedings and claims with respect to our intellectual property, including such matters as trade secrets, patents, product liabilities and other actions arising out of the normal course of business. See “Legal Proceedings”. These claims may increase as our intellectual property portfolio becomes larger or more valuable. Intellectual property claims against us, and any resulting lawsuit, may cause us to incur significant expenses, subject us to liability for damages and invalidate our proprietary rights. In one case we paid $3.5 million to settle a litigation matter. These lawsuits, regardless of their outcome, would likely be time-consuming and expensive to resolve and could divert management’s time and attention. Any potential intellectual property litigation against us could also force us to take actions such as:

•

ceasing the sale or use of products or services that incorporate the infringed intellectual property;

•

obtaining from the holder of the infringed intellectual property a license to sell or use the relevant technology, which license may not be available on acceptable terms, if at all; or

•

redesigning those products or services that incorporate the disputed intellectual property, which could result in substantial unanticipated development expenses and prevent us from selling the products until the redesign is completed, if at all.

          If we are subject to a successful claim of infringement and we fail to develop non-infringing intellectual property or license the infringed intellectual property on acceptable terms and on a timely basis, we may be unable to sell some or all of our products, and our operating results could be adversely affected. We may in the future initiate claims or litigation against third parties for infringement of our intellectual property rights or to determine the scope and validity of our proprietary rights or the proprietary rights of competitors. These claims could also result in significant expense and the diversion of technical and management attention.

If we do not effectively manage our growth, our ability to increase our revenues and improve our earnings could be adversely affected.

          Our growth has placed, and will continue to place, a significant strain on our management and other resources. In particular, we expect that we will continue to face challenges in managing the expansion of our operations in China. To manage our growth effectively, we must, among other things:

•

implement and improve operational, financial and accounting systems;

•

train and manage our employee base; and

•

attract and retain qualified personnel with relevant experience.

          In addition, from time to time our inventory and accounts receivables, net, have increased quarter-to-quarter and, at times, an increase in our day’s sales outstanding have increased, primarily as a result of our revenue growth in fiscal 2003 and fiscal 2004. Our failure to effectively manage our inventory levels could either result in excess

40

ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

inventories, which could adversely affect our gross margins and operating results, or lead to an inability to fill customer orders, which would result in lower sales and could harm our relationships with existing and potential customers. Concurrent with the increase in our sales during fiscal 2004, our accounts receivables and, at times, our days sales outstanding increased. If we do not manage effectively our accounts receivable, our cash balance and operating results will be adversely affected.

          We must also manage multiple relationships with customers, business partners and other third parties, such as our foundries and process and assembly vendors. Moreover, our growth may significantly overburden our management and financial systems and other resources. We may not make adequate allowances for the costs and risks associated with our expansion. In addition, our systems, procedures or controls may not be adequate to support our operations, and we may not be able to expand quickly enough to capitalize on potential market opportunities. Our future operating results will also depend on our ability to expand sales and marketing, research and development, accounting, finance and administrative support.

Our future tax rates could be higher than we anticipate if the proportion of future operating income generated outside the U.S. by our foreign subsidiaries is less than we expect.

          A number of factors will affect our tax rate in the future, and certain of these factors could increase our effective tax rate in future periods, which could adversely impact our operating results. For example, if our foreign subsidiaries are unable to achieve the levels of operating income in fiscal 2005 that we expect, our effective tax rate in fiscal 2005 may be significantly higher than the combined federal and state statutory rates or what our effective tax rates have been in prior periods.

          In common with all multi-national companies, we are subject to tax in multiple jurisdictions. The tax authorities in any given jurisdiction may seek to increase the taxes being collected by, for example, asserting that we transfer prices we charge between related entities are either too high or too low depending on which side of the transaction they are looking at. Although we believe we have provided sufficient taxes in prior periods, in some cases, adjustments that could be proposed could result in liabilities in excess of such provisions.

Our sales through distributors increase the complexity of our business, which may increase our operating costs and may reduce our ability to forecast revenues.

          During fiscal 2004, approximately 25% of our sales were made through distributors. For the six months ended October 31, 2004, approximately 19% of our sales were made through distributors. Selling through distributors reduces our ability to accurately forecast sales and increases the complexity of our business, requiring us to, among other matters:

•

manage a more complex supply chain;

•

manage the level of inventory at each distributor;

•

provide for credits, return rights and price protection;

•

estimate the impact of credits, return rights, price protection and unsold inventory at distributors; and

•

monitor the financial condition and creditworthiness of our distributors.

          Any failure to manage these challenges could cause us to inaccurately forecast sales and carry excess or insufficient inventory, thereby adversely affecting our operating results.

We face foreign business, political and economic risks, because a majority of our products and those of our customers are manufactured and sold outside of the United States.

          We face difficulties in managing our third party foundries, color filter application service providers, ceramic and plastic packaging service providers and our foreign distributors, most of whom are located in Asia. Potential political and economic instability in Asia may have an adverse impact on foreign exchange rates and could cause service disruptions for our vendors and distributors.

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

          Sales outside of the United States accounted for approximately 99% of our revenues for both fiscal 2004 and for the six months ended October 31, 2004. We anticipate that sales outside of the United States will continue to account for nearly all of our revenues in future periods. Dependence on sales to foreign customers involves certain risks, including:

•

longer payment cycles;

•

the adverse effects of tariffs, duties, price controls or other restrictions that impair trade;

•

decreased visibility as to future demand;

•

difficulties in accounts receivable collections; and

•

burdens of complying with a wide variety of foreign laws and labor practices.

          Sales of our products have been denominated to date exclusively in U.S. dollars. Over the last several years, the US dollar has weakened against most other currencies. Future increases in the value of the U.S. dollar, if any, would increase the price of our products in the currency of the countries in which our customers are located. This may result in our customers seeking lower-priced suppliers, which could adversely impact our operating results. A portion of our international revenues may be denominated in foreign currencies in the future, which would subject us to risks associated with fluctuations in those foreign currencies.

Our lengthy manufacturing, packaging and assembly cycle, in addition to our customers’ design cycle, may result in uncertainty and delays in generating revenues.

          The production of our image sensors requires a lengthy manufacturing, packaging and assembly process, typically lasting 14 to 16 weeks or more. Additional time may pass before a customer commences volume shipments of products that incorporate our image sensors. Even when a manufacturer decides to design our image sensors into its products, the manufacturer may never ship final products incorporating our image sensors. Given this lengthy cycle, we experience a delay between the time we incur expenditures for research and development and sales and marketing efforts and the time we generate revenue, if any, from these expenditures. This delay makes it more difficult to forecast customer demand, which adds uncertainty to the manufacturing planning process and could adversely affect our operating results. In addition, the product life cycle for certain or our image-sensor products designed for use in certain applications can be relatively short. If we fail to appropriately time the manufacturing, packaging and assembly process, our products may become obsolete before they can be incorporated into our customers’ products and we may never realize a return on investment for the expenditures we incur in producing these products.

The assembly and packaging of our image sensors into camera modules further complicates and reduces our ability to control the manufacturing process, and may decrease our gross margins.

          Some of our camera manufacturer customers request that we deliver our image-sensor products in the more finished form of camera modules. This increases the complexity of the overall manufacturing process and, as a result, may result in decreased yields. We have engaged third party contract manufacturers to assemble and package our image sensors into camera modules, requiring us to manage service provider relationships that have not historically been a part of our business. If these third party contract manufacturers are unable to provide timely, reliable and high quality assembly and packaging services, we could experience product shortages and be unable to fill customer orders, resulting in loss of revenues, damage to our reputation and an adverse effect on our ability to retain existing customers and attract new customers. In addition, several of these third party contract manufacturers also sell camera modules directly to third parties. Any of these third party contract manufacturers may decide to reduce or terminate their relationship with us, which could create product shortages for us and result in a loss of revenues and damage to our customer relationships. Moreover, we must purchase and hold in our inventory products that are not related to our semiconductor business in order to deliver our image sensors in a more finished form, which adds complexity to the overall manufacturing process and increases inventory risks. The gross margin percentage we realize on modules has been lower than the gross margin percentage we have achieved historically on our image-sensor products, and we expect this to continue. In addition, if we are unable to realize a premium in the sales price for camera modules compared to our image-sensor products, our profitability would be adversely affected.

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

We may be unable to maintain our recent levels of profitability.

          We have a limited history of profitability and may be unable to sustain our recent levels of profitability. If we fail to sustain or increase our levels of profitability, our financial condition may be materially and adversely affected, and the trading price of our common stock may decline. Since our inception in 1995, we have achieved profitability on an annual basis in only three fiscal years: fiscal 2000, fiscal 2003 and fiscal 2004. In fiscal 2001 we incurred a net loss of $11.6 million and in fiscal 2002 we incurred a net loss of $1.3 million. In fiscal 2000, fiscal 2003 and fiscal 2004, we recorded net income of $3.4 million, $15.3 million and $58.7 million, respectively. For the six months ended October 31, 2004, we recorded net income of $37.6 million. In the future, we expect to incur significant expenses, including expenses related to our research and development efforts, our operations in China and capital commitments to our Chinese subsidiary and our joint venture with TSMC, which could impair our ability to sustain profitability. In addition, we plan to hire additional personnel throughout various departments of our company, and we expect our selling, general and administrative and other expenses to increase. If we fail to attract qualified personnel with relevant experience, our ability to meet competitive challenges and create new products and technology to meet the demands of our customers will be adversely affected. Other risks associated with our business described elsewhere in this section could also affect our ability to sustain profitability, including the possibility that the end-markets for our products may not grow at the same rate as they did in fiscal 2003 and fiscal 2004. If our revenues do not increase or if we cannot effectively control our expenses, we may be unable to sustain profitability at levels consistent with our financial performance in fiscal 2004, if at all.

The high level of complexity and integration of our products increases the risk of latent defects, which could damage customer relationships and increase our costs.

          Because we integrate many functions on a single chip, our products are complex and are based upon evolving technology. The integration of additional functions into the complex operations of our products could result in a greater risk that customers or end users could discover latent defects or subtle faults after volumes of product have already been shipped. Although we test our products, we have in the past and may in the future encounter defects or errors. Delivery of products with defects or reliability, quality or compatibility problems may damage our reputation and ability to retain existing customers and attract new customers. In addition, product defects and errors could result in additional development costs, diversion of technical resources, delayed product shipments, increased product returns, product warranty costs for recall and replacement and product liability claims against us which may not be fully covered by insurance.

Our business could be harmed if we lose the services of one or more members of our senior management team, or if we are unable to attract and retain qualified personnel.

          The loss of the services of one or more of our executive officers or key employees, or the decision of one or more of these individuals to join a competitor, could adversely affect our business and harm our operating results and financial condition. Our success depends to a significant extent on the continued service of our senior management, in particular, Shaw Hong, our President and Chief Executive Officer, Raymond Wu, our Executive Vice President, Peter V. Leigh, our Vice President of Finance and Chief Financial Officer and certain other key technical personnel. None of our senior management is bound by an employment or non-competition agreement. We do not maintain key man life insurance on any of our employees.

          Our success also depends on our ability to identify, attract and retain qualified sales, marketing, finance, management and technical personnel, particularly analog or mixed signal design engineers. We have experienced, and may continue to experience, difficulty in hiring and retaining candidates with appropriate qualifications. If we do not succeed in hiring and retaining candidates with appropriate qualifications, our revenues and product development efforts could be harmed.

We may experience integration or other problems with potential acquisitions, which could have an adverse effect on our business or results of operations. New acquisitions could dilute the interests of existing stockholders, and the announcement of new acquisitions could result in a decline in the price of our common stock.

          We may in the future make acquisitions of or large investments in businesses that offer products, services and technologies that we believe would complement our products, including other CMOS image sensor manufacturers. We may also make acquisitions of or investments in businesses that we believe could expand our distribution

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

channels. Even if we were to announce an acquisition, we may not be able to complete it. Additionally, any future acquisition or substantial investment would present numerous risks, including:

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difficulty in integrating the technology, operations or work force of the acquired business with our existing business;

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disruption of our ongoing business;

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difficulty in realizing the potential financial or strategic benefits of the transaction;

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difficulty in maintaining uniform standards, controls, procedures and policies;

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possible impairment of relationships with employees, customers, suppliers and strategic partners as a result of integration of new businesses and management personnel; and

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impairment of assets related to resulting goodwill, and reductions in our future operating results from amortization of intangible assets.

          We expect that any future acquisitions could provide for consideration to be paid in cash, shares of our common stock or a combination of cash and our common stock. If consideration for a transaction is paid in common stock, this would further dilute our existing stockholders.

We need to upgrade our enterprise resource planning system.

          As our business grows, we have to expand and upgrade our enterprise resource planning, or ERP, system which is critical to the accounting and financial functions of our company. Our ERP system imposes certain financial and various other demands due to the cost of implementation. The ERP system also imposes certain risks inherent in the conversion to a new computer system, including disruption to our accounting controls and problems achieving accuracy in the conversion of electronic data. Failure to properly or adequately address these issues could result in the diversion of management’s attention and resources and could materially adversely affect our operating results and impact our ability to manage our business. At some point, we may outgrow our existing ERP system and need to transition our systems to a new platform. Such a transition would be time consuming and costly, and requires management resources in excess of those we currently have.

Our operations may be impaired as a result of disasters, business interruptions or similar events.

          Disasters such as earthquakes, water, fire, electrical failure, accidents and epidemics affecting our operating activities, major facilities, and employees’ and customers’ health could materially and adversely affect our operating results and financial condition. In particular, our Asian operations and most of our third party manufacturers and service providers involved in the manufacturing of our products are located within relative close proximity. Therefore, any disaster that strikes within close proximity of that geographic area could be tremendously disruptive to our business and could materially and adversely affect our operating results and financial condition. We do not currently have a disaster recovery plan.

Acts of war and terrorist acts may seriously harm our business and revenue, costs and expenses and financial condition.

          Acts of war or terrorist acts, wherever located around the world, may cause damage or disruption to our business, employees, facilities, suppliers, distributors or customers, which could significantly impact our revenue, costs, expenses and financial condition. In addition, as a company with significant operations and major distributors and customers located in Asia, we may be adversely impacted by heightened tensions and acts of war that occur in locations such as the Korean Peninsula, Taiwan and China. The potential for future terrorist attacks, the national and international responses to terrorist attacks or perceived threats to national security, and other acts of war or hostility have created many economic and political uncertainties that could adversely affect our business and results of operations in ways that cannot presently be predicted. We are uninsured for losses and interruptions caused by terrorist acts and acts of war.

Risks related to our stock

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

Provisions in our charter documents and Delaware law, as well as our stockholders’ rights plan, could prevent or delay a change in control of our company and may reduce the market price of our common stock.

          Provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a merger or acquisition that a stockholder may consider favorable. These provisions include:

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adjusting the price, rights, preferences, privileges and restrictions of preferred stock without stockholder approval;

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providing for a classified board of directors with staggered, three year terms;

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requiring supermajority voting to amend some provisions in our certificate of incorporation and bylaws;

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limiting the persons who may call special meetings of stockholders; and

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prohibiting stockholder actions by written consent.

          Provisions of Delaware law also may discourage, delay or prevent another company from acquiring or merging with us. Our board of directors adopted a preferred stock rights agreement in August 2001. Pursuant to the rights agreement, our board of directors declared a dividend of one right to purchase one one-thousandth share of our Series A Participating Preferred Stock for each outstanding share of our common stock. The dividend was paid on September 28, 2001 to stockholders of record as of the close of business on that date. Each right entitles the registered holder to purchase from us one one-thousandth of a share of Series A Preferred at an exercise price of $176.00 (reflecting the stock split that took effect on February 17, 2004 and the amendment to the rights agreement our board of directors approved in June 2004), subject to adjustment. The exercise of the rights could have the effect of delaying, deferring or preventing a change of control of our company, including, without limitation, discouraging a proxy contest or making more difficult the acquisition of a substantial block of our common stock. The rights agreement could also limit the price that investors might be willing to pay in the future for our common stock.

Our stock has been and will likely continue to be subject to substantial price and volume fluctuations due to a number of factors, many of which are beyond our control, that may prevent our stockholders from selling our common stock at a profit.

          The market price of our common stock has fluctuated substantially, and there can be no assurance that such volatility will not continue. Since the beginning of fiscal 2002, the trading price of our common stock has ranged from a high of $33.46 per share to a low of $1.18 per share. The closing sales price of our common stock on November 8, 2004 was $18.50. The securities markets have experienced significant price and volume fluctuations in the past, and the market prices of the securities of semiconductor companies have been especially volatile. This market volatility, as well as general economic, market or political conditions, could reduce the market price of our common stock in spite of our operating performance. The market price of our common stock may fluctuate significantly in response to a number of factors, including:

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actual or anticipated fluctuations in our operating results;

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changes in expectations as to our future financial performance;

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changes in financial estimates of securities analysts;

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release of lock-up or other transfer restrictions on our outstanding shares of common stock or sales of additional shares of common stock;

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sales or the perception in the market of possible sales of shares of our common stock by our directors, officers, employees or principal stockholders;

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changes in market valuations of other technology companies; and

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announcements by us or our competitors of significant technical innovations, design wins, contracts, standards or acquisitions.

          Due to these factors, the price of our stock may decline and investors may be unable to resell their shares of our stock for a profit. In addition, the stock market experiences extreme volatility that often is unrelated to the

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — (Continued)

performance of particular companies. These market fluctuations may cause our stock price to decline regardless of our performance.

Recent Accounting Pronouncements

          The Financial Accounting Standards Board (“FASB”) has issued FASB Statement No. 151, “Inventory Costs, an Amendment of ARB No. 43, Chapter 4” (“FAS No. 151”). The amendments made by FAS No. 151 are intended to improve financial reporting by clarifying that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges and by requiring the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities.

          FAS No. 151 is the result of a broader effort by the FASB to improve the comparability of cross-border financial reporting by working with the International Accounting Standards Board (“IASB”) toward development of a single set of accounting standards. The FASB and the IASB noted that ARB 43, Chapter 4 and International Accounting Standard No. 2, “Inventories”, or IAS 2, are both based on the principle that the primary basis of accounting for inventory is cost. Both of these accounting standards also require that abnormal amounts of idle freight, handling costs, and wasted materials be recognized as period costs; however, the Boards noted that differences in the wording of the two standards could lead to inconsistent application of essentially similar requirements. The FASB concluded that clarifying the existing requirements in ARB 43 by adopting language similar to that used in IAS 2 is consistent with its goals of improving financial reporting in the United States and promoting convergence of accounting standards internationally.

          The guidance is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal years beginning after November 23, 2004. The provisions of FAS No. 151 will be applied prospectively. We do not expect the adoption of FAS No. 151 to have a material impact on our consolidated financial position, results of operations or cash flows.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Foreign Currency Exchange Risk

          We sell our products globally, in particular, to branded customers, contract manufacturers, VARs and distributors in China, Hong Kong, Japan, Korea and Taiwan.

          All of our transactions with our vendors and customers are carried out in U.S. dollars. The only expenses the Company incurs in currencies other than U.S. dollars are certain costs affecting gross profits, selling, general and administrative and research and development expenses, which are primarily incurred in China, where the renminbi, or RMB, is the local currency, and in Taiwan, where the New Taiwan Dollar, or NTD, is the local currency. Historically, the Chinese government has benchmarked the RMB exchange ratio against the U.S. dollar, thereby mitigating the associated foreign currency exchange rate fluctuation risk. Taiwan does not currently benchmark the NTD exchange ratio against the U.S. dollar. These certain expenses that are denominated in currencies other than U.S. dollars have not historically been a material percentage of our revenues.

          We do not believe that our foreign currency exchange rate fluctuation risk is significant, especially if the Chinese government continues to benchmark the RMB against the U.S. dollar. Moreover, given that the only expenses that we incur in denominations other than U.S. dollars are certain immaterial costs affecting gross profits, selling, general and administrative and research and development expenses, we do not believe that a 10% change in foreign currency exchange rates would have a significant effect on our future net income or cash flows.

          We have not hedged exposures denominated in foreign currencies or used any other derivative financial instruments as we do not believe that we currently have any significant direct foreign currency exchange rate risk. Although we transact our business in U.S. dollars, future fluctuations in the value of the U.S. dollar may affect the competitiveness of our products, and results of operations.

Quantitative and Qualitative Discussion of Market Interest Rate Risk

          Our cash equivalents and short-term investments are exposed to financial market risk due to fluctuation in interest rates, which may affect our interest income and, in the future, the fair market value of our investments. We manage our exposure to financial market risk by performing ongoing evaluations of our investment portfolio. We presently invest in short-term bank market rate accounts, certificates of deposit issued by banks, high-grade corporate securities and government bonds maturing approximately 12 months or less from the date of purchase. Due to the short maturities of our investments, the carrying value should approximate the fair market value. In addition, we do not use our investments for trading or other speculative purposes. Due to the short duration of our investment portfolio, we do not expect that an immediate 10% change in interest rates would have a material effect on the fair market value of our portfolio. Therefore, we would not expect our operating results or cash flows to be affected to any significant degree by the effect of a sudden change in market interest rates.

ITEM 4. CONTROLS AND PROCEDURES

          (a) Evaluation of Disclosure Controls and Procedures.

          We restated our financial results for the quarters ended July 31, 2003, October 31, 2003 and January 31, 2004 to reflect adjustments to our previously reported financial information on Form 10-Q. The restatements arose out of an internal review which was initiated in response to issues raised by an employee. We notified the Audit Committee of the Board of Directors of the issues raised, and the Audit Committee, with assistance from special legal counsel, conducted its own independent investigation. As a result of the internal review and the independent investigation, management and the Audit Committee determined that certain errors had occurred which principally affected the timing of revenue recognition for certain sales. The independent investigation concluded that there was no evidence of wrongdoing in connection with these errors.

          The restatement of our financial results for the first three quarters of fiscal 2004 related primarily to two issues identified as part of the internal review and independent investigation. First, beginning in the second half of fiscal 2003 and continuing through the first nine months of fiscal 2004, certain distribution sales, for which we recognize revenue on a “sell-through” basis, were not reported to us by one of our distributors in a timely manner. Additionally, in the second and third quarters of fiscal 2004, during the transition of testing operations and certain

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international sales functions to overseas locations, some shipments made to customers late in the quarter were incorrectly classified as transferring title upon delivery as opposed to upon shipment, and therefore revenue was not recognized when product was shipped. Both of these issues resulted in delayed revenue recognition.

          Partly in connection with the restatement of our financial statements for the first, second and third quarters for fiscal 2004, our Independent Registered Public Accounting Firm has identified material weaknesses in our internal controls and procedures relating to errors in our recognition of revenue resulting from failure to review distributor reports and from incorrectly applying revenue recognition policies in accordance with title transfer, risk of loss and related shipping terms. Our Independent Registered Public Accounting Firm also noted a material weakness related to our need to increase our financial reporting and accounting staffing levels to ensure that we can meet our financial reporting obligations given the significant growth in our business in recent periods. In addition, our Independent Registered Public Accounting Firm reported additional observations and recommendations with respect to our financial reporting and internal controls. Correcting the identified material weaknesses and addressing the other issues identified by our Independent Registered Public Accounting Firm, responding to the findings of the internal review and the independent investigation and continuously strengthening our internal controls and financial reporting capabilities are amongst of our highest priorities. We have adopted and implemented measures to ensure that information required to be disclosed in this Quarterly Report on Form 10-Q has been recorded, processed, summarized and reported accurately, and we continue to adopt and implement, several measures in connection with our ongoing efforts to improve our control processes and corporate governance in response to the issues identified in the internal review, independent investigation and the report of our Independent Registered Public Accounting Firm. Measures taken to date include the following:

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Working in cooperation with the distributor who did not report resales of our image-sensor products on a timely basis to receive sell-through data from such distributor for each full quarterly period.

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Additional training of our financial reporting and accounting staff to be particularly attentive to reviewing distributor reports to prevent revenue recognition errors from occurring.

          Measures we are continuing to implement include the following:

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Additional training of our marketing and our financial reporting and accounting staff as to be particularly attentive to the terms of purchase orders, including matters related to title transfer, risk of loss and related shipping terms, to prevent revenue recognition errors from occurring.

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Augmenting our internal control and financial reporting staff, both domestically and abroad, to help ensure that we can adequately meet our financial reporting responsibilities as our business continues to grow.

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Improving and standardizing our internal processes, and taking additional steps to ensure that all transactions follow the relevant process.

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Improving our IT infrastructure on an enterprise-wide basis.

          We believe that we have addressed the specific accounting issues identified in the internal review and independent investigation. In addition, we believe we have improved, and are in the process of further improving, our infrastructure, personnel, processes and controls to help ensure that we are able to produce accurate financial statements on a timely basis. In particular, we are focused on increasing our financial reporting and accounting staffing levels in the immediate future. However, our growth in operations will continue to place a strain on our management systems, controls and resources. To address these issues, we will need to continue to improve our financial and managerial controls, reporting systems and procedures in the future and will need to continue to expand, train and manage our work force company-wide, including the size of our accounting and financial reporting staff. If we are unable to maintain an adequate level of financial processes and controls, we may not be able to accurately report our financial performance on a timely basis and our business and stock price would be harmed.

          In addition to efforts to strengthen our internal controls as a result of the matters identified in connection with the independent investigation and internal review discussed above as well as those identified by our Independent Registered Public Accounting Firm, we are in the process of documenting our internal controls in connection with Section 404 of the Sarbanes-Oxley Act, which requires annual management assessments of the effectiveness of our internal controls over financial reporting and a report by our Independent Registered Public Accounting Firm

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addressing these assessments. Both we and our Independent Registered Public Accounting Firm will be testing our internal controls in connection with the requirements of Section 404 and expect that as part of the documentation and testing of our internal controls there could be areas identified for further attention or improvement. We also could identify areas to be addressed where failure to strengthen internal controls could adversely affect our ability to report on our operating results and financial condition accurately or on a timely basis, which could adversely affect our stock price.

          While we continue to enhance our internal controls and procedures, we have instituted disclosure controls and procedures that are designed to ensure that the information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such 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 based closely on the definition of “disclosure controls and procedures” in Rule 13a-14(c). In designing and evaluating the disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures in reaching that level of reasonable assurance. Because of inherent limitations in any system of disclosure controls and procedures, no evaluation of controls can provide absolute assurance that all instances of error or fraud, if any, within our company may be detected.

          Our management carried out an evaluation, with the participation of our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of our disclosure controls and procedures. Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that as of the end of the period covered by this Quarterly Report on Form 10-Q our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) and 15d-15(e) promulgated under the Exchange Act, are effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms.

          (b) Changes in Internal Controls.

          Other than as noted above, there have been no changes in our internal control over financial reporting during the period covered by this Quarterly Report on Form 10-Q that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.