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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

x    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the three months ended December 31, 2002

OR

¨    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the transition period from                          to                         

Commission File No. 0-14225

EXAR CORPORATION

(Exact Name of Registrant as specified in its charter)

48720 Kato Road, Fremont, CA 94538

(Address of principal executive offices, Zip Code)

(510) 668-7000

(Registrant’s telephone number, including area code)

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

As of January 31, 2003, 39,997,337 shares of Common Stock, par value $0.0001, were issued and outstanding, net of 245,000 treasury shares.

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INDEX

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PART I – FINANCIAL INFORMATION

ITEM 1.    FINANCIAL STATEMENTS

EXAR CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share amounts)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

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EXAR CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share amounts)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

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EXAR CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS

(In thousands)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

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EXAR CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Description of Business — Exar Corporation (“Exar” or the “Company”) designs, develops and markets high-performance, analog and mixed-signal silicon solutions for the worldwide communications infrastructure. Leveraging its industry-proven analog design expertise, system-level knowledge and standard CMOS process technologies, Exar provides OEMs (original equipment manufacturers) with innovative, highly integrated circuits (ICs) that facilitate the transport and aggregation of signals in access, metro and wide area networks. The Company’s physical layer silicon solutions address transmission standards such as T/E carrier, ATM and SONET/SDH. Additionally, Exar offers ICs for both the serial communications and the video and imaging markets. Exar’s customers include Alcatel, Cisco Systems, Inc., Hewlett-Packard Company, Logitech International S.A., and Tellabs Inc. Exar’s Common Stock trades on the Nasdaq Stock Market under the symbol “EXAR” and is included in the S&P 600 SmallCap Index.

Use of Management Estimates — 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 and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates, and material effects on operating results and financial position may result.

Basis of Presentation — The accompanying consolidated financial statements include the accounts of Exar and its wholly-owned subsidiaries. All significant inter-company accounts and transactions have been eliminated in the consolidation process.

Cash Equivalents — The Company considers all highly liquid investments with an original maturity of ninety days or less to be cash equivalents.

Investments in Marketable Securities — All investments with maturities in excess of ninety days but less than twelve months from the date of the balance sheet are considered short-term marketable securities. Long-term marketable securities, which primarily consist of government, bank and corporate obligations, have maturities in excess of one year from the date of the balance sheet. Short-term and long-term marketable securities are held as securities available for sale and are carried at their market value based on quoted market prices as of the balance sheet date. The amortized cost of securities is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in Other income, net. Realized gains or losses are determined on the specific identification method and are reflected in Income. Net unrealized gains or losses are recorded directly in stockholders’ equity except that those unrealized losses that are deemed to be other than temporary are reflected in Other income, net.

Inventories — Inventories are recorded at the lower of cost or market, determined on a first-in, first-out basis and consist of the following (in thousands):

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Property, Plant and Equipment — Property, plant and equipment are stated at cost. Depreciation of plant and equipment is computed using the straight-line method over the estimated useful lives of the assets. Property, plant and equipment consist of the following (in thousands):

Long-Lived Assets — Long-lived assets are evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company’s policy is to review the recoverability of all long-lived assets based on undiscounted cash flows on an annual basis at a minimum, and in addition, whenever events or changes indicate that the carrying amount of the asset may not be recoverable. An impairment loss would be recognized when the sum of the undiscounted future net cash flows expected to result from the use of the asset and its eventual disposition is less than its carrying amount. Substantially all of the Company’s property, plant and equipment and other long-lived assets are located in the United States of America.

Income Taxes — The Company accounts for income taxes using the asset and liability approach for financial accounting and reporting of income taxes. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.

Revenue Recognition — The Company generally recognizes product revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed and determinable and collection is probable. The Company’s distributor agreements generally permit the return of up to 10% of a distributor’s purchases annually for purposes of stock rotation and also provide for credits to distributors in the event the Company reduces the price of any inventoried product. The Company records an allowance, at the time of shipment to the distributor, based on the Company’s historical patterns of returns, price protection and other authorized pricing allowances.

Stock Based Compensation — The Company accounts for stock-based awards to employees in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and has adopted the disclosure-only alternative of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Options granted to non-employees are accounted for at fair market value in accordance with SFAS 123.

The Company also complies with the provisions of EITF 96-18 with respect to stock option grants to non-employees who are consultants to the Company. EITF 96-18 requires variable plan accounting with respect to such non-employee stock options, whereby compensation associated with such options is measured on the date such options vest, and incorporates the then-current fair market value of the Company’s common stock into the option valuation model.

Foreign Currency — The functional currency of each of the Company’s foreign subsidiaries is the local currency of that country. Accordingly, gains and losses from the translation of the financial statements of the foreign subsidiaries are included in stockholders’ equity. Gains and losses resulting from foreign currency transactions are included in Other income, net. Foreign currency transaction losses were minimal for the three and nine months ended December 31, 2002 and 2001.

The Company enters into foreign currency exchange contracts from time to time to hedge certain currency exposures. Gains and losses on these contracts serve as hedges in that they offset fluctuations that might otherwise impact the Company’s financial results. The Company is exposed to credit-related losses in the event of nonperformance by the parties to its foreign currency exchange contracts. At December 31, 2002 and 2001, there were no such foreign currency exchange contracts outstanding.

Reclassifications — Certain amounts in the Company’s 2001 Condensed Consolidated Financial Statements have been reclassified to conform to the 2002 presentation.

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The Company operates in one reportable segment and is engaged in the design, development and marketing of a variety of analog and mixed-signal application-specific integrated circuits for use in communications and in video and imaging applications. The nature of the Company’s products and production processes as well as type of customers and distribution methods is consistent among all of the Company’s products. The Company’s foreign operations are conducted primarily through its wholly-owned subsidiaries in Japan, the United Kingdom and France. The Company’s principal markets include North America, Asia/Japan and Europe. Net sales by geographic area represent sales to unaffiliated customers.

Basic EPS excludes dilution and is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that would occur if outstanding securities or other contracts to issue common stock were exercised or converted into common stock.

As a result of the net loss for the nine months ended December 31, 2002, approximately 2,032,000 of potentially dilutive shares of common stock have not been included in the calculation of diluted loss per share for the period presented because to do so would have been anti-dilutive.

Options to purchase 6,448,167 shares of common stock at prices ranging from $13.52 to $60.75 were outstanding as of December 31, 2002 but not included in the computation of diluted net income per share because the options’ exercise prices were greater than the average market price of the common shares as of such dates and, therefore, would be anti-dilutive under the treasury stock method.

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A summary of the Company’s EPS for the three and nine months ended December 31, 2002 and 2001 is as follows (in thousands, except per share amounts):

A summary of comprehensive income is as follows (in thousands):

In July 2001, Exar invested $40.3 million in the Series C Preferred Stock financing for a 16% equity interest in Internet Machines Corporation, a pre-revenue, privately-held company developing a family of highly-integrated communications ICs that will provide protocol-independent network processing, switch fabric and traffic management solutions for high-speed optical, metro area network and Internet infrastructure equipment.

During the three months ended September 30, 2002, the Company became aware of a potential decline in the value of its 16% equity investment in Internet Machines Corporation. As a result, the Company retained an independent third party to assist in determining the fair market value of its investment. As a consequence, the Company recorded against its earnings a one-time asset impairment charge of $35.3 million, reducing its equity investment from $40.3 million to $5.0 million. As of December 31, 2002, the Company is not aware of any matters that could result in an additional impairment to its investment carrying value on the Company’s Condensed Consolidated Balance Sheet. If the Company’s assessed value of its investment were to fall below the carrying value, the Company would be required to recognize additional impairment to the asset, resulting in additional expense in the Company’s Condensed Consolidated Statements of Income.

Exar became a limited partner in TechFarm Ventures (Q), L.P. in May of 2001. This partnership is a venture capital fund, managed by TechFarm Ventures Management L.L.C., the general partner of TechFarm Ventures (Q), L.P., a Delaware Limited Partnership, and focuses its investment activities on seed and early stage technology companies. Effective May 31, 2002, in connection with the amendment of the partnership agreement, the Company and TechFarm Ventures Management L.L.C. agreed to reduce the Company’s capital commitment in the fund to approximately $4.0 million, or approximately 5% of the fund’s total committed capital. Additionally, the Company and TechFarm Ventures Management L.L.C. agreed to change the

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Company’s status from a limited partner to that of an assignee having less rights and status than a limited partner. Because of these modifications, the Company changed its method of accounting for this investment from the equity method to the cost basis method as of May 31, 2002. The Company has fulfilled its capital contribution commitment and, therefore will not be required to fund additional amounts.

For the nine months ended December 31, 2002, Exar has recorded charges against its earnings totaling $513,000, representing Exar’s portion of total losses in the Techfarm fund and expenses for the current fiscal year. No charges were recorded in the three months ended December 31, 2002. In fiscal year ended March 31, 2002, the Company recorded a $679,000 charge against its earnings for its proportionate share of the Techfarm fund losses and expenses. At December 31, 2002, the investment amount represents Exar’s total contributed capital of $4.0 million less an investment write-down of $1.2 million, netting to the $2.8 million reflected on the Company’s Condensed Consolidated Balance Sheet. If the Company’s assessed value of its investment were to fall below the carrying value on the Company’s Condensed Consolidated Balance Sheet, the Company would be required to recognize an impairment to the asset, which would result in additional expense in the Company’s Condensed Consolidated Statements of Income.

In July 2001, Exar became a limited partner in Skypoint Telecom Fund II (US), L.P., a venture capital fund focused on investments in communications infrastructure companies. The investment provides the Company with the opportunity to align itself with potential strategic partners in emerging technology companies within the telecommunications and/or networking industry. Exar is obligated to fund $5.0 million, which represents 5% of the fund’s total capital commitments. Of the $5.0 million obligation, Exar has funded $925,000 as of December 31, 2002, which reflects the return to the Company of $750,000 of previously funded capital in the three months ended September 30, 2002. As of December 31, 2002, the Company’s remaining capital contribution obligation was $4.1 million. The investment in the venture fund is reflected at cost on the Company’s Condensed Consolidated Balance Sheet. If the Company’s assessed value of its investment were to fall below the carrying value, the Company would be required to recognize impairment to the asset, resulting in additional expense on the Company’s Condensed Consolidated Statements of Income.

In November 2002, the FASB issued FASB Interpretation No. 45 (FIN 45), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an interpretation of FASB Statements No. 5, 57, and 107 and Rescission of FASB Interpretation No. 34.” FIN 45 clarifies the requirements of FASB Statement No. 5, “Accounting for Contingencies,” relating to the guarantor’s accounting for and disclosure of the issuance of certain types of guarantees. The disclosure provisions of the Interpretation are effective for financial statements of interim or annual reports that end after December 15, 2002. However, the provisions for initial recognition and measurement are effective on a prospective basis for guarantees that are issued or modified after December 31, 2002, irrespective of the guarantor’s year-end.

In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” (FAS 146). This Statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” This Statement requires that a liability for costs associated with an exit or disposal activity be recognized and measured initially at fair value only when the liability is incurred. The Company has adopted FAS 146 effective January 1, 2003.

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations, as well as information contained in “Risk Factors” below and elsewhere in this Report, 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. Forward-looking statements are not guarantees of future performance and involve risks and uncertainties. Actual results may differ materially from those projected in the forward-looking statements as a result of various factors. These risks, uncertainties and other factors include, among others, those identified under “Risk Factors.” Forward-looking statements are generally written in the future tense and/or are preceded by

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words such as “will,” “may”, “should,” “could,” “expect,” “suggest,” “believe,” “anticipate,” “intend,” “plan,” or other similar words. Forward-looking statements contained in this Report include, among others, statements made in “Financial Outlook” and elsewhere regarding (1) the Company’s net sales, (2) the Company’s gross margins, (3) the Company’s ability to control and/or reduce operating expenses, (4) the Company’s research and development efforts, (5) acceptance by the market of the Company’s new products, (6) the Company’s ability to maintain positive operating cash flows to fund future operations, (7) the sufficiency of the Company’s capital resources, (8) the Company’s capital expenditures and (9) the general economic outlook.

Overview

Exar designs, develops and markets high-performance, analog and mixed-signal silicon solutions for the worldwide communications infrastructure. Leveraging its industry-proven analog design expertise, system-level knowledge and standard CMOS process technologies, Exar provides OEMs innovative, highly-integrated ICs that facilitate the transport and aggregation of signals in access, metro and wide area networks. The Company’s physical layer silicon solutions address transmission standards such as T/E carrier, ATM and SONET/SDH. Additionally, Exar offers ICs for both the serial communications and the video and imaging markets.

The Company’s customers include Alcatel, Cisco Systems, Inc., Hewlett-Packard Company, Logitech International S.A., and Tellabs Inc., among others. For the three months and nine months ended December 31, 2002, one customer, Hewlett-Packard, accounted for 27.7% and 30.7%, respectively, of the Company’s net sales. No other customer accounted for more than 10% of the Company’s net sales during the three months and nine months ended December 31, 2002.

The Company markets its products in the Americas through independent sales representatives and non-exclusive distributors as well as the Company’s own direct sales organization. In Europe and the Asia/Japan region, the Company is represented by its wholly-owned subsidiaries and individual sales representatives. The Company’s international sales represented 36.5% and 32.1% of net sales for the three months ended December 31, 2002 and December 31, 2001, respectively. For the nine months ended December 31, 2002 and December 31, 2001, the Company’s international sales represented 35.0% and 37.6%, respectively of net sales. International sales consist primarily of export sales from the United States that are denominated in United States dollars. International sales and operations expose the Company to fluctuations in currency exchange rates because the Company’s foreign operating expenses are denominated in foreign currencies while its sales are denominated in United States dollars. The Company has adopted a set of practices to minimize its foreign currency risk, which include the occasional use of foreign currency exchange contracts to hedge the operating results of its foreign subsidiaries against this currency exchange risk. Although foreign sales within certain countries and/or foreign sales comprised of certain products may subject the Company to tariffs, the Company’s profit margin on international sales of ICs, adjusted for differences in product mix, is not significantly different from that realized on the Company’s sales to domestic customers. The Company’s operating results are subject to quarterly and annual fluctuations as a result of a number of factors, many of which are described in “Risk Factors.”

Significant Accounting Policies and Use of Estimates

The Company’s financial statements and accompanying disclosures, which are prepared in conformity with the accounting principles generally accepted in the United States, require that management make and rely on certain estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses and the related disclosure of contingent assets and liabilities. Estimates and assumptions are reviewed periodically, and the effects of revisions are reflected in the consolidated financial statements in the period for which they are determined to be necessary.

Exar’s most critical accounting policies relate to: (1) net sales; (2) valuation of inventories; (3) income taxes; and (4) investments in non-public entities. Should any of the estimates embedded within the Company’s accounting policies prove to be inaccurate, the Company’s Condensed Consolidated Financial Statements could be negatively impacted. A further discussion can be found in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” of the Company’s Annual Report on Form 10-K for the fiscal year ended March 31, 2002. Management believes that the Company consistently applies these judgments and estimates, and such consistent application fairly represents the Company’s Condensed Consolidated Financial Statements and accompanying notes for all periods presented.

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Financial Outlook

Communication carriers have indicated that they will make further reductions in their capital expenditures in calendar year 2003. This, in turn, will put further downward pressure on demand for Exar’s customers’ equipment. As a consequence, Exar continues to have limited visibility with respect to customer demand. Additionally, as indicated by the sales mix for the three months ended December 31, 2002, the Company expects that its video and imaging sales will continue to decline over the next several quarters both in absolute terms and as a percentage of Exar’s net sales due to Hewlett-Packard’s product transitions, seasonality and the establishment of a competing component supplier. Although the Company experienced modest increases in its communications revenue in the quarter ended December 31, 2002 as compared to the previous quarter, the Company may not be able to sustain or grow its communications revenue sufficiently to offset the anticipated decline in its video and imaging revenue, thus negatively impacting the Company’s future results of operations and financial condition.

The Company has continued to have its communication products designed into several of its customers’ new and enhanced networking equipment, contributing to the Company’s belief that it is positioned to meet future demand as market conditions improve. However, if the Company’s assumptions prove to be inaccurate, the design wins fail to result in significant revenue or the Company experiences pressure on its bookings and backlog as a result of competition or unfavorable market conditions, the Company’s future results of operations and financial condition may be negatively impacted.

The Company anticipates that interest income will continue to be under pressure as interest rates remain at historical lows. However, the Company plans to continue exchanging some of its shorter-termed marketable securities for longer-termed marketable securities in its attempt to capitalize on higher yields offered by longer-termed securities. However, if the Company consumes cash in excess of future cash receipts, resulting in decreased average cash balances available for earning interest, the Company’s results of operations and financial condition may be negatively impacted.

Results of Operations

For the periods indicated, the following table sets forth certain cost, expense and other income items as a percentage of net sales. The table and subsequent discussion should be read in conjunction with the Condensed Consolidated Financial Statements and Notes thereto.

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Product Line Sales as a Percentage of Net Sales

The following table sets forth product line revenue information as a percentage of net sales. The table and subsequent discussion should be read in conjunction with the Condensed Consolidated Financial Statements and Notes thereto.

Three Months Ended December 31, 2002 compared to Three Months Ended December 31, 2001

Net sales

Net sales for the three months ended December 31, 2002 increased by 7.4% to $15.0 million from $14.0 million for the three months ended December 31, 2001. The increase was driven by a 68.6% increase in video and imaging product sales, offset by a decrease of 9.5% in communications product sales and a 15.8% decrease in other product sales associated with the decline in product sales related to last-time buy programs. For the three months ended December 31, 2002 and December 31, 2001, sales to Hewlett-Packard represented 27.7% and 12.9%, respectively of net sales, consisting of shipments of the Company’s imaging products that support Hewlett-Packard’s multifunctional products.

The Company expects that non-communications revenue will continue to decline due to an anticipated decline in video and imaging product sales as a result of Hewlett-Packard’s product transitions, seasonality and a competing source that will supply Hewlett-Packard. Although the Company anticipates a modest increase in communications product sales, this increase is not anticipated to offset the potential decline in video and imaging product sales. If communications product sales do not increase to offset such anticipated decline, the Company’s financial condition and results of operations will likely be materially and adversely impacted.

For the three months ended December 31, 2002, U.S. sales decreased slightly to 63.5% of net sales as compared to 67.9% of net sales for the same period one year ago. For the three months ended December 31, 2002, sales to Europe and Asia/Japan increased to $5.5 million from $4.5 million from the three months ended December 31, 2001. The 22.0% increase in international sales was related to the corresponding increase in imaging product sales to Hewlett-Packard in the three months ended December 31, 2002 over the same period a year ago.

Gross Profit

Gross profit represents net sales less cost of sales. Cost of sales includes:

Gross profit as a percentage of net sales for the three months ended December 31, 2002 was 58.0% compared to 55.9% for the three months ended December 31, 2001. The increase in gross profit, as a percentage of net sales was primarily the result of the Company’s ability to achieve manufacturing efficiencies resulting from increased production volumes. Such efficiencies were modestly offset by the increase in sales of video and imaging products, which typically have lower margins than the Company’s communications products.

Due to the proprietary nature of the Company’s products, price changes have not had a material effect on net sales nor gross margins. However, recently the Company has experienced pricing pressures earlier in the communication products sales cycle. Historically, pricing pressures, if they occurred at all, occurred at the time that the products were in production whereas such pressures in the current environment are occurring at the initiation of a design.

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Research and development

Research and development (“R&D”) costs consist primarily of:

R&D expenses for the three months ended December 31, 2002 were $5.3 million, or 35.6% of net sales, compared to $5.6 million, or 39.6% of net sales for the three months ended December 31, 2001.

As part of the approximate 10% workforce reduction effected on October 21, 2002 to align the Company’s expenses with anticipated revenue (the “October Workforce Reduction”), the Company reduced the number of engineering employees engaged in R&D. The cost benefits associated with the October Workforce Reduction are expected to be realized in the quarter ending March 31, 2003. However, the Company anticipates that the impact of these cost benefits will be partially offset by continued spending on product development.

Some aspects of the Company’s research and development efforts require significant short-term expenditures, the timing of which may cause significant fluctuations in the Company’s expenses. The Company expects that R&D expenses as a percentage of net sales will continue to fluctuate in the future because of the timing of expenditures and changes in the level of net sales. The Company believes that technological innovation is critical to its long-term success, and it intends to continue to make substantial investments to enhance its product offerings to meet the current and future technological requirements of its customers and markets.

Selling, general and administrative

Selling, general and administrative (“SG&A”) expenses consist primarily of:

SG&A expenses for the three months ended December 31, 2002 were $4.6 million, or 30.4% of net sales, compared to $4.3 million, or 30.9% of net sales, for the three months ended December 31, 2001. The increase in SG&A spending in absolute dollars was primarily the result of increased compensation related expenses, certain professional fees and sales commissions.

In connection with the October Workforce Reduction, the Company reduced the number of employees engaged in selling, marketing and administration. The cost benefits associated with the October Workforce Reduction are expected to be realized in the quarter ending March 31, 2003. However, it is possible that future SG&A expenses will increase in absolute dollars as a result of possible future expansion of the Company’s infrastructure to support increased headcount, potential acquisition and integration activities, and general expansion of the Company’s operations. The Company continues to assess its cost structure and other programs to improve operational efficiencies. In the short term, many of the SG&A expenses are fixed, which results in a decline in SG&A expense as a percentage of net sales in periods of increasing net sales and an increase as a percentage of net sales when net sales decrease.

Other income, net

Other income, net primarily consists of:

Other income, net for the three months ended December 31, 2002 was $2.3 million, as compared to $2.7 million for the three months ended December 31, 2001. The decrease was due to lower interest-related earnings on cash and marketable securities, despite an increase in cash and securities of $16.8 million at December 31, 2002 when compared to December 31, 2001. The Company expects that its interest income will continue to be adversely affected by continued downward pressure on interest rates and current economic conditions.

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Included in Other income, net for the three months ended December 31, 2001, is a charge of $456,000 recorded for the Company’s equity investment portion of the loss experienced by TechFarm Ventures (Q), L.P. during that period. In connection with the amendment of the partnership agreement effective May 31, 2002, the Company and TechFarm Ventures Management L.L.C. agreed to reduce the Company’s capital commitment in the fund to approximately $4.0 million, or approximately 5% of the fund’s total committed capital. The Company has fulfilled its capital contribution commitment. Additionally, the Company and TechFarm Ventures Management L.L.C. agreed to change the Company’s status from a limited partner to that of an assignee, having less rights and status than a limited partner. Because of these modifications, the Company changed its method of accounting for this investment from the equity method to the cost basis method as of May 31, 2002. There were no similar charges recorded by the Company for the three months ended December 31, 2002. The Company does not anticipate that it will take additional charges against earnings for losses incurred by the fund. However, if the Company’s assessed value of its investment were to fall below the carrying value reported on the Company’s Condensed Consolidated Balance Sheet, the Company would be required to recognize an impairment to the asset, resulting in additional expense in the Company’s Condensed Consolidated Statement of Income.

Provision for income taxes

The effective income tax rate for the three months ended December 31, 2002 was 30%, which is the same as the income tax rate recorded by the Company for the fiscal year ended March 31, 2002.

Net sales

Net sales for the nine months ended December 31, 2002 increased by 31.6% to $52.0 million from $39.5 million for the nine months ended December 31, 2001. The increase resulted from a 131.7% increase in video and imaging product sales coupled with a 4.2% increase in communications product sales. Also contributing to the increase in net sales was an increase in other product revenue sales of 7.0% associated with last-time buy transactions. For the nine months ended December 31, 2002 and December 31, 2001, sales to Hewlett-Packard represented 30.7% and 11.4%, respectively of net sales, consisting of shipments of the Company’s imaging products to support Hewlett-Packard’s multifunction products.

The Company expects that non-communications revenue will continue to decline due to an anticipated decline in video and imaging product sales as a result of Hewlett-Packard’s product transitions, seasonality and a competing source that will supply Hewlett-Packard. Although the Company anticipates a modest increase in communications product sales, this increase is not anticipated to offset the estimated decline in video and imaging product sales. If communications product sales do not increase to offset such anticipated decline, the Company’s financial condition and results of operations will likely be materially and adversely impacted.

For the nine months ended December 31, 2002, U.S. sales increased by 37.2% and sales to Europe and Asia/Japan increased 22.3% over the same period a year ago. The increase in international sales was primarily a result of a corresponding increase in imaging product sales to Hewlett-Packard.

Gross Profit

Included in the cost of sales for the nine months ended December 31, 2002 is a $2.3 million inventory write-off charge taken by the Company during the three months ended September 30, 2002 for inventory the Company determined to be in excess of a six-month demand forecast for the Company’s communications products.

Gross profit as a percentage of net sales for the nine months ended December 31, 2002, including the inventory write-off of $2.3 million, was 52.7% compared to 56.2% for the nine months ended December 31, 2001. Gross profit for the nine months ended December 31, 2002, excluding the inventory write-off of $2.3 million, was 57.1%. The slight increase in gross profit, as a percentage of net sales, excluding the inventory write-off of $2.3 million, was primarily the result of the Company’s ability to achieve manufacturing efficiencies resulting from increased production volumes. Such efficiencies were modestly offset by the increase in imaging and video product sales, which typically have lower margins than the Company’s communications products, for the nine months ended December 31, 2002 when compared to the same period a year ago.

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Due to the proprietary nature of the Company’s products, price changes have not had a material effect on net sales nor gross margins. However, recently the Company has experienced pricing pressures earlier in the communication products sales cycle. Historically, pricing pressures, if they occurred at all, occurred only at the time that the products were in production whereas such pressures in the current environment are occurring at the initiation of a design.

Research and development

R&D expenses for the nine months ended December 31, 2002 were $16.7 million, or 32.2% of net sales, compared to $16.2 million, or 41.1% of net sales, for the nine months ended December 31, 2001.

In connection with the October Workforce Reduction, the Company reduced the number of engineering employees engaged in R&D. The cost benefits associated with the October Workforce Reduction are expected to be realized in the quarter ending March 31, 2003. However, the Company anticipates that the impact of these cost benefits will be partially offset by continued spending on product development.

Some aspects of the Company’s research and development efforts require significant short-term expenditures, the timing of which may cause significant fluctuations in its expenses. The Company expects that R&D expenses as a percentage of net sales will continue to fluctuate in the future because of the timing of expenditures and changes in the level of its net sales. The Company believes that technological innovation is critical to its long-term success, and it intends to continue to make substantial investments to enhance its product offerings to meet the current and future technological requirements of its customers and markets.

Selling, general and administrative

SG&A expenses for the nine months ended December 31, 2002 were $14.4 million, or 27.8% of net sales, compared to $13.4 million, or 33.9% of net sales, for the nine months ended December 31, 2001. The increase in SG&A spending in absolute dollars was primarily the result of increased compensation related expenses, certain professional fees and sales commissions.

In connection with the October Workforce Reduction, the Company reduced the number of employees engaged in selling, marketing and administration. The cost benefits associated with the October Workforce Reduction are expected to be realized in the quarter ending March 31, 2003. However, it is possible that future SG&A expenses will increase in absolute dollars as a result of possible future expansion of the Company’s infrastructure to support potential acquisition and integration activities, and a general expansion of the Company’s operations. The Company continues to assess its cost structure and other programs to improve operational efficiencies. In the short term, many of the SG&A expenses are fixed, which results in a decline in SG&A expense as a percentage of net sales in periods of increasing net sales and an increase as a percentage of net sales when net sales decrease.

Other income, net

During the quarter ended September 30, 2002, the Company became aware of a potential decline in the value of its 16% equity investment in Internet Machines Corporation. As a result, the Company retained an independent third party to assist in determining the fair market value of its investment. As a consequence, the Company recorded an asset impairment charge of $35.3 million against earnings, and, therefore, the nine months ended December 31, 2002 Other income, net reflects a loss of $28.8 million as compared to income of $11.9 million for the nine months ended December 31, 2001. Excluding the asset impairment charge, Other income, net for the nine months ended December 31, 2002 was $6.6 million. The decrease, excluding the asset impairment charge, was due to lower interest-related earnings on cash and marketable securities. The Company expects that its interest income will continue to be adversely affected by continued downward pressure on interest rates and current economic conditions.

Included in Other income, net for the nine months ended December 31, 2002 and December 31, 2001, are charges of $513,000 and $496,000, respectively, recorded for the Company’s equity investment portion of the loss experienced by TechFarm Ventures (Q), L.P. during that period. In connection with the amendment of the partnership agreement effective May 31, 2002, the Company and TechFarm Ventures Management L.L.C. agreed to reduce the Company’s capital commitment in the fund to approximately $4.0 million, or approximately 5% of the fund’s total committed capital. The Company has fulfilled its capital contribution commitment. Additionally, the Company and TechFarm Ventures Management L.L.C. agreed to change the

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Company’s status from a limited partner to that of an assignee, having less rights and status than a limited partner. Because of these modifications, the Company changed its method of accounting for this investment from the equity method to the cost basis method as of May 31, 2002. The Company does not anticipate that it will take additional charges against earnings for losses incurred by the fund. However, if the Company’s assessed value of its investment were to fall below the carrying value reported on the Company’s Condensed Consolidated Balance Sheet, the Company would be required to recognize an impairment to the asset, resulting in additional expense in the Company’s Condensed Consolidated Statement of Income.

Provision for income taxes

The Company did not recognize a tax benefit for the Internet Machines Corporation asset impairment charge because the Company is uncertain whether it will have future capital gains to offset this capital loss after the loss is recognized for tax purposes. The effective income tax rate for the nine months ended December 31, 2002, excluding the $35.3 million asset impairment charge, was 30%, which is the same as the income tax rate recorded by the Company for the fiscal year ended March 31, 2002.

Liquidity and Capital Resources

The Company does not have any off balance-sheet arrangements, investments in special purpose entities or undisclosed borrowings or debt. Additionally, the Company is not a party to any derivative contracts, nor does it have any synthetic leases. The Company has a credit facility agreement with a domestic bank under which it may execute up to $15.0 million in foreign currency transactions. At December 31, 2002, the Company had no foreign currency contracts outstanding.

Cash and cash equivalents, short-term marketable securities and long-term marketable securities increased by $13 million to $417.2 million at December 31, 2002 from $404.2 million at March 31, 2002. The majority of the increase is the result of cash flows from operating activities, including a tax refund.

The Company generated cash flows from operating activities of $11.3 million during the nine months ended December 31, 2002. The positive cash flow from operations was attributable to the $4.7 million refund from the Internal Revenue Service resulting from favorable tax law changes under the 2002 Federal Economic Stimulus Bill, which enabled companies to apply any 2001 net operating tax losses to taxable income realized in the previous five years. Also contributing to the positive operating cash flow for the nine months ended December 31, 2002 was the net loss of $33.4 million including non-cash charges totaling approximately $47.1 million for depreciation and amortization, loss on Other long-term investments, provision for doubtful accounts and inventory write-off. These amounts were slightly offset by increases in accounts receivable and prepaid expenses.

During the nine months ended December 31, 2002, the Company’s investing activities included the maturity of $61.6 million and $22.5 million of both short-term and long-term marketable securities, respectively. For the same period, purchases of both short-term and long-term securities, were $75.5 million and $107.3 million, respectively. Purchases of manufacturing test equipment, computer equipment, software and hardware used for product development, amounted to $4.5 million for the nine months ended December 31, 2002. Also included in the investing activities were progress payments totaling $2.8 million related to the on-site power generation project that the Company has undertaken in order to produce its own electricity for its Fremont headquarters. The Company expects that the total on-site power generation project costs, net of an approximate $900,000 refund to be issued by the California Energy Commission, will be approximately $2.8 million. The on-site power generation project is expected to be completed and operational in the March 2003 quarter.

As of December 31, 2002, the Company had funded $925,000 of its $5.0 million committed capital in Skypoint Telecom Fund II (US), L.P. As of June 30, 2002, the Company had funded $1.5 million of its committed capital. However, during the quarter ended September 30, 2002, Skypoint Telecom Fund II (US), L.P. refunded $750,000 of the Company’s previous capital contribution. The Company is obligated to contribute its remaining committed capital of approximately $4.1 million as needed. To meet its capital commitment to the fund, the Company may need to use its existing cash, cash equivalents and marketable securities.

Effective May 31, 2002, the Company and TechFarm Ventures Management L.L.C. agreed to, among other matters, reduce the Company’s capital commitment in the fund to approximately $4.0 million, or approximately 5% of the fund’s total committed capital. As of June 1, 2002, the Company had satisfied its capital contribution obligation through the final capital contribution of $801,517.

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During the nine months ended December 31, 2002, the Company received $5.8 million from the issuance of 762,000 shares of common stock upon the exercise of stock options under the Company’s stock option plans and the purchase of shares of common stock under the Company’s employee stock purchase plan.

In March 2001, the Board of Directors authorized a stock repurchase program to acquire outstanding common stock in the open market. Under this program, the Board of Directors authorized the acquisition of up to $40.0 million of Exar’s common stock, of which $4.6 million was acquired in fiscal 2001. Although the Company did not repurchase any of its outstanding shares during the nine months ended December 31, 2002, the Company may utilize this program in the future, which would reduce cash, cash equivalents and/or marketable securities available to fund future operations and meet all other liquidity requirements.

The Company places purchase orders with wafer foundries and other vendors as part of its normal course of business. As of December 31, 2002, the Company had approximately $5.1 million of outstanding purchase commitments with several suppliers for the purchase of wafers, capital equipment (including the on-site power generation project) and various service contracts, of which $900,000 is expected to be refunded to the Company from the California Energy Commission. The Company expects to receive and pay for the wafers and capital equipment within the next six months and pay for its various service contracts over the next twelve months from its existing cash balances.

The Company anticipates that it will continue to finance its operations with cash flows from operations, existing cash and investment balances, and some combination of long-term debt and/or lease financing and additional sales of equity securities. The combination and sources of capital will be determined by management based on the Company’s needs and prevailing market conditions. The Company believes that its cash and cash equivalents, short-term marketable securities, long-term marketable securities and cash flows from operations will be sufficient to satisfy working capital requirements and capital equipment needs for at least the next 12 months. However, should the demand for the Company’s products decrease in the future, the availability of cash flows from operations may be limited, thus possibly having a material adverse effect on the Company’s financial condition or results of operations. From time to time, the Company evaluates potential acquisitions and equity investments complementary to its design expertise and market strategy, including investments in wafer fabrication foundries. To the extent that the Company pursues or positions itself to pursue these transactions, the Company could choose to seek additional equity or debt financing. There can be no assurance that additional financing could be obtained on terms acceptable to the Company. The sale of additional equity or convertible debt could result in dilution to the Company’s stockholders.

RISK FACTORS

The Company is subject to a number of risks. Some of these risks are endemic to the fabless semiconductor industry and are the same or similar to those disclosed in the Company’s previous SEC filings, and some risks may arise in the future. You should carefully consider all of these risks and the other information in this Report before investing in the Company. The fact that certain risks are endemic to the industry does not lessen the significance of these risks.

As a result of these risks, the Company’s business, financial condition or operating results could be materially and adversely affected. This could cause the trading price of the Company’s common stock to decline, and stockholders might lose some or all of their investment.

IF THE COMPANY IS UNABLE TO GENERATE ADDITIONAL REVENUE FROM THE SALE OF ITS COMMUNICATIONS PRODUCTS, OR ITS REVENUE FROM THESE PRODUCTS DECLINES, THE COMPANY’S BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS COULD BE MATERIALLY AND ADVERSELY IMPACTED.

Although communications revenue is expected to grow in the long term, it is not anticipated to grow fast enough to offset the expected decline in revenue from non-communications products. Accordingly, if communications revenue does not increase in the future, the Company’s financial condition and results of operations will be materially and adversely impacted.

The Company is continuing to focus its research and sales resources on the communications market. As a result, the Company’s dependence on this market, as compared to Exar’s dependence on other markets, such as video and imaging, is increasing. Given

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the Company’s increasing dependence on the communications market to support revenue growth, the Company must continue to generate additional sales from this market, either by taking market share from competitors or by maintaining market share while growing absolute sales. If the Company is not able to generate additional revenue in the communications market, the Company’s business, financial condition and results of operations will be materially and adversely impacted.

THE SLOWDOWN AND UNCERTAINTY IN THE U.S. AND GLOBAL ECONOMIES MAY CONTINUE TO ADVERSELEY AFFECT THE COMPANY’S BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

Decreased consumer confidence, reduced corporate profits and capital spending and the threat of war have had (and continue to have) a negative impact on the U.S. and global economies. Many of the Company’s customers continue to experience significant declines in demand for their products as a result of continued uncertainty regarding future capital spending by the communications service providers. This uncertainty regarding capital spending is based upon the weak operating results of these service providers, which, in turn, have hindered their ability to obtain additional capital from the public markets in order to continue to build their networks. Communications service providers continue to face significant financial challenges and, therefore, may continue to delay or further reduce their spending on the Company’s customers’ products. These challenges have been exacerbated by disclosures of accounting irregularities by communications service providers and other large public companies. If the Company’s customers delay or cancel their orders for the Company’s products, the Company’s revenues and results of operations may be negatively impacted.

The extent and severity of this economic downturn, in conjunction with the uncertainty of the timing and nature of the military and political controversies, have made it difficult for the Company to predict when and if demand for its products will increase. Additionally, the Company does not expect the trend of lower capital spending among service providers to reverse itself in the near future. Therefore, the Company does not know when or how quickly its customers will place new orders. Furthermore, the Company’s revenues may decline in the future, which could materially and adversely impact the Company’s business, financial condition and results of operations.

IF THE COMPANY FAILS TO DEVELOP AND INTRODUCE NEW PRODUCTS THAT MEET THE EVOLVING NEEDS OF ITS CUSTOMERS, THE COMPANY’S BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS COULD BE MATERIALLY AND ADVERSELY IMPACTED.

The markets for the Company’s products are characterized by:

To develop successful products for the Company’s target markets, the Company must develop, gain access to and use leading technologies in a cost-effective and timely manner and continue to expand its technical and design expertise. In addition, the Company must continue to have its products designed into its customers’ future products and maintain close working relationships with key customers in order to develop new products that meet their changing needs.

Products for communications applications are based on continually evolving industry standards. The Company’s ability to compete will depend in part on its ability to identify and ensure compliance with these industry standards. As a result, the Company could be required to invest significant time, effort and expenses redesigning its products to ensure compliance with industry standards.

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The process of developing new products is complex and uncertain, and if the Company fails to accurately predict customers’ changing needs and emerging technological trends, the Company’s business could be harmed. The Company cannot assure that it will be able to identify new product opportunities successfully, develop and bring to market new products, achieve design wins or respond effectively to technological changes or product announcements by its competitors. In addition, the Company may not be successful in developing or using new technologies or in developing new products or product enhancements that achieve market acceptance. The Company’s pursuit of necessary technological advances may require substantial time and expense. Failure in any of these areas could harm its business, financial condition and results of operations.

THE MARKETS IN WHICH THE COMPANY PARTICIPATES ARE INTENSELY COMPETITIVE. THE COMPANY’S FAILURE TO COMPETE EFFECTIVELY IN THESE MARKETS COULD MATERIALLY AND ADVERSLY IMPACT THE COMPANY’S BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The Company’s target markets are intensely competitive. The Company’s ability to compete effectively in its target markets depends on, among others, the following factors:

In addition, the Company expects that its competitors and customers will offer new products based on new technologies, industry standards or end-user or customer requirements, including products that have the potential to replace or provide lower-cost or higher-performance alternatives to the Company’s current products. The introduction of new products by the Company’s competitors or customers could render the Company’s existing and future products obsolete or unmarketable. In addition, the Company’s competitors and customers may introduce products that integrate the functions performed by the Company’s ICs on a single IC, thus eliminating the need for the Company’s products.

Because the IC markets are highly fragmented, the Company generally encounters different competitors in the various markets in which it competes. Competitors with respect to the Company’s communications products include Applied Micro Circuits Corporation, Conexant Systems Inc., PMC-Sierra, Inc., TranSwitch Corporation, and Vitesse Semiconductor Corporation. Competitors in the Company’s serial communications and video and imaging markets include Philips Electronics, Texas Instruments, Inc. and Wolfson Microelectronics LTD. Many of the Company’s competitors have greater financial, technical and management resources than the Company. Some of these competitors may be able to sell their products at prices below which it would be profitable for the Company to sell its products.

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THE COMPANY’S FINANCIAL RESULTS MAY FLUCTUATE SIGNIFICANTLY BECAUSE OF A NUMBER OF FACTORS, MANY OF WHICH ARE BEYOND THE COMPANY’S CONTROL.

The Company’s financial results may fluctuate significantly. Some of the factors that affect the Company’s quarterly and annual financial results, many of which are difficult or impossible to control or predict, are: