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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year Ended December 31, 2002

Commission File Number 0-23006

DSP GROUP, INC.

(Exact name of registrant as specified in its charter)

3120 Scott Boulevard, Santa Clara, CA 95054

(Address of principal executive offices, including zip code)

(408) 986-4300

(Registrant’s telephone number)

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.001 per share

(Title of class)

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  ¨

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

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

As of June 30, 2002, the aggregate market value of voting stock held by non-affiliates of the Registrant, based on the closing price of the Common Stock on June 30, 2002, as reported on the Nasdaq National Market, was $383,874,310. Shares of Common Stock held by each officer and director and by each person who owns 5% or more of the outstanding Common Stock have been excluded from this computation in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

As of March 21, 2003, the Registrant had outstanding 27,335,436 shares of Common Stock.

Documents incorporated by reference: Portions of the Registrant’s proxy statement to be filed pursuant to Regulation 14A within 120 days after Registrant’s fiscal year end of December 31, 2002 are incorporated herein by reference into Part II, Item 5 and Part III of this annual report.

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DSP GROUP, INC.

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

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

PART I

Item 1.    BUSINESS.

Introduction

We are a fabless semiconductor company that is a leader in residential wireless markets. By combining Digital Signal Processing (DSP) cores technology with advanced Complementary Metal Oxide Semiconductor (CMOS) radio frequency (RF) devices, communications technologies and speech-processing algorithms, we are a worldwide leader in developing and providing Total Telephony Solutions^™. We were incorporated in California in 1987 and reincorporated in Delaware in 1994. We completed our initial public offering in February 1994.

On November 1, 2002, we transferred the assets and liabilities of our DSP cores licensing business to Ceva, Inc., one of our then wholly-owned subsidiaries (the “Separation”). Immediately thereafter, Ceva affected a combination (the “Combination”) with Parthus Technologies plc whereby Ceva acquired Parthus and issued Ceva common stock to the former Parthus shareholders. After the Combination, Ceva changed its name to ParthusCeva, Inc. ParthusCeva’s common stock is quoted on the Nasdaq National Market (Nasdaq: PCVA) and listed on the London Stock Exchange (London: PCV).

In connection with the Separation, we contributed our DSP cores licensing business to Ceva in exchange for Ceva common stock and subsequently distributed all of the Ceva common stock we held to our stockholders of record. In addition to the other assets transferred to Ceva, we also contributed a sum of $40 million in cash and prepaid transaction expenses related to the Separation and Combination that exceeded $2 million. We received private letter rulings from the U.S. Internal Revenue Service to the effect that, among other things, the Separation was a tax-free transaction for our stockholders for federal income tax purposes, except with respect to cash distributed to our stockholders in lieu of fractional shares of Ceva common stock.

In anticipation of the Separation, we reclassified the DSP cores licensing business as discontinued operations in our financial statements for the years ended December 31, 2002, 2001 and 2000. After the Separation, we have one reporting segment.

Web Site Access to Company’s Reports

Our Internet Web site address is www.dspg.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act are available free of charge through our Web site as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission. We will also provide the reports in electronic or paper form free of charge upon request. Furthermore, all reports we file with the Commission are available free of charge via EDGAR through the Commission’s Web site at www.sec.gov. In addition, the public may read and copy materials filed by us at the Commission’s public reference room located at 450 Fifth St., N.W., Washington, D.C., 20549.

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General Business

We have developed several semiconductor devices for residential wireless communication applications. Our main product lines provide an optimized solution for digital 900MHz, 2.4GHz and 5.8GHz cordless telephony. Our advanced CMOS RF and integrated DSP voice modem device provide us with a clear path to a Phone-on-a-Chip solution.

We also develop and market embedded, integrated silicon/software solutions for Digital Voice Recorder, Hands Free Car Kit, Voice over Digital Subscriber Line (VoDSL) and Voice over Internet Protocol (VoIP) applications, as well as other Voice over Packet applications for Integrated Access Device (IAD) and Internet Protocol (IP) telephony markets.

We introduced the first integrated digital telephony speech processor in 1989. Since then, we have shipped approximately 141 million units of speech processors and RF devices to original equipment manufacturers (OEMs), of which approximately 44 million were shipped in 2002. Sales of our Integrated Digital Telephony (IDT) speech processors and RF devices accounted for approximately 97% of our total revenues in 2002.

Our work in the field of wireless residential technology has yielded various synergistic product families:

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

Cordless Telephony.    Digital 900MHz, 1.9GHz, 2.4GHz and 5.8GHz spread spectrum narrow-band chip-sets. The chip-sets are composed of an RF transceiver and a highly-integrated DSP core-based chip. The DSP core-based chip combines three main functions into one chip: the wireless baseband modem, speech processing and telephony functions.

DSP-Based Speech and Telephony Processors

We have developed three generations of speech processors based on PineDSPCore^® and TeakLiteDSPCore^®. The devices are fully-integrated DSP System-on-a-Chip designed to provide custom solutions for IDT, stand-alone answering machines, Digital Voice Recorder, Hands Free Car Kit, and VoDSL and VoIP applications. The processors provide a flexible and open system, thereby enabling our customers to develop an optimal and cost effective system. Furthermore, our systems architecture provides an open design environment for OEMs and original design manufacturers (ODMs) to design and market their own end products with the maximum differentiation.

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Our IDT speech processors are based on PineDSPCore^® and TeakLiteDSPCore^®, which are more fully described below.

In 1999, we shipped the first D16000 family of fully-integrated speech processors, which combined the components of a mixed signal system on a single chip. Each speech processor in the D16000 family contains a DSP core, converters that transform analog signals into digital signals and vice versa, and various signal amplifiers, all embedded on a single chip. In addition to implementing DSP algorithms, including data compression, Caller ID and full-duplex speaker phone, these speech processors also perform tasks that would typically be handled by a separate central processing unit (CPU) chip. Our goal is for the D16000 family of processors to provide optimal value to our OEM customers by eliminating the need for virtually all other electronic components, thereby reducing materials and manufacturing costs.

In 2000, we developed the D36000 family of fully-integrated speech processors based on TeakLiteDSPCore^®, which can support two-line telephony as well as cordless baseband modems with low power usage. D36000 speech processors, which entered into mass production in the second quarter of 2001, have received marketplace acceptance as an upgrade to our D16000 family of products for cordless and corded telephony standards. With this new family of products, we provide a complete solution for 900MHz, 2.4GHz single hand-set, 2.4GHz multi-hand-set and 5.8GHz baseband markets.

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

DSP Group’s IDT Speech Processors

Cordless Telephony

In 1999, we acquired technology and products, including associated intellectual property related to 900MHz spread spectrum cordless telephones, from Advanced Micro Devices. In addition, in connection with the acquisition, we acquired two integrated groups of engineers, one located in Israel and the other in the United States.

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

In 2001, we entered into mass production of 900MHz narrow-band cordless chip-set. The chip-set includes a D36000 fully-featured telephony and baseband device and an integrated RF device. During 2001, we completed the design of our advanced chip-set for 2.4GHz single hand-set and multi-hand-set for the U.S. market. In the same year, we also developed an integrated CMOS RF device, which was an important step in our development efforts to integrate telephony features, the communications modem and the RF device into an integrated Phone-on-a-Chip.

In 2002, we introduced a complete chip-set for a 2.4GHz single hand-set solution and an advanced 2.4GHz multi-hand-set solution with walkie-talkie and baby monitor capabilities. As the U.S. market transitioned from 900MHz to 2.4GHz, we introduced an optimal and low-cost 2.4GHz multi-hand-set solution to serve the growing requirements for systems with two to three hand-sets. Furthermore, in the second half of 2002, we introduced a baseband device for the 5.8GHz market. During the same period, we started the development of a unique residential cordless/PBX system to support voice and data connectivity, based on Bluetooth protocol. Our universal platform ensures fast time to market and seamless migration to data connectivity and broadband wireless home applications.

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The following table presents the main features of the cordless chip-sets that we currently offer:

DSP Group’s IDT Cordless Speech Processors

Voice over Packet Speech Co-Processors

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

In March 2000, we acquired approximately 73% of VoicePump, Inc., a company which specializes in speech coding and telecom algorithms for Voice over Packet applications developed for voice gateway, customer-oriented equipment manufacturers and broadband network providers. In March 2001, VoicePump became one of our wholly-owned subsidiaries when we exercised our option to acquire the remaining equity.

In 2001, VoicePump launched its first VP100 family of products. This product line is based on TeakLiteDSPCore^®, which includes an integrated set of peripherals optimized for VoDSL Integrated Access Device (IAD) and other Voice over Packet applications. VoicePump plans to offer its current and future product lines as low-cost and efficient applications for both VoDSL and VoIP solutions.

The following table sets forth other features of the VoIP speech co-processors that we currently offer:

DSP Group’s Voice over Packet Speech Co-Processors

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The following is a list of manufacturers and brand names in which our products are incorporated:

Manufacturers and Brands

International Sales and Operations

Export sales accounted for 99% of our total revenues in each of the years 2002 and 2001, and 95% in 2000. Although all of our sales to foreign entities are denominated in United States dollars, we are subject to risks of conducting business internationally. These risks include unexpected changes in regulatory requirements, fluctuations in exchange rates that could increase the price of our products in foreign markets, delays resulting from difficulty in obtaining export licenses for certain technology, tariffs, other barriers and restrictions and the burden of complying with a variety of foreign laws. See Note 9 of the attached Notes to Consolidated Financial Statements for the year ended December 31, 2002, for a summary of our operations within various geographic areas.

Moreover, part of our expenses in Israel are paid in Israeli currency, which subjects us to the risks of foreign currency fluctuations between the U.S. dollar and the New Israeli Shekel (NIS) and to economic pressures resulting from Israel’s general rate of inflation. Our primary expenses paid in NIS are employee salaries and lease payments on our Israeli facilities. As a result, an increase in the value of Israeli currency in comparison to the U.S. dollar could increase the cost of our technology development, research and development expenses and general and administrative expenses.

Sales, Marketing and Distribution

We market and distribute our products through our direct sales and marketing offices, as well as through a network of distributors and independent OEM representatives. Our sales and marketing team, working out of our sales offices in Santa Clara, California; Tokyo, Japan; Herzelia Pituach, Israel and Edinburgh, Scotland, pursues business with our customers in North and South America, Europe and Asia. In territories worldwide where we do not have sales offices, we solely operate through a network of distributors and independent OEM representatives. A significant portion of our worldwide sales is derived from our Japanese distributor, Tomen Electronics. Sales to Tomen Electronics comprised 81% of our total revenues in 2002, 72% in 2001 and 66% in 2000. In September 2000, we invested approximately $485,000 in the parent company of Tomen Electronics. For more information, see Note 6 to the attached Notes to Consolidated Financial Statements for the year ended December 31, 2002. Furthermore, Tomen Electronics sells our products to a limited number of customers. One customer of Tomen Electronics, Panasonic, has continually accounted for a majority of Tomen Electronics’ sales. Moreover, our sales representatives and distributors are not subject to minimum purchase requirements and can cease marketing our products at any time. The loss of one or more representatives or their failure to renew

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agreements with us upon expiration, especially Tomen Electronics, could harm our business, financial condition and results of operations. Additionally, the loss of Panasonic and Tomen Electronics’ inability to thereafter effectively market our products could also materially harm our sales and results of operations.

Manufacturing and Design Methodology

All of our manufacturing occurs at independent foundries. We contract fabrication services for speech and telephony processors and RF devices from TSMC, Sony and UMC. Under non-exclusive arrangements, these independent foundries normally provide us with either finished, packaged and tested speech processors at variable prices depending on the volume of units purchased or as sorted good wafers or as un-sorted wafers. We develop detailed testing procedures and specifications for each product and require each subcontractor to use these procedures and specifications before shipping us finished products. We test our products at ASE, TSMC and Sony and use ASE and SPIL as subcontractors for dies packaging.

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

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

Competition

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

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

Similar principal competitive factors affect the Voice over Packet market. We also believe that we are competitive with respect to most of these factors. Our principal competitors in the Voice over Packet market include Telogy Network (a Texas Instruments Company), GlobalVirata, AudioCodes, Texas Instruments, Broadcom, Infineon and Oki Electronic.

Also, in addition to our TrueSpeech algorithms, several other digital speech compression technologies exist and are currently being developed that may be promoted by our competitors as industry standards for the computer telephony and personal computer markets.

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Price competition in the markets in which we currently compete and propose to compete is intense and may increase, which could harm our business, financial condition and results of operations. We have experienced and will continue to experience increased competitive pricing pressures for our IDT processors. We were able to partially offset price reductions which occurred during 2002 through manufacturing cost reductions and by achieving a higher level of product integration. However, we cannot assure you that we will be able to further reduce production costs, or be able to compete successfully with respect to price or any other key competitive factors in the future.

Research and Development

We believe that the continued timely development and introduction of new products is essential to maintain our competitive position. We currently conduct most of our product development at our facilities. At December 31, 2002, we had a staff of 85 research and development personnel, of which 67 were located in Israel. We also employ independent contractors to assist with certain product development and testing activities. We spent approximately $19.7 million in 2002, $21.1 million in 2001 and $16.1 million in 2000, on research and development activities.

Licenses, Patents and Trademarks

We have been granted 20 United States patents, one Canadian patent, two Israeli patents and one Taiwanese patent, and have seven patents pending in the United States, two patents pending in Japan, and two patents pending in Israel. We actively pursue foreign patent protection in countries of interest to us. Our policy is to apply for patents or for other appropriate statutory protection when we develop valuable new or improved technology. The status of any patent involves complex legal and factual questions, and the breadth of claims allowed is uncertain. Accordingly, we cannot assure you that any patent application filed by us will result in a patent being issued, or that our patents, and any patents that may be issued in the future, will afford adequate protection against competitors with similar technology; nor can we provide assurance that patents issued to us will not be infringed or designed around by others. In addition, the laws of certain countries in which our products are or may be developed, manufactured or sold, including Hong Kong, Japan and Taiwan, may not protect our products and intellectual property rights to the same extent as the laws of the United States.

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

The semiconductor and software industries are subject to frequent litigation regarding patent and other intellectual property rights. While claims involving any material patent or other intellectual property rights have not been brought against us to date, we cannot provide assurance that third parties will not assert claims against us with respect to existing or future products, or that we will not need to assert claims against third parties to protect our proprietary technology. For example, in a lawsuit against Microsoft Corporation, AT&T has asserted that our TrueSpeech algorithm includes certain elements covered by a patent held by AT&T. AT&T has sued Microsoft, one of our TrueSpeech licensees, for infringement. We have not been named in AT&T’s suit against Microsoft. If litigation becomes necessary to determine the validity of any third party claims or to protect our proprietary technology, it could result in significant expense to us and could divert the efforts of our technical and management personnel, whether or not the litigation is determined in our favor. In the event of an adverse result in any litigation, we could be required to expend significant resources to develop non-infringing technology or to obtain licenses to the technology that is the subject of the litigation. We cannot provide assurance that we would be successful in developing non-infringing technology or that any licenses would be available on commercially reasonable terms.

We have trademark registrations for the following marks:  TRUESPEECH, FULL DUPLEX SPEAKERPHONE, and TRIPLE RATE CODER. In addition, we have applied for a trademark registration for TOTAL TELEPHONY SOLUTIONS.

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

Backlog

At December 31, 2002, our backlog was approximately $29.6 million compared with approximately $17.0 million at December 31, 2001. We include in our backlog all accepted product purchase orders with respect to which a delivery schedule has been specified for product shipment within one year. Our business is characterized by short-term order and shipment schedules. Product orders in our current backlog are subject to changes in delivery schedules or to cancellation by the purchaser. Accordingly, although useful for scheduling production, backlog as of any particular date may not be a reliable measure of our sales for any future period.

Employees

At December 31, 2002, we had 149 employees, including 85 in research and development, 21 in marketing and sales and 43 in corporate and administration and manufacturing coordination. Competition for personnel in the semiconductor, software and personal computer industries in general is intense. We believe that our future prospects will depend, in part, on our ability to continue to attract and retain highly-skilled technical, marketing and management personnel, who are in great demand. In particular, there is a limited supply of highly-qualified engineers with digital signal processing experience. None of our employees is represented by a collective bargaining agreement, nor have we ever experienced any work stoppage. We believe that relations with our employees are good.

Risk Factors

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

We rely on a primary distributor for significant portion of our total revenues and the failure of this distributor to perform as expected would materially reduce our future sales and revenues.

We sell our products to customers primarily through a network of distributors and OEM representatives. Particularly, revenues from our Japanese distributor, Tomen Electronics, accounted for 81% of our total revenues in 2002 and 72% of our total revenues in 2001. Our future performance will depend, in part, on this distributor to continue to successfully market and sell our products. Furthermore, Tomen Electronics sells our products to a limited number of customers. One customer of Tomen Electronics, Panasonic, has continually accounted for a majority of Tomen Electronics’ sales. The loss of Tomen Electronics as our distributor and our inability to obtain a satisfactory replacement in a timely manner will materially harm our sales and results of operations. Additionally, the loss of Panasonic and Tomen Electronics’ inability to thereafter effectively market our products could also materially harm our sales and results of operations.

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Because our products are components of end products, if OEMs do not incorporate our products into their end products or if the end products of our OEM customers do not achieve market acceptance, we may not be able to generate adequate sales of our products.

Our products are not sold directly to the end-user; rather, they are components of end products. As a result, we rely upon OEMs to incorporate our products into their end products at the design stage. Once an OEM designs a competitor’s product into its end product, it becomes significantly more difficult for us to sell our products to that customer because changing suppliers involves significant cost, time, effort and risk for the customer. As a result, we may incur significant expenditures on the development of a new product without any assurance that an OEM will select our product for design into its own product and without this “design win,” it becomes significantly difficult to sell our products. Moreover, we rely on the end products of our OEM customers that incorporate our products to achieve market acceptance. Many of our OEM customers face intense competition in their markets. If end products that incorporate our products are not accepted in the marketplace, we may not achieve adequate sales volume of our products, which would have a negative effect on our results of operations.

The continuing worldwide economic slowdown and related uncertainties may adversely impact our revenues and profitability.

Slower economic activity, decreased consumer confidence, reduced corporate profits and capital spending, adverse business conditions and liquidity concerns in the telecommunications, semiconductor and related industries, and recent international conflicts and terrorist and military activity have resulted in a continuing downturn in worldwide economic conditions. If these unfavorable economic conditions continue, we may experience a slowdown in customer orders, an increase in the number of cancellations and rescheduling of backlog. We cannot predict the timing, strength and duration of any economic recovery in the telecommunications and semiconductor industry. In addition, the events of September 11, 2001, subsequent international conflicts and terrorist acts, and the current war with Iraq, can be expected to place further pressure on economic conditions in the United States and worldwide. These conditions make it difficult for our customers, our vendors and for us to accurately forecast and plan future business activities. If such conditions continue or worsen, our business, financial condition and results of operations may be materially and adversely affected.

Because our quarterly operating results may fluctuate significantly, the price of our common stock may decline.

Our quarterly results of operations may vary significantly in the future for a variety of reasons, many of which are outside our control, including the following:

Each of the above factors is difficult to forecast and could harm our business, financial condition and results of operations. Also, we sell our products to OEM customers that operate in consumer markets. As a result, our

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revenues are affected by seasonality sales to our OEM customers and the market acceptance of end products supplied by our OEM customers. The fourth quarter is usually the strongest quarter for sales by our OEM customers in the consumer markets, and thus, our third quarter is usually the strongest quarter for revenues.

Our average selling prices continue to decline which may materially adversely affect our profitability.

Sales of our Integrated Digital Telephony (IDT) products comprised 97% in 2002 and 94% in 2001 of our total revenues. We have experienced and continue to experience a decrease in the average selling prices of our IDT processors, which we have to date been able to partially offset on an annual basis through manufacturing cost reductions by achieving a higher level of product integration and combining other functions. We cannot guarantee that our ongoing efforts will be successful or that they will keep pace with the anticipated, continuing decline in average selling prices of our IDT processors.

We generate a significant amount of our total revenues from the sale of Integrated Digital Telephony (IDT) products and our business and operating results may be materially adversely affected if we do not continue to succeed in the highly competitive IDT market.

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

Because we depend on independent foundries to manufacture all of our integrated circuit products, we are subject to additional risks that may materially disrupt our business.

All of our integrated circuit products are manufactured by independent foundries. While these foundries have been able to adequately meet the demands of our increasing business, we are and will continue to be dependent upon these foundries to achieve acceptable manufacturing yields, quality levels and costs, and to allocate to us a sufficient portion of their foundry capacity to meet our needs in a timely manner. We currently do not have long-term supply arrangements with any of these foundries. Therefore, they are not obligated to perform services or supply products to us for any specific period or in any specific quantities. Our business could also be harmed if one or more of the foundries terminates its relationship with us and we are unable to obtain satisfactory replacements to fulfill customer orders on a timely basis and in a cost-effective manner.

To meet our increased wafer requirements, we have added additional manufacturing sites to manufacture our processors. However, there may be shortages in worldwide foundry capacity due to increases in semiconductor demand or other factors. In the event of such a shortage, we may not be able to obtain a sufficient allocation of foundry capacity to meet our product needs. In addition, such a shortage could lengthen our products’ manufacturing cycle and cause a delay in the shipments of our products to our customers. This could ultimately lead to a loss of sales of our products, harm our reputation and competitive position, and our revenues could be materially reduced. In addition, foundries in Taiwan produce a significant portion of our wafers. As a result, earthquakes, aftershocks or other natural disasters in Asia could preclude us from obtaining an adequate supply of wafers to fill customer orders and could harm our reputation, business, financial condition, and results of operations.

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Because the manufacture of our products is complex, the foundries on which we depend may not achieve the necessary yields or product reliability that our business requires.

The manufacture of our products is a highly complex and precise process, requiring production in a highly controlled environment. Changes in manufacturing processes or the inadvertent use of defective or contaminated materials by a foundry could adversely affect the foundry’s ability to achieve acceptable manufacturing yields and product reliability. If the foundries we currently use do not achieve the necessary yields or product reliability, our customer relationships could suffer. This could ultimately lead to a loss of sales of our products and have a negative effect on our results of operations.

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

Because we have significant international operations, we may be subject to political, economic and other conditions relating to our international operations that could increase our operating expenses and disrupt our business.

We are dependent on sales to customers outside the United States. We expect that international sales will continue to account for a significant portion of our net product sales for the foreseeable future. For example, export sales, primarily consisting of IDT speech processors shipped to manufacturers in Europe and Asia, including Japan, represented 99% of our total revenues for 2002. As a result, the occurrence of any negative international political, economic or geographic events could result in significant revenue shortfalls. These shortfalls could cause our business, financial condition and results of operations to be harmed. Some of the risks of doing business internationally include:

Because we have significant operations Israel, we may be subject to political, economic and other conditions affecting Israel that could increase our operating expenses and disrupt our business.

Our principal research and development facilities are located in the State of Israel and, as a result, at December 31, 2002, 112 of our 149 employees were located in Israel, including 67 out of 85 of our research and development personnel. In addition, although we are incorporated in Delaware, a majority of our directors and executive officers are residents of Israel. Although substantially all of our sales currently are being made to customers outside of Israel, we are nonetheless directly influenced by the political, economic and military conditions affecting Israel. Any major hostilities involving Israel, or the interruption or curtailment of trade between Israel and its present trading partners, could significantly harm our business, operating results and financial condition.

Israel’s economy has been subject to numerous destabilizing factors, including a period of rampant inflation in the early to mid-1980’s, low foreign exchange reserves, fluctuations in world commodity prices, military

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conflicts and civil unrest. In addition, Israel and companies doing business with Israel have been the subject of an economic boycott by the Arab countries since Israel’s establishment. Although they have not done so to date, these restrictive laws and policies may have an adverse impact on our operating results, financial condition or expansion of our business.

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

Our future profits may be diminished if the current Israeli tax benefits that we enjoy are reduced or withheld.

We receive certain tax benefits in Israel, particularly as a result of the “Approved Enterprise” status of our facilities and programs. To be eligible for tax benefits, we must meet certain conditions, relating principally to adherence to the investment program filed with the Investment Center of the Israeli Ministry of Industry and Trade and to periodic reporting obligations. Although we have met such conditions in the past, should we fail to meet such conditions in the future, we would be subject to corporate tax in Israel at the standard rate of 36%, and could be required to refund tax benefits already received. We cannot assure you that such grants and tax benefits will be continued in the future at their current levels, if at all. The termination or reduction of certain programs and tax benefits (particularly benefits available to us as a result of the Approved Enterprise status of our facilities and programs) or a requirement to refund tax benefits already received may have a material adverse effect on our business, operating results and financial condition.

Our failure, and the failure of our OEM customers, to obtain the necessary complementary components required to produce various products could diminish the sales of our products.

Our IDT speech processor products require an external component in the finished product to provide Analog Random Access Memory circuits (ARAMs) and flash memory which are supplied by third party manufacturers. Temporary fluctuations in the pricing and availability of these components could negatively impact sales of our IDT speech processors, which could in turn harm our business, financial condition and results of operations. In addition, some of the raw materials, components and subassemblies included in the end products manufactured by our OEM customers, which also incorporate our products, are obtained from a limited group of suppliers. Supply disruptions, shortages or termination of any of these sources could have an adverse effect on our business and results of operations due to the delay or discontinuance of orders for our products by our OEM customers until those necessary components are available for their end products.

We may engage in future acquisitions that could dilute our stockholders’ equity and harm our business, results of operations and financial condition.

We have pursued, and will continue to pursue, growth opportunities through internal development and acquisition of complementary businesses, products and technologies. We are unable to predict whether or when any other prospective acquisition will be completed. The process of integrating an acquired business may be prolonged due to unforeseen difficulties and may require a disproportionate amount of our resources and management’s attention. We cannot assure you that we will be able to successfully identify suitable acquisition candidates, complete acquisitions, integrate acquired businesses into our operations, or expand into new markets.

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Further, once integrated, acquisitions may not achieve comparable levels of revenues, profitability or productivity as our existing business or otherwise perform as expected. The occurrence of any of these events could harm our business, financial condition or results of operations. Future acquisitions may require substantial capital resources, which may require us to seek additional debt or equity financing.

Future acquisitions by us could result in the following, any of which could seriously harm our results of operations or the price of our stock:

Third party claims of infringement or other claims against us could adversely affect our ability to market our products, require us to redesign our products or seek licenses from third parties, and seriously harm our operating results and disrupt our business.

As is typical in the semiconductor industry, we have been and may from time to time be notified of claims that we may be infringing patents or intellectual property rights owned by third parties. For example, in a lawsuit against Microsoft Corporation, AT&T has asserted that our TrueSpeech algorithm includes certain elements covered by a patent held by AT&T. AT&T has sued Microsoft, one of our TrueSpeech licensees, for infringement. If litigation becomes necessary to determine the validity of any third party claims, it could result in significant expense to us and could divert the efforts of our technical and management personnel, whether or not the litigation is determined in our favor.

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

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

We may not be able to adequately protect or enforce our intellectual property rights, which could harm our competitive position.

Our success and ability to compete is in part dependent upon our internally-developed technology and other proprietary rights, which we protect through a combination of copyright, trademark and trade secret laws, as well as through confidentiality agreements and licensing arrangements with our customers, suppliers, employees and consultants. In addition, we have filed a number of patents in the United States and in other foreign countries with respect to new or improved technology that we have developed. However, the status of any patent involves

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complex legal and factual questions, and the breadth of claims allowed is uncertain. Accordingly, we cannot assure you that any patent application filed by us will result in a patent being issued, or that the patents issued to us will not be infringed by others. Also, our competitors and potential competitors may develop products with similar technology or functionality as our products, or they may attempt to copy or reverse engineer aspects of our product line or to obtain and use information that we regard as proprietary. Moreover, the laws of certain countries in which our products are or may be developed, manufactured or sold, including Hong Kong, Japan and Taiwan, may not protect our products and intellectual property rights to the same extent as the laws of the United States. Policing the unauthorized use of our products is difficult and may result in significant expense to us and could divert the efforts of our technical and management personnel. Even if we spend significant resources and efforts to protect our intellectual property, we cannot assure you that we will be able to prevent misappropriation of our technology. Use by others of our proprietary rights could materially harm our business and expensive litigation may be necessary in the future to enforce our intellectual property rights.

Our operating results may fluctuate significantly due to the cyclicality of the semiconductor industry, which could adversely affect the market price of our common stock.

We operate in the semiconductor industry, which is cyclical and subject to rapid technological change and evolving industry standards. From time to time, the semiconductor industry has experienced significant downturns such as the current one. These downturns are characterized by diminished product demand, excess customer inventories, accelerated erosion of prices and excess production capacity. These factors could cause substantial fluctuations in our revenues and in our results of operations. The current downturn and future downturns in the semiconductor industry may be severe and prolonged, and any failure of this industry to fully recover from the current downturn could seriously impact our revenue and harm our business, financial condition and results of operations. The semiconductor industry also periodically experiences increased demand and production capacity constraints, which may affect our ability to ship products in future periods. Our quarterly results may vary significantly as a result of the general conditions in the semiconductor industry, which could cause our stock price to decline.

Because the markets in which we compete are highly competitive, and many of our competitors have greater resources than we do, we cannot be certain that our products will be accepted in the marketplace or capture market share.

The markets in which we operate are extremely competitive and characterized by rapid technological change, evolving standards, short product life cycles and price erosion. We expect competition to intensify as current competitors expand their product offerings and new competitors enter the market. Given the highly competitive environment in which we operate, we cannot be sure that any competitive advantages enjoyed by our current products would be sufficient to establish and sustain our new products in the market. Any increase in price or competition could result in the erosion of our market share, to the extent we have obtained market share, and would have a negative impact on our financial condition and results of operations.

In each of our business activities, we face current and potential competition from competitors that have significantly greater financial, technical, manufacturing, marketing, sales and distribution resources and management expertise than we do. These competitors may also have pre-existing relationships with our customers or potential customers. Further, in the event of a manufacturing capacity shortage, these competitors may be able to manufacture products when we are unable to do so. Our principal competitors in the cordless market include National Semiconductor, Philips and Infineon. Our principal competitors in the Voice over Packet market include Telogy Network (a Texas Instruments Company), GlobalVirata, AudioCodes, Texas Instruments, Broadcom, Infineon and Oki Electronic. Our principal competitors with respect to digital speech compression technologies include AT&T and Motorola.

We cannot be sure that we will have the financial resources, technical expertise or marketing and support capabilities to continue to compete successfully. Our future prospects will depend greatly on our ability to

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successfully develop and introduce new products that are responsive to market demands. We cannot assure you that we will be able to successfully develop or market new products.

Because our products are complex, the detection of errors in our products may be delayed, and if we deliver products with defects, our credibility will be harmed, the sales and market acceptance of our products may decrease and product liability claims may be made against us.

Our products are complex and may contain errors, defects and bugs when introduced. If we deliver products with errors, defects or bugs, our credibility and the market acceptance and sales of our products could be significantly harmed. Furthermore, the nature of our products may also delay the detection of any such error or defect. If our products contain errors, defects and bugs, then we may be required to expend significant capital and resources to alleviate these problems. This could result in the diversion of technical and other resources from our other development efforts. Any actual or perceived problems or delays may also adversely affect our ability to attract or retain customers. Furthermore, the existence of any defects, errors or failures in our products could lead to product liability claims or lawsuits against us or against our customers. We generally provide our customers with a standard warranty for our products, generally lasting one year from the date of purchase. Although we attempt to limit our liability for product defects to product replacements, we may not be successful, and customers may sue us or claim liability for the defective products. A successful product liability claim could result in substantial cost and divert management’s attention and resources, which would have a negative impact on our financial condition and results of operations.

Our executive officers and key personnel are critical to our business, and because there is significant competition for personnel in our industry, we may not be able to attract and retain such qualified personnel.

Our success depends to a significant degree upon the continued contributions of our executive management team, and our technical, marketing, sales customer support and product development personnel. The loss of significant numbers of such personnel could significantly harm our business, financial condition and results of operations. We do not have any life insurance or other insurance covering the loss of any of our key employees. Because our products are specialized and complex, our success depends upon our ability to attract, train and retain qualified personnel, including qualified technical, marketing and sales personnel.

However, the competition for personnel is intense and we may have difficulty attracting and retaining such personnel.

We are exposed to fluctuations in currency exchange rates.

A significant portion of our business is conducted outside the United States. Export sales to manufacturers in Europe and Asia, including Japan, represented 99% of our total revenues in both 2002 and 2001, and 95% in 2000. Although most of our revenue and expenses are transacted in U.S. dollars, we may be exposed to currency exchange fluctuations in the future as business practices evolve and we are forced to transact business in local currencies. Moreover, part of our expenses in Israel are paid in Israeli currency, which subjects us to the risks of foreign currency fluctuations between the U.S. dollar and the New Israeli Shekel (NIS) and to economic pressures resulting from Israel’s general rate of inflation. Our primary expenses paid in NIS are employee salaries and lease payments on our Israeli facilities. As a result, an increase in the value of Israeli currency in comparison to the U.S. dollar could increase the cost of our technology development, research and development expenses and general and administrative expenses. From time to time, we use derivative instruments in order to minimize the effects of currency fluctuations, but our hedging positions may be partial, may not exist at all in the future or may not succeed in minimizing our foreign currency fluctuation risks.

Because the markets in which we compete are subject to rapid changes, our products may become obsolete or unmarketable.

The markets for our products and services are characterized by rapidly changing technology, short product life cycles, evolving industry standards, changes in customer needs, demand for higher levels of integration,

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growing competition and new product introductions. Our ability to adapt to these changes and to anticipate future standards, and the rate of adoption and acceptance of those standards, will be a significant factor in maintaining or improving our competitive position and prospects for growth. If new industry standards emerge, our products or our customers’ products could become unmarketable or obsolete, and we could lose market share. We may also have to incur substantial unanticipated costs to comply with these new standards. If our product development and improvements take longer than planned, the availability of our products would be delayed. Any such delay may render our products obsolete or unmarketable, which would have a negative impact on our ability to sell our products and our results of operations.

Because of changing customer requirements and emerging industry standards, we may not be able to achieve broad market acceptance of our products. Our success is dependent, in part, on our ability to:

We cannot be sure that we will be successful in these pursuits, that the growth in demand will continue or that our products will achieve market acceptance. Our failure to develop and introduce new products that are compatible with industry standards and that satisfy customer requirements, and the failure of our products to achieve broad market acceptance, could have a negative impact on our ability to sell our products and our results of operations.

We may experience difficulties in transitioning to smaller geometry process technologies or in achieving higher levels of design integration, which may result in reduced manufacturing yields, delays in product deliveries and increased expenses.

A growing trend in our industry is the integration of greater semiconductor content into a single chip to achieve higher levels of functionality. In order to remain competitive, we must achieve higher levels of design integration and deliver new integrated products on a timely basis. We will require us to expend greater research and development resources, and may be required to modify the manufacturing processes for some of our products, to achieve greater integration. We periodically evaluate the benefits, on a product-by-product basis, of migrating to smaller geometry process technologies to reduce our costs. Although this migration to smaller geometry process technologies has helped us to offset the declining average selling prices of our IDT products, this effort may not continue be successful. Also, because we are a fabless semiconductor company, we depend on our foundries to transition to smaller geometry processes successfully. We cannot assure you that our foundries will be able to effectively manage the transition. If our foundries or we experience significant delays in this transition or fail to efficiently implement this transition, our business, financial condition and results of operations could be materially and adversely affected.

Our certificate of incorporation and bylaws contain anti-takeover provisions that could prevent or discourage a third party from acquiring us.

Our certificate of incorporation and bylaws contain provisions that may prevent or discourage a third party from acquiring us, even if the acquisition would be beneficial to our stockholders. We have a staggered board, which means it will generally take two years to change the composition of our board. Our board of directors also has the authority to fix the rights and preferences of shares of our preferred stock and to issue such shares without

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a stockholder vote. We also have a rights plan in place. It is possible that these provisions may prevent or discourage third parties from acquiring us, even if the acquisition would be beneficial to our stockholders. In addition, these factors may also adversely affect the market price of our common stock, and the voting and other rights of the holders of our common stock.

War with Iraq and future attacks may negatively impact all aspects of our operations, revenues, costs and stock price.

The current war with Iraq and recent terrorist attacks in the United States, as well as future events occurring in response or connection to them, including future terrorist attacks against United States targets, or military or trade disruptions impacting our domestic or foreign suppliers of merchandise, may impact our operations. We may experience delays or losses in the delivery of wafer supplies to us and decreased sales of our products. More generally, any of these events could cause consumer confidence and spending to decrease or result in increased volatility in the United States and worldwide financial markets and economy. They also could result in economic recession in the United States or abroad. Any of these occurrences could have a significant impact on our operating results, revenues and costs.

Our stock price may be volatile so you may not be able to resell your shares of our common stock at or above the price you paid for them.

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

Item 2.    PROPERTIES.

Our operations in the United States are located in an approximately 14,345 square foot leased facility in Santa Clara, California. This facility is leased through March 31, 2004. Our operations in Israel are located in approximately 19,645 square feet of leased facilities, with the primary leased facility located in Herzelia Pituach, Israel. These facilities are leased through November 2003. We also have approximately 3,197 square feet of leased facility in Tokyo, Japan, used for sales and marketing activities. VoicePump operations in the United States are located in approximately 2,055 square feet of leased facilities in Chicago, Illinois. We believe that our existing facilities are adequate to meet our needs for the immediate future.

Item 3.    LEGAL PROCEEDINGS.

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

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

None.

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PART II

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

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

As of March 14, 2003, there were approximately 79 holders of record of our common stock, which we believe represents approximately 11,237 beneficial holders. We have not paid cash dividends on our common stock and presently intend to continue a policy of retaining any earnings for reinvestment in our business.

Information relating to our equity compensation plans will be presented under the caption “Equity Compensation Plan Information” of our definitive proxy statement pursuant to Regulation 14A in connection with the Annual Meeting of Stockholders to be held on May 27, 2003. The definitive proxy statement will be filed with the Securities and Exchange Commission no later than 120 days after the end of the fiscal year covered by this report. Such information is incorporated herein by reference.

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Item 6.    SELECTED FINANCIAL DATA.

The selected historical consolidated financial data presented below is derived from our consolidated financial statements. The results of operations, including revenue, operating expenses, financial income and taxes on income of the DSP cores licensing business for the years ended December 31, 2002, 2001, 2000, 1999 and 1998, have been reclassified in the accompanying statements of operations as discontinued operations. Our balance sheets at December 31, 2002, 2001, 2000, 1999, 1998 reflect the assets and the liabilities of the DSP cores licensing business as assets and liabilities of discontinued operations within current assets and liabilities. Thus, the financial information presented herein includes only the continued operations. The consolidated financial statements for the fiscal years ended December 31, 2002, 2001 and 2000 have been audited by Kost Forer & Gabbay, a member of Ernst & Young Global. The selected consolidated financial data set forth below is qualified in its entirety by, and should be read in conjunction with, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

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

Overview

The financial section of this Annual Report consists of the following management’s discussion of our financial condition and results of operations, and the accompanying consolidated financial statements for the year ended December 31, 2002 and the related notes. The management’s discussion section is designed to provide you with a narrative about our financial results. Our consolidated financial statements include an overview of our income and cash flow performance and financial position. Explanatory notes follow the consolidated financial statements. Among other things, the notes to our financial statements contain our accounting policies, detailed information on balances within the financial statements and certain contingencies and commitments. We follow United States Generally Accepted Accounting Principles. We have one reporting segment after the separation of our DSP core licensing business.

Due to various applicable reporting and disclosure rules, a reader may be somewhat overwhelmed by the length and detail required for a discussion of our financial condition and results of operations. Therefore, the following overview is designed to provide you with some perspective regarding the information contained in this financial section, as well as a better understanding of the key drivers and concerns of our business.

Our business model is relatively straightforward. We are a fabless semiconductor company. We develop, design, market and sell chip-sets that incorporate technologies such as DSP processors, communications technologies, highly advanced RF devices and in-house developed VoIP hardware and software technologies, to residential telephone equipment manufacturers.

As discussed earlier in the introduction to the business section of this Annual Report, in November 2002, we transferred our DSP cores licensing business to Ceva which thereafter combined with Parthus and the combined company was renamed ParthusCeva. The assets contributed to Ceva included $40 million in cash and prepaid transaction expenses related to the Separation and Combination that exceeded $2 million, as well as fixed assets and other tangible assets related to the DSP cores licensing business. This transfer of cash and assets is reflected in our financial statements as “dividend-in-kind” and was charged to our retained earnings in the amount of $48,428,000.

In anticipation of the consummation of the Separation, as of June 30, 2002, we began to report the operating results of our DSP cores licensing business as discontinued operations. The results of operations, including revenue, operating expenses, financial income and taxes on income of the DSP cores licensing business for the years ended December 31, 2002, 2001, 2000, 1999 and 1998, have been reclassified in the accompanying statements of operations as discontinued operations. Our balance sheets at December 31, 2002, 2001, 2000, 1999, 1998 reflect the assets and the liabilities of the DSP cores licensing business as assets and liabilities of discontinued operations within current assets and liabilities. Thus, the financial information presented herein includes only the continued operations. Prior to the Separation, we also generated revenues from software licensing, royalties and maintenance and support fees. After the Separation, we are a more focused fabless semiconductor business concentrating on product sales.

During the last five years, from 1998 to 2002, our fabless semiconductor business model has produced $410 million of revenues and $118 million of net income from continuing operations, excluding revenues from the DSP cores licensing business. We also achieved an increase of $170 million in our cash, cash equivalents and marketable securities after the distribution of $40 million in cash to Ceva and other related payments in connection with the Separation.

During recent years, we have become a worldwide leader in developing and marketing Total Telephony Solutions^™ for a wide range of applications for wireless residential markets. The key factor that enabled us to grow our business over the previous years is our ability to combine and integrate our expertise in DSP core

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technology with proprietary advanced RF devices and communications technologies and speech-processing algorithms. The integration and expansion of various capabilities, features and technologies allow us to better penetrate the residential wireless telephony markets and to take advantage of the three trends in the market: (1) the move from wired to wireless products, (2) the transformation from analog-based to digital-based technologies incorporated within the telephony products, and (3) the market acceptance of and change of bandwidth for the telephony products from 900MHz to 2.4GHz technologies. Our focus on the convergence of these three trends has allowed us to offer products with more features, and better range, security and voice quality, as well as, the ability in the future to integrate voice and data in the same device.

In 2002, the increase in our revenues was primarily a result of strong demand from our OEM customers, especially in Japan, for our 2.4GHz single- and multi-hand-set chip-sets. Our ability to offer a more integrated product, together with the growth of wireless residential markets, contributed to our significant growth. Products which we are developing in 2003 are the DECT (1.9GHz) chip-set for the European market, and a Bluetooth chip-set and a 5.8GHz chip-set for the U.S. market.

During 2002, we were able to offset the continued decline in average selling prices of our integrated circuits for the cordless telephony products by decreasing our manufacturing costs, partially due to technological improvements. Due to an increase in revenues and close monitoring of our expenses, we significantly increased our operating income as a percentage of total revenues from 1% in 2001 to 11% in 2002. Operating expenses as a percentage of total revenues decreased from 39% in 2001 to 29% in 2002.

However, our ability to continue the growth we experienced during the previous years depends significantly on market acceptance of our new products, as well as our ability to deliver state-of-the-art technologies in a cost-effective and timely manner. We are also very dependent on the ability of our OEM customers to penetrate the consumer markets with their end products that integrate our technologies. Further, we are dependent on our ability to continue to monitor and control costs and improve operating yields in order to offset future declines in average selling prices. We cannot assure you that our business will grow at the previous pace, if at all. You should not rely upon our past operating results as an indication of future performance.

Critical Accounting Policies

We consider certain accounting policies related to revenue recognition, allowance for doubtful accounts, inventory valuation, impairment of goodwill other than a temporary decline in the value of marketable securities, and contingencies to be critical policies due to the estimation processes involved in each.

Use of Estimates.    The preparation of the consolidated financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires us to establish accounting policies that contain estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. On an on-going basis, we evaluate our estimates, including those related to product returns, bad debts, inventories, investments, intangible assets and contingencies. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. These policies include:

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We have other equally important accounting policies and practices which may not require us to make significant estimates or assumption. Despite our intention to establish accurate estimates and assumptions, actual results could differ from those estimates under different assumptions or conditions.

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

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Such impairment loss is measured by comparing the recoverable amount of an asset with its carrying value. The determination of the value of goodwill requires management to make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective asset. If these estimates or the related assumptions change in the future, we could be required to record impairment charges. Any material change in our valuation of assets in the future and any consequent adjustment for impairment could have a material adverse impact on our future reported financial results.

Our future operating results will be dependent upon a variety of factors. In evaluating our business, you should carefully consider the information set forth in the section captioned “Risk Factors” and other sections of this Annual Report on Form 10-K.

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

Results of Operations:

Despite facing the challenging, volatile and uncertain global business environment and contraction in the semiconductor industry, during 2002, we significantly increased our revenues and net income from our fabless semiconductor business (excluding the discontinued operations of our DSP cores licensing business). In 2002, we demonstrated year-over-year growth of 40% in revenues. Our gross profit and operating income increased by 40% and 1129%, respectively, compared to 2001.

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Total Revenues.    Our total revenues from continuing operations were $125.2 million in 2002, $89.1 million in 2001 and $86.6 million in 2000. This represents an increase in revenues of 40% in 2002 as compared to revenues in 2001, and an increase of 6% in revenues in 2001 as compared to those in 2000. Our revenues for the year 2002 increased primarily as a result of strong demand for our new 2.4GHz single hand-set and 2.4GHz multi-hand-set products. The increase in revenues in 2001 as compared to 2000 was primarily the result of strong demand for our 900MHz narrow-band chip-set. As we are a fabless semiconductor company selling our products to OEM customers that operate in the consumer market, our revenues are affected by seasonality sales to these customers. The fourth quarter is usually the strongest quarter for sales by our OEM customers in the consumer markets, and thus, our third quarter is usually the strongest quarter for revenues, as we supply components to our OEM customers for integration into their end products. This trend can be observed from reviewing our quarterly information and results of operations.

We also generate revenues from the licensing of our TrueSpeech algorithms. However, license fees and per unit royalties from TrueSpeech licensees have not been significant to date, and we do not expect them to increase significantly in the future.

Export sales consisting of Integrated Digital Telephony (IDT) speech processors shipped to manufacturers in Europe and Asia, including Japan, represented 99% of our total revenues in both 2002 and 2001, and 95% in 2000. The increase in export sales in 2002 and 2001 as compared to 2000 was primarily due to higher sales to the Japanese market. All export sales are denominated in U.S. dollars.

Significant Customers.    Revenues from one distributor, Tomen Electronics, accounted for 81% of our total revenues in 2002 as compared to 72% in 2001 and 66% in 2000. The increase in 2002 as compared to 2001 was primarily due to a greater volume of sales in Japan. The Japanese market and the OEMs that operate in that market are among the largest suppliers with significant market share in the U.S. market for residential wireless products. The loss of Tomen Electronics or one or more of our other major distributors or customers, or the loss by Tomen Electronics of one of its major customers, could materially harm our business, financial condition and results of operations.

Gross Profit.    Gross profit as a percentage of product sales was 40% in each of 2002 and 2001, and 44% in 2000. In 2002, we managed to offset the continued decline in average selling prices of our products with a reduction in manufacturing costs, due to technological improvements and continuing improvements in our yield percentages, especially in our RF products. Maintaining our gross margins in 2002 as compared to 2001 was also attributed to the introduction of our new 2.4GHz product lines which have higher pricing and higher margins, as well as the integration of more semiconductor content in a single system. However, we cannot guarantee that our ongoing efforts in cost reduction will be successful or that they will keep pace with the anticipated continued decline in average selling prices of our processors.

Research and Development Expenses.    Research and development expenses decreased to $19.7 million in 2002 from $21.0 million in 2001, and were $16.0 million in 2000. The decrease was primarily attributed to the decrease in expenses related to VoIP projects, as well as the devaluation of the New Israeli Shekel (NIS) compared to the U.S. dollar. A significant portion of our research and development team is located and employed in our Israeli development center. As a result, we experienced a decrease in engineers’ payroll expenses denominated in NIS of our research and development employees employed by our Israeli subsidiary, partially offset by greater use of subcontractors and semiconductor mask work expenses incurred in connection with the introduction of new products. The increase in research and development expenses in 2001 as compared to 2000 was primarily due to the hiring of additional engineers associated with our VoIP and RF 2.4GHz CMOS design projects. Research and development expenses as a percentage of total revenues were 16% in 2002, 24% in 2001 and 19% in 2000. The decrease in percentage in 2002 as compared to 2001 resulted mainly from higher level of revenues in 2002. The increase in 2001 as compared to 2000 was primarily due to hiring additional engineers associated with our VoIP and RF projects. Research and development expenses consist mainly of payroll to employees involved in research and development activities, tape-out and mask work, subcontracting and

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engineering, depreciation and maintenance fees relating to equipment and software tools involved with the development work and associated facilities expenses.

Sales and Marketing Expenses.    Our sales and marketing expenses were $10.7 million in 2002, $9.2 million in 2001 and $10.4 million in 2000. The increase in 2002 as compared to 2001 was primarily attributed to payment of higher sales commissions due to higher revenues. The higher sales commissions were partially offset by lower payroll expenses denominated in NIS for our sales and marketing employees employed by our Israeli subsidiary due to a decrease in the value of NIS in comparison to the United States dollar. The slight decrease in expenses in 2001 as compared to 2000 was primarily attributed to lower sales commissions due to different commission rates applied to the change in product mix sold in 2001. Sales and marketing expenses as a percentage of total revenues were 9% in 2002, 10% in 2001 and 12% in 2000. Sales and marketing expenses consist mainly of sales commissions to our representatives and distributors, payroll expenses to direct sales and marketing employees, trade show expenses and associated facilities expenses.

General and Administrative Expenses.    Our general and administrative expenses increased slightly to $5.0 million in 2002 from $4.9 million in 2001 and $3.7 million in 2000. The increase in general and administrative expenses in 2002 was mainly due to higher level of bonus payments to our employees which was partially offset by lower expenses. These lower expenses were due to the cessation of amortization of goodwill associated with the acquisition of VoicePump, in accordance with SFAS No. 142 “Goodwill and Other Intangible Assets,” which was adopted in January 1, 2002. General and administrative expenses increased in 2001 from 2000 mainly due to additional personnel expenses as well as amortization of goodwill related to the acquisition of VoicePump. General and administrative expenses as a percentage of total revenues were 4% in 2002, 5% in 2001 and 4% in 2000. General and administrative expenses consist mainly of payroll for management and administrative employees, investor relations expenses, accounting and legal costs, as well as associated facilities expenses.

Unusual Items.    In the first quarter of 2002, we recorded two non-recurring expense items amounting to approximately $865,000 in the aggregate. An expense of approximately $767,000 was recorded with respect to the aborted initial public offering of our DSP cores licensing business. These expenses were comprised mainly of legal and accounting services rendered in 2001. Additionally, an expense of approximately $98,000 was recorded to reflect the write-off of all of our investment in Messagebay, Inc., a private company that develops both turnkey and customized software. In the first quarter of 2000, we recorded two non-recurring expense items amounting to approximately $14.2 million in the aggregate. A write-off of $11.9 million was recorded in respect of the acquired in-process research and development recorded in connection with the acquisition of approximately 73% of the outstanding shares of VoicePump. An expense of $2.3 million was recorded in order to reflect the accelerated amortization of acquired assets and intangibles related to the 1999 acquisition of 900MHz RF and baseband technology from Applied Micro Devices, Inc. We did not record any unusual items in 2001.

Interest and Other Income (Expense).    Interest and other income, net, decreased to income of $9.5 million in 2002 from income of $12.5 in 2001 and $13.0 million in 2000. The decrease in interest and other income net of interest expense in 2002 as compared to 2001 and in 2001 as compared to 2000, was a result of overall lower market interest rates in 2002 and 2001, partially offset by higher levels of cash, cash equivalents, marketable securities and short term bank deposits in 2002 and 2001.

Equity in Earnings of Affiliate.    Since April 1, 2001, we no longer maintained significant influence over the operating and financial policies of AudioCodes, Ltd. and thus stopped accounting for this investment under the equity method of accounting. Our equity in the net income of AudioCodes was $105,000 in 2001 (all of which was recorded in the first quarter of 2001) and $2,644,000 in 2000.

Minority Interest in Losses of Subsidiary.    We included in our consolidated statements of income for 2001, an amount of $173,000 for our minority interest in VoicePump’s losses (all of which was recorded in the first quarter of 2001). In 2000, our minority interest in VoicePump’s losses was $627,000.

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Impairment of Available-for-Sale Marketable Securities.    During the second quarter of 2002, our management’s evaluation indicated that the decline in value of AudioCodes’ ordinary shares was other than temporary. Therefore, in accordance with SFAS No. 115, we realized a loss on our investment in AudioCodes in the amount of $9.8 million, which was recorded as “impairment of available-for-sale marketable securities” in our unaudited consolidated statements of income for the six months ended June 30, 2002 and included as such in the consolidated statements of income for the year ended December 31, 2002. Impairment of available-for-sale marketable securities also included the decline in value of our investment in the equity securities of Tower Semiconductors Ltd. and Tomen Corporation, which were assessed to be other than temporary, amounting to $212,000 and $203,000, respectively (both recorded in the fourth quarter of 2002).

Provision for Income Taxes.    Our tax provision for 2002 and 2001 was $4.4 million and $2.4 million, respectively. In addition, we recorded a tax benefit which decreased our tax liability related to our investment in AudioCodes in the second quarter of 2002 in the amount of $3.5 million due to the impairment of such investment. Thus, the provision for income taxes presented in the financial statements amounted to $894,000 in 2002. In 2002 and 2001, we benefited for federal tax purposes from foreign tax holiday and tax exempt income in Israel.

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

In 2002, in connection with the Separation, DSP Group Ltd., our wholly-owned Israeli subsidiary, obtained a tax ruling from the Israeli tax authorities for the tax-exempt split plan pursuant to Section 105A(a) of the Israeli Income Tax Ordinance (“Section 105”). Under Section 105 and pursuant to the ruling, the majority of the assets that remain in DSP Group Ltd. after the Separation cannot be sold for a two-year period and is subject to other requirements as determined by law. As part of the Separation, certain benefits of the approved plans were assigned from DSP Group Ltd. to ParthusCeva Ltd., a wholly-owned Israeli subsidiary of ParthusCeva, Inc., as determined by the Israeli tax authorities, based on the volume of revenues of DSP Group Ltd. and its DSP cores licensing division in prior years.

Discontinued Operations.    On April 4, 2002, we entered into a combination agreement with Ceva, Inc., our then wholly-owned subsidiary and Parthus Technologies plc pursuant to which we agreed to affect a combination of Ceva with Parthus. On November 1, 2002, we contributed our DSP cores licensing business and the operations and related assets and liabilities of such business to Ceva and distributed all of the Ceva common stock we held to our stockholders. Immediately afterwards, Parthus was acquired by Ceva in exchange for the issuance of additional shares of Ceva common stock. The new combined company was renamed ParthusCeva, Inc.

In anticipation of the consummation of these transactions, as of June 30, 2002, we began to report the statements of income of our DSP cores licensing business as discontinued operations. Our financial statements for the years ended December 31, 2002, 2001 and 2000 are presented to reflect the operations of Ceva as discontinued operations.

Our financial statements for previous years included the DSP cores licensing business that was transferred to ParthusCeva. The assets, liabilities, results of operations and cash flows of the DSP cores licensing business were carved out from our financial statements and are presented as discontinued operations.

The consolidated financial statements have been carved out using the historical basis of the assets and liabilities and historical results of operations related to the DSP cores licensing business.

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Additionally, the discontinued operations for previous years include allocations of certain of our corporate headquarters assets, liabilities and expenses relating to the DSP cores licensing business.

The net income from discontinued operations include the costs directly attributable to the DSP cores licensing business, including charges for shared facilities, functions and services used by the DSP cores licensing business. Such costs include research and development costs, sales, and general and administrative expenses. Such allocations and charges are based on either a direct cost pass-through or a percentage of total costs for the services provided based on factors such as headcount or the specific level of activity directly related to such costs.

Our statements of income for 2002 include the results of operations of Ceva from the beginning of the year until the date of the Separation—November 1, 2002.

Net income derived from our DSP cores licensing business was $2.1 million for the 10 months ended October 30, 2002, as compared to $10.3 million and $9.3 million for the years ended December 31, 2001 and 2000, respectively. The decrease in 2002 as compared to 2001 and 2000 was primarily due to a decrease in total revenues for the DSP cores licensing business. Our total revenues for the DSP cores licensing business were $14.1 million for the 10 months period of 2002, as compared to $25.2 million and $22.9 million for the years 2001 and 2000, respectively. The decrease in 2002 as compared to 2001 was primarily due to (i) lower licensing revenues for the DSP cores licensing business, (ii) lower per-unit royalties from some of the license agreements for the DSP cores licensing business primarily due to volume pricing, and (iii) lower technical support and other revenues primarily attributed to the provision of fewer technical support and related services for the DSP cores licensing business primarily as a result of the slowdown in the global wireless and cellular markets.

In the first ten months of 2002, the DSP core licensing business witnessed a challenging environment in the telecommunications and semiconductors industries, resulting in longer sales cycles and delays in purchases by potential customers of products incorporating our DSP cores technologies.

Our results of operations for the year ended December 31, 2002 include an amount of $393,000 related to the disposal of assets and liabilities, net, of our licensing business after the Separation.

Liquidity and Capital Resources

Operating Activities.    During 2002, we generated $34.3 million of cash and cash equivalents from our operating activities, as compared to $26.4 million during 2001 and $8.4 million in 2000. The increase in cash provided by our operations during 2002 as compared to 2001 was primarily due to higher volume of revenues and increase in gross margins which resulted in a significant increase in our gross profit which was slightly offset by an increase in our operating expenses. The combination of these factors resulted in an increase in operating income in 2002. In addition, the increase in cash from operating activities resulted from an increase in income taxes payable as well as from an increase in accrued expenses and other accounts payable. This increase in 2002 was partially offset by an increase in inventory as well as a decrease in accrued compensation and benefits in 2002 in comparison to 2001. The significant increase in cash from operating activities from 2000 to 2001 was mainly due to the non-cash effects of the capital gains attributed to the sale of AudioCodes stock, an increase in deferred income tax, net, and a decrease in our trade receivables. The significant increase in 2001 of cash and cash equivalents from operations was partially offset by a decrease in amortization of in-process research and development costs related to the VoicePump acquisition, as well as a decrease in trade payables, income tax payable, accrued expenses and other accounts payable. Our inventory increased to $6.9 million as of December 31, 2002 from $2.0 million as of December 31, 2001. The increase in inventory was primarily attributed to our higher levels of sales and production during 2002, as well as from changing our manufacturing procedures from a “turn-key solution” to “work in progress” utilizing subcontractors to test, assemble and pack the integrated circuits.

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Investing activities.    We invest excess cash in marketable securities of varying maturity, depending on our projected cash needs for operations, capital expenditures and other business purposes. In 2002, we purchased $144.3 million of investments classified as held-to-maturity marketable securities, as compared to $194.0 million in 2001 and $155.0 million in 2000. In addition, $156.5 million of our investments in marketable securities matured in 2002 as compared to $162.9 million in 2001 and $120.0 million in 2000.

Our capital equipment purchases amounted to $1.9 million in 2002, $3.0 million in 2001 and $2.7 million in 2000 and were mainly for computer hardware and software used in engineering development, engineering test and lab equipment, leasehold improvements, vehicles, and furniture and fixtures.

In addition, in January 2002, we invested $2.0 million in 333,000 ordinary shares of an independent wafer manufacturer company, Tower Semiconductor Ltd., and in June 2002, we sold 250,000 of Tower Semiconductor’s ordinary shares for approximately $1.5 million. The investment was recorded as available-for-sale marketable securities in accordance with SFAS No. 115 and was recorded in our consolidated balance sheets under “other assets.”

Our cash contributed to Ceva, presented as discontinued operations, for 2002 was $6.5 million, as compared to $2.3 million for 2001. The increase in cash contributed to discontinued operations for 2002 was mainly due to an increase in prepaid accounting and legal expenses incurred in relation to consummating the transfer of our DSP cores licensing business to Ceva and its subsequent combination with Parthus.

Financing Activities.    During 2002, we received $3.9 million upon the exercise of employee stock options and through purchases pursuant to our employee stock purchase plan, as compared to $4.8 million during 2001 and $15.6 million during 2000. As part of the Separation, we transferred to Ceva $40 million in cash and paid $754,000 in cash to the Israeli tax authorities, these amounts were recorded as a dividend in our statements of cash flows as part of our financing activities.

Stock Repurchase Program.    Our board of directors has authorized the company to repurchase up to a maximum of 4,000,000 shares of our common stock from time to time on the open market or in privately negotiated transactions. During the year 2001, we repurchased 40,000 shares of our common stock at an average price of $20.30 per share, for an aggregated purchase price of $0.8 million. In 2002, we did not repurchase any shares of our common stock. In February 2003, we repurchased 26,000 shares of our common stock at an average price of $14.96 per share, for an aggregate purchase price of approximately $400,000.

At December 31, 2002, our principal source of liquidity consisted of cash and cash equivalents totaling $39.9 million and held-to-maturity marketable securities totaling $196.1 million. Our working capital at December 31, 2002 was $76.6 million.

We believe that our current cash, cash equivalents and marketable securities will be sufficient to meet our cash requirements through at least the next 12 months. A decrease in our sales would likely affect our working capital balance. As part of our business strategy, we occasionally evaluate potential acquisitions of businesses, products and technologies. Accordingly, a portion of our available cash may be used at any time for the acquisition of complementary products or businesses. Such potential transactions may require substantial capital resources, which may require us to seek additional debt or equity financing. There can be no assurance that we will consummate any such transactions. See “Risk Factors—We may engage in future acquisitions that could dilute our stockholders’ equity and harm our business, results of operations and financial condition.” for more detailed information.

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Item 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS.

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

Foreign Currency Exchange Rate Risk.    As a significant part of our sales and expenses are denominated in U.S. dollars, we have experienced only insignificant foreign exchange gains and losses to date, and do not expect to incur significant gains and losses in 2003. However, due to the volatility in the exchange rate of the NIS versus the U.S. dollar, we decided to hedge part of the risk of a devaluation of the NIS, which could have an adverse effect on the expenses that we incur in the State of Israel. For example, to protect against the increase in value of forecasted foreign currency cash flows resulting from salary payments denominated in NIS during the year, we instituted a foreign currency cash flow hedging program.

These option contracts are designated as cash flow hedges, as defined by SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, and are all effective as hedges of these expenses. For more information about our hedging activity, see Note 2 to the attached Notes to Consolidated Financial Statement for the year ended December 31, 2002.

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Item 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

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REPORT OF INDEPENDENT AUDITORS

To The Stockholders of

DSP Group, Inc.

We have audited the accompanying consolidated balance sheets of DSP Group, Inc. (the “Company”) and its subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2002. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of DSP Group, Inc. and its subsidiaries as of December 31, 2002 and 2001, and the consolidated results of their operations and cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material reports the information set forth therein.

KOST FORER & GABBAY

A Member of Ernst & Young Global

Tel-Aviv, Israel

January 17, 2003

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DSP GROUP, INC. AND ITS SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

U.S. dollars in thousands

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

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DSP GROUP, INC. AND ITS SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

U.S. dollars in thousands, except per share data