EXAR CORP - 10-Q Quarterly Report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended December 31, 2003

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

For the transition period from to

Commission File No. 0-14225

EXAR CORPORATION

(Exact Name of Registrant as specified in its charter)


Delaware		94-1741481
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

48720 Kato Road, Fremont, CA 94538

(Address of principal executive offices, Zip Code)

(510) 668-7000

(Registrant’s telephone number, including area code)

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

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

As of December 31, 2003, 40,890,163 shares of Common Stock, par value $0.0001, were issued and outstanding, net of 247,110 treasury shares.

EXAR CORPORATION AND SUBSIDIARIES

INDEX TO

QUARTERLY REPORT ON FORM 10-Q

FOR QUARTER ENDED DECEMBER 31, 2003


		Page
	PART I – FINANCIAL INFORMATION

Item 1.	Financial Statements (Unaudited)
	Condensed Consolidated Balance Sheets	3
	Condensed Consolidated Statements of Operations	4
	Condensed Consolidated Statements of Cash Flows	5
	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	6
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	33
Item 4.	Controls and Procedures	33

	PART II – OTHER INFORMATION

Item 6.	Exhibits and Reports on Form 8-K	35

Signatures		36

PART I – FINANCIAL INFORMATION

ITEM 1.

FINANCIAL STATEMENTS

EXAR CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share amounts)

(Unaudited)


	December 31, 2003			March 31, 2003
ASSETS
Current assets:
Cash and cash equivalents	$	300,846		$	231,007
Short-term marketable securities		131,093			136,844
Accounts receivable (net of allowances of $1,103 and $1,142, respectively)		5,720			4,275
Inventories		2,787			2,893
Prepaid expenses and other		2,072			2,384
Deferred income taxes, net		3,233			3,233

Total current assets		445,751			380,636
Property, plant and equipment, net		28,077			28,054
Long-term marketable securities		—			54,259
Other long-term investments		3,214			8,759
Deferred income taxes, net		7,523			7,482
Other non-current assets		48			35

Total assets	$	484,613		$	479,225

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	1,258		$	2,295
Accrued compensation and related benefits		3,089			3,269
Accrued sales commissions		748			740
Other accrued expenses		2,549			1,336
Income taxes payable		5,344			4,507

Total current liabilities		12,988			12,147
Long-term obligations		278			312

Total liabilities		13,266			12,459

Commitments and contingencies (Note 8)
Stockholders’ equity:
Preferred stock: $.0001 par value; 2,250,000 shares authorized; no shares outstanding		—			—
Common stock: $.0001 par value; 100,000,000 shares authorized; 41,137,273 and 40,329,609 shares outstanding		404,210			398,606
Accumulated other comprehensive income		92			372
Retained earnings		71,695			72,399
Treasury stock: 247,110 and 245,000 shares of common stock at cost		(4,650	)		(4,611	)

Total stockholders’ equity		471,347			466,766

Total liabilities and stockholders’ equity	$	484,613		$	479,225

See Notes to Condensed Consolidated Financial Statements.

EXAR CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)


	Three Months Ended December 31,					Nine Months Ended December 31,
	2003		2002			2003			2002
Net sales	$	17,088	$	15,029		$	49,334		$	51,961
Cost of sales		5,981		6,312			17,668			24,597

Gross profit		11,107		8,717			31,666			27,364

Operating expenses:
Research and development		5,338		5,344			16,296			16,742
Selling, general and administrative		4,874		4,581			14,210			14,444

Total operating expenses		10,212		9,925			30,506			31,186

Income (loss) from operations		895		(1,208	)		1,160			(3,822	)

Other income (loss), net
Interest income and other, net		1,745		2,339			5,460			7,120
Net loss on other long-term investments		—		—			(6,000	)		(35,886	)

Total other income (loss), net		1,745		2,339			(540	)		(28,766	)

Income (loss) before income taxes		2,640		1,131			620			(32,588	)
Provision for income taxes		448		339			1,324			836

Net income (loss)	$	2,192	$	792		$	(704	)	$	(33,424	)

Income (loss) per share:
Basic income (loss) per share	$	0.05	$	0.02		$	(0.02	)	$	(0.84	)

Diluted income (loss) per share	$	0.05	$	0.02		$	(0.02	)	$	(0.84	)

Shares used in the computation of income (loss) per share:
Basic		40,715		39,788			40,488			39,566

Diluted		42,604		41,180			40,488			39,566

See Notes to Condensed Consolidated Financial Statements.

EXAR CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)


	Nine Months Ended December 31,
	2003			2002
Cash flows from operating activities:
Net loss	$	(704	)	$	(33,424	)
Reconciliation of net loss to net cash provided by operating activities:
Depreciation and amortization		3,689			2,891
Provision for doubtful accounts receivable and sales returns		1,834			1,371
Provision for excess inventory		—			2,311
Other than temporary decline in the value of other long-term investments		6,000			35,886
Deferred income taxes, net		(41	)		4,677
Changes in operating assets and liabilities:
Accounts receivable		(3,279	)		(1,485	)
Inventory		106			1,903
Prepaid expenses and other		299			(1,135	)
Accounts payable		(1,037	)		(1,421	)
Accrued compensation and related benefits		(180	)		(440	)
Accrued sales commissions and other accrued expenses		1,187			(441	)
Income taxes payable		1,017			578

Net cash provided by operating activities		8,891			11,271

Cash flows from investing activities:
Purchases of property, plant and equipment		(3,712	)		(4,474	)
Purchases of short-term marketable securities		(171,435	)		(75,512	)
Proceeds from maturities of short-term marketable securities		176,703			61,624
Purchases of long-term marketable securities		—			(107,314	)
Proceeds from maturities of long-term marketable securities		54,186			22,518
Other long-term investments		(455	)		(266	)

Net cash provided by (used in) investing activities		55,287			(103,424	)

Cash flows from financing activities:
Proceeds from issuance of common stock		5,565			5,773

Net cash provided by financing activities		5,565			5,773
Effect of exchange rate changes on cash		96			112

Net increase (decrease) in cash and cash equivalents		69,839			(86,268	)
Cash and cash equivalents at the beginning of period		231,007			317,429

Cash and cash equivalents at the end of period	$	300,846		$	231,161

Supplemental disclosure of cash flow information:
Cash paid for income taxes	$	330		$	434

See Notes to Condensed Consolidated Financial Statements.

I TEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

NOTE 1. ORGANIZATION AND BASIS OF PRESENTATION

Description of Business – Exar Corporation and its subsidiaries (“Exar” or the “Company”) designs, develops and markets high-performance, high-bandwidth physical interface and access control solutions for the worldwide communications infrastructure. Leveraging its industry-proven analog design expertise, system-level knowledge and standard complementary metal oxide semiconductors (“CMOS”) process technologies, Exar provides original equipment manufacturers (“OEMs”) with innovative, highly integrated circuits (“ICs”) that facilitate the transport and aggregation of signals in access, metro and wide area networks. The Company’s physical layer silicon solutions address transmission standards such as T/E carrier, ATM and SONET/SDH. The Company also provides one of the industry’s most comprehensive family of serial communications solutions. Within this product offering, the low voltage and multi-channel universal asynchronous receiver transmitters (“UARTS”) are particularly well suited to support high data rates and increase data transfer efficiency for various industrial, telecom and computer server applications. In addition, the Company designs, develops and markets IC products that address select applications for the video and imaging markets. Exar’s Common Stock trades on the NASDAQ Stock Market under the symbol “EXAR” and is included in the S&P 600 SmallCap Index.

Basis of Presentation and Use of Management Estimates – The accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with generally accepted accounting principles in the United States of America. This financial information reflects all adjustments, which are, in the opinion of the Company, of a normal and recurring nature and necessary to present fairly the statements of financial position, results of operations and cash flows for the dates and periods presented. The March 31, 2003 balance sheet was derived from audited financial statements as of that date. All significant intercompany transactions and balances have been eliminated.

The financial statements include management’s estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates, and material effects on operating results and financial position may result.

These Condensed Consolidated Financial Statements should be read in conjunction with the Company’s audited consolidated financial statements for the fiscal year ended March 31, 2003 included in its Annual Report on Form 10-K, as filed on June 20, 2003 with the U.S. Securities and Exchange Commission (the “SEC”). The results of operations for the three and nine months ended December 31, 2003 are not necessarily indicative of the results to be expected for any future periods.

NOTE 2. NON-GAAP NET INCOME AND NET INCOME PER SHARE

The Company accounts for stock-based employee compensation using the intrinsic value method under the Financial Standards Board (“FASB”) Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, (“APB 25”), and related interpretations, and complies with the disclosure provisions of Statements of Financial Accounting Standards No. 123 and 148, (“SFAS 123”) and (“SFAS 148”), respectively. SFAS 123 requires the disclosure of pro forma net income and earnings per share. Under SFAS 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which significantly differ from the Company’s stock option awards. These models also require subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values.

The Company’s calculations were made using the Black-Scholes Option-Pricing Model with the following weighted average assumptions for options granted:


	Three Months Ended December 31,
	2003		2002
Expected option life (years)	5.8		5.6
Risk-free interest rate	3.5	%	2.8	%
Expected stock price volatility	66.9	%	76.3	%
Expected dividend yield	0.0	%	0.0	%

Under SFAS 123, Non-GAAP compensation cost is calculated for the fair market value of the options granted under the Employee Stock Participation Plan (“ESPP”). The fair value of each stock purchase right granted under the ESPP is estimated using the Black-Scholes Option-Pricing Model with the following weighted average assumptions by fiscal year:


	Three Months Ended December 31,
	2003		2002
Expected option life (years)	0.25		0.25
Risk-free interest rate	0.95	%	2.8	%
Expected stock price volatility	35.5	%	76.3	%
Expected dividend yield	0.0	%	0.0	%

The Company’s calculations are based on a single option valuation approach and forfeitures are recognized as they occur. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options vesting periods.

The Non-GAAP amounts for the three and nine months ended December 31, 2003 and 2002 are not indicative of future period Non-GAAP amounts:


	Three Months Ended December 31,						Nine Months Ended December 31,
	2003			2002			2003			2002
Net income (loss) - GAAP	$	2,192		$	792		$	(704	)	$	(33,424	)
Fair value stock-based compensation		7,683			6,904			23,183			21,502

Net loss - Non-GAAP	$	(5,491	)	$	(6,112	)	$	(23,887	)	$	(54,926	)

GAAP:
Income (loss) per share - Basic and Diluted	$	0.05		$	0.02		$	(0.02	)	$	(0.84	)

Non-GAAP:
Loss per share - Basic and Diluted	$	(0.13	)	$	(0.15	)	$	(0.59	)	$	(1.39	)

NOTE 3. INVENTORIES

Inventories consisted of the following (in thousands):


	December 31, 2003		March 31, 2003
Work-in-process	$	1,490	$	1,493
Finished goods		1,297		1,400

Total inventories	$	2,787	$	2,893

NOTE 4. PROPERTY, PLANT AND EQUIPMENT, NET

Property, plant and equipment, net consist of the following (in thousands):


	December 31, 2003			March 31, 2003
Land	$	6,584		$	6,584
Building		13,439			13,485
Machinery and equipment		45,265			38,370
Construction-in-progress		—			3,732

		65,288			62,171
Accumulated depreciation and amortization		(37,211	)		(34,117	)

Total	$	28,077		$	28,054

NOTE 5. EARNINGS PER SHARE

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

A summary of the Company’s EPS for the three and nine months ended December 31, 2003 and 2002 is as follows (in thousands, except per share amounts):


	Three Months Ended December 31,				Nine Months Ended December 31,
	2003		2002		2003			2002
Net income (loss)	$	2,192	$	792	$	(704	)	$	(33,424	)

Shares used in computation:
Weighted average common shares outstanding used in computation of basic income (loss) per share		40,715		39,788		40,488			39,566
Dilutive effect of stock options		1,889		1,392		—			—

Shares used in computation of diluted income (loss) per share		42,604		41,180		40,488			39,566

Income (loss) per share - Basic	$	0.05	$	0.02	$	(0.02	)	$	(0.84	)

Income (loss) per share - Diluted	$	0.05	$	0.02	$	(0.02	)	$	(0.84	)

For the three months ended December 31, 2003 and 2002, options to purchase 3,839,052 and 6,448,167 shares of common stock, respectively at prices ranging from $17.63 to $59.31 and $13.52 to $60.75, respectively were outstanding but not included in the computation of diluted net income per share because the options’ exercise prices were greater than the average market price of the common shares as of such dates and, therefore, would be anti-dilutive under the treasury stock method.

As a result of the net loss for the nine months ended December 31, 2003 and 2002, options to purchase 1,787,000 and 2,032,000, respectively, of common stock have not been included in the calculation of diluted loss per share for the periods presented because to do so would have been anti-dilutive.

NOTE 6. COMPREHENSIVE INCOME (LOSS)

Comprehensive income (loss) for the three and nine months ended December 31, 2003 and 2002 is as follows (in thousands):


	Three Months Ended December 31,					Nine Months Ended December 31,
	2003			2002		2003			2002
Net income (loss)	$	2,192		$	792	$	(704	)	$	(33,424	)
Other comprehensive income:
Cumulative translation adjustments		27			28		54			68
Unrealized gain (loss), net on marketable securities		(261	)		11		(334	)		322

Total other comprehensive income (loss)	$	1,958		$	831	$	(984	)	$	(33,034	)

NOTE 7. OTHER LONG-TERM INVESTMENTS

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

During the three months ended September 30, 2002, the Company became aware of a potential decline in the value of its investment in IMC. As a result, the Company retained an independent third party to assist in determining the fair market value of its investment. As a consequence, the Company recorded an impairment charge against its earnings of $35.3 million, reducing the value of its equity investment from $40.3 million to $5.0 million as of September 30, 2002.

During the three months ended September 30, 2003, the Company determined that the carrying value of its investment in IMC was further impaired and, consequently, recorded an asset impairment charge of $5.0 million, writing off the remainder of its investment carrying value in IMC.

Exar became a limited partner in TechFarm Ventures (Q), L.P. (the “TechFarm Fund”) in May 2001. This partnership is a venture capital fund, managed by TechFarm Ventures Management L.L.C., the general partner of the TechFarm Fund, and a Delaware Limited Partnership, and focuses its investment activities on seed and early stage technology companies. Effective May 31, 2002, in connection with the amendment of the partnership agreement, the Company and TechFarm Ventures Management L.L.C. agreed to reduce the Company’s capital commitment in the TechFarm Fund to approximately $4.0 million, or approximately 5% of the TechFarm Fund’s total committed capital. Additionally, the Company and TechFarm Ventures Management L.L.C. agreed to change the Company’s status from a limited partner to that of an assignee having less rights and status than a limited partner. Because of these modifications, the Company changed its method of accounting for this investment from the equity method to the cost

basis method as of May 31, 2002. The Company has fulfilled its capital contribution commitment and, therefore, will not be required to fund additional amounts.

At March 31, 2003, the carrying value of the Company’s investment in the TechFarm Fund was $2.8 million. During the three months ended September 30, 2003, the Company became aware of significant changes in the business of certain portfolio companies within the TechFarm Fund. Exar believes that these changes impaired the carrying value of its investment in the TechFarm Fund. Therefore, during the three months ended September 30, 2003, Exar recorded an impairment charge against its earnings of $1.0 million, reducing its carrying value to $1.8 million. If the Company’s assessed value of its investment were to fall below the remaining carrying value, the Company would be required to recognize an impairment to the asset, resulting in additional expense in the Company’s Condensed Consolidated Statements of Income.

In July 2001, Exar became a limited partner in Skypoint Telecom Fund II (US), L.P. (the “Skypoint Fund”), a venture capital fund focused on investments in communications infrastructure companies. Exar is obligated to fund $5.0 million, which represents approximately 5% of the fund’s total capital commitments. Of the $5.0 million obligation, Exar has funded $1.4 million as of December 31, 2003. As of December 31, 2003, the Company’s remaining capital contribution obligation was $3.6 million. The investment in the Skypoint Fund is reflected at cost on the Company’s Condensed Consolidated Balance Sheets. If the Company’s assessed value of its investment were to fall below the carrying value, the Company would be required to recognize an impairment to the asset, resulting in additional expense in the Company’s Condensed Consolidated Statements of Income.

NOTE 8. COMMITMENTS AND CONTINGENCIES

Generally, the Company warrants all of its products against defects in materials and workmanship for a period of ninety days from the delivery date. The Company’s sole liability is limited to replacing, repairing or issuing credit, at its option, for the product for which the Company has received payment. Historically, warranty expense has been immaterial.

Additionally, the Company’s sales agreements indemnify its customers for any expenses or liability resulting from alleged or claimed infringements of any United States letter patents of third parties. However, the Company is not liable for any collateral, incidental or consequential damages arising out of patent infringement. The terms of these indemnification agreements are generally perpetual. The maximum amount of potential future indemnification is difficult to ascertain. However, to date, the Company has not paid any claims or been required to defend any lawsuits with respect to any such customer indemnity claim.

From time to time, the Company is involved in various claims, legal actions and complaints arising in the normal course of business. Although the ultimate outcome of these matters is not presently determinable, management believes that the resolution of all such pending matters will not have a material adverse effect on the Company’s financial position, results of operations, or cash flows.

In June 1994, the Company acquired Micro Power Inc. Previously, Micro Power Inc. had identified low-level groundwater contamination at its principal manufacturing site. Although the area and extent of the contamination appear to have been defined, the exact source of the contamination has not been identified. Prior to its acquisition, Micro Power Inc. had reached an agreement with another entity to participate in the cost of ongoing site investigations and the operation of remedial systems to remove subsurface chemicals. The Company believes that its site closure costs pertaining to the capping of wells and removal of the filtering system will not be material. Management estimates that the accrual of $350,000 as of December 31, 2003 is sufficient to cover near term remediation activities and post-remediation site closure activities.

The following table summarizes the Company’s contractual payment obligations and commitments as of December 31, 2003 (in thousands):


	Fiscal Year
	Remaining 2004		2005		2006		2007		2008		Thereafter		Total
Contractual Obligations
Purchase Obligations ⁽¹⁾	$	7,165	$	2,069	$	61	$	11	$	—	$	—	$	9,306
Venture Investment Commitments (Skypoint Fund) ⁽²⁾		3,601		—		—		—		—		—		3,601
Property Lease Obligations		55		72		12		12		12		3		166

Total	$	10,821	$	2,141	$	73	$	23	$	12	$	3	$	13,073

⁽¹⁾	The Company places purchase orders with wafer foundries and other vendors as part of its normal course of business. The Company expects to receive and pay for wafers, capital equipment and various service contracts over the next 12 to 18 months from its existing cash balances.

⁽²⁾

The Company is obligated to contribute its remaining committed capital of $3.6 million to the Skypoint Fund per the limited partnership agreement. The timing of the remaining capital contribution is not known as it is at the discretion of the Skypoint Fund’s General Manager. For presentation purposes, the entire amount of the remaining commitment is presented in Fiscal Year 2004.

NOTE 9. INDUSTRY AND SEGMENT INFORMATION

The Company operates in one reportable segment and is engaged in the design, development and marketing of a variety of analog and mixed-signal application-specific integrated circuits for use in communications, industrial and video and imaging applications. The nature of the Company’s products and production processes as well as type of customers and distribution methods is consistent among all of the Company’s products. The Company’s foreign operations are conducted primarily through its wholly-owned subsidiaries in Japan, the United Kingdom and France. The Company’s principal markets include North America, Asia/Japan and Europe. Net sales by geographic area represent sales to unaffiliated customers. Substantially all of the Company’s long-lived assets at December 31, 2003 and 2002 were located in the United States.

All information on sales by geographic area is based upon the location to which the products were shipped. The following table sets forth revenue by geographic area for the three and nine months ended December 31, 2003 and 2002 (in thousands):


	Three Months Ended December 31,				Nine Months Ended December 31,
	2003		2002		2003		2002
Net sales:
United States	$	7,952	$	6,035	$	21,666	$	20,333
Asia		4,276		2,239		10,452		6,753
Europe		2,537		1,687		7,680		5,403
Singapore		1,343		4,145		5,780		17,087
Japan		689		714		3,265		1,992
Rest of the World		291		209		491		393

Total net sales	$	17,088	$	15,029	$	49,334	$	51,961

NOTE 10. RECENTLY ISSUED ACCOUNTING STANDARDS

On December 18, 2003 the SEC issued Staff Accounting Bulletin No. 104, Revenue Recognition (“SAB 104”), which supercedes SAB 101, Revenue Recognition in Financial Statements. SAB 104’s primary purpose is to rescind accounting guidance contained in SAB 101 related to multiple element revenue arrangements, which was superceded as a result of the issuance of EITF 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” SAB 104 does not have a material impact on the Company’s financial position or results of operations.

NOTE 11. VOLUNTARY STOCK OPTION EXCHANGE PROGRAM

On August 27, 2003, the Company offered eligible employees the opportunity to exchange certain outstanding options for new options. Eligible employees included regular, full-time, U.S. resident employees of the Company or its subsidiaries. Members of the Company’s board of directors, executive officers and employees of the Company subject to Section 16(b) of the Securities Exchange Act of 1934, as amended, were not eligible to participate in the offer. The offer expired on September 25, 2003 at 5:00 p.m., Pacific Time.

The offer was a voluntary exchange for eligible option holders under the Company’s 1997 Equity Incentive Plan and 2000 Equity Incentive Plan, to exchange all of their options, vested or unvested, with exercise prices equal to or greater than $26.00 per share and all options granted on or after February 27, 2003, regardless of price.

A total of 1,438,205 exchanged options were cancelled on September 26, 2003 and new options will be granted at least six months and one day after the cancellation date, September 26, 2003. The number of new options granted to the participants will depend on the original exercise price at which the exchanged options were granted. Exchanged options with an exercise price per share equal to or greater than $26.00 and less than or equal to $50.00 will be replaced with new options at an exchange ratio of one new option for every two exchanged options. Exchanged options with an exercise price per share greater than $50.00 will be replaced with new options at an exchange ratio of one new option for every four exchanged options. Options with an exercise price per share less than $26.00 were not eligible for exchange under the offer, except for options granted on or after February 27, 2003, which were required to be exchanged as a condition to participate in the offer. Such options will be replaced with new options at an exchange ratio of one new option for every one exchanged option. The new options will be granted at the fair market value as of the grant date. The Company expects to grant 551,000 replacement options at least six months and one day after the cancellation date, September 26, 2003.

Each new option to be granted to participants in the offer will be subject to a new vesting schedule that will commence on the new option grant date. If any portion of the exchanged options are vested as of the date such options are cancelled, then the corresponding portion of the new options granted to such participants in exchange for the vested exchanged options shall be fully vested nine months from the new option grant date. If any portion of the exchanged options is unvested as of the date such options are cancelled, then 50% of the corresponding portion of the new options granted to such participants in exchange for the unvested exchanged options shall vest on the one year anniversary of the new option grant date and the remaining 50% of the corresponding portion of the new options shall vest on the two year anniversary of the new option grant date. For additional information about the offer, please refer to the Schedule TO-C filed with the SEC on August 21, 2003 and the Schedule TO-I filed with the SEC on August 27, 2003.

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations, as well as information contained in “Risk Factors” below and elsewhere in this Report, contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are not guarantees of future performance and involve risks and uncertainties. These forward-looking statements apply only as of the date of this Quarterly Report. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Actual results may differ materially from those projected in the forward-looking statements as a result of various factors. These risks, uncertainties and other factors include, among others, those identified under “Risk Factors.” Forward-looking statements are generally written in the future tense and/or are preceded by words such as “will,” “may,” “should,” “could,” “expect,” “suggest,” “believe,” “anticipate,” “intend,” “plan,” “continue,” “estimate,” “seek,” or other similar words. Forward-looking statements contained in this Quarterly Report include, among others, statements made in “Financial Outlook” and elsewhere regarding (1) the demand for the Company’s products and the Company’s net sales, (2) the Company’s gross profits, (3) the Company’s ability to control and/or reduce operating expenses, (4) the Company’s research and development efforts, (5) the effect of interest rates on the Company’s interest income, (6) the Company’s ability to maintain positive operating cash flows to fund future operations, (7) competitive pressures, (8) charges against earnings, (9) international sales and (10) the general market and economic outlook.

Overview

The Company designs, develops and markets high-performance, high-bandwidth physical interface and access control solutions for the worldwide communications infrastructure. The Company’s current IC products for the communications market are designed to respond to the growing demand for cost effective line card solutions based on transmission standards such as T/E carrier, ATM and SONET/SDH. The Company also provides one of the industry’s most comprehensive family of serial communications solutions. Within this product offering, the low voltage and multi-channel universal asynchronous receiver transmitters (“UARTS”) are particularly well suited to support high data rates and increase data transfer efficiency for various industrial, telecom and computer server applications. In addition, the Company designs, develops and markets IC products that address select applications for the video and imaging markets. Exar uses its design methodologies to develop products ranging from application specific standard products (“ASSPs”), designed for industry-wide applications, to semi-custom solutions for specific customer applications. These complementary products enable the Company to offer a range of solutions for its customers’ applications. Exar’s products provide the following benefits to its users:

•

increased bandwidth through the integration of multiple channels on a single device;

•

reduced overall system cost through the integration of multiple functions on a single device; and

•

accelerated time-to-market by allowing its customers to focus on core competencies and to outsource standards-based solutions.

The Company’s customers include, among others, Alcatel, Cisco Systems, Inc., Digi International, Inc., Hewlett-Packard Company (“Hewlett-Packard”), Huawei Technologies Company, LTD., Logitech International S.A., NEC Corporation, Nokia Corporation, Plantronics, Inc. and Tellabs, Inc. For the three months ended December 31, 2003, no one customer accounted for 10% or greater of the Company’s net sales. For the three months ended December 31, 2002, sales to Hewlett-Packard represented 27.7% of net sales. For the nine months ended December 31, 2003 and 2002, one customer, Hewlett-Packard, accounted for 11.6% and 30.7%, respectively, of the Company’s net sales. No other customer accounted for more than 10% of the Company’s net sales for the nine months ended December 31, 2003 and 2002.

The Company is leveraging its analog expertise by focusing its product strategy and development efforts predominantly in the communications markets. For the three months ended December 31, 2003 and 2002, the Company’s communications product sales represented 83.0% and 60.0% of its net sales, respectively. The Company’s communications product sales represented 78.2% and 55.9% of its net sales, respectively, for the nine months ended December 31, 2003 and 2002.

The Company markets its products in North America through independent non-exclusive sales representatives and independent non-exclusive distributors as well as the Company’s own direct sales organization. Additionally, the Company is represented in Europe and the Asia/Pacific Region by its wholly owned subsidiaries and independent sales representatives. The Company defines international sales as product shipped to locations outside of the United States. The Company’s international sales represented 53.5% and 59.8% of net sales for the three months ended December 31, 2003 and 2002, respectively. For the nine months ended December 31, 2003 and 2002, the Company’s international sales represented 56.1% and 60.9% of net sales, respectively. These international sales consist of export sales from the United States that are denominated in United States dollars. Such international sales and operations expose the Company to fluctuations in currency exchange rates because the Company’s foreign operating expenses are denominated in foreign currency while its sales are denominated in United States dollars. The Company has adopted a set of practices to minimize its foreign currency risk, which include the occasional use of foreign currency exchange contracts to hedge the operating results of its foreign subsidiaries against this currency exchange risk. Although foreign sales within certain countries or foreign sales comprised of certain products may subject the Company to tariffs, the Company’s profit margin on international sales of ICs, adjusted for differences in product mix, is not significantly different from that realized on the Company’s sales to domestic customers.

The Company’s operating results are subject to quarterly and annual fluctuations as a result of several factors that could materially and adversely affect the Company’s future profitability, as described below in “Risk Factors” and those described in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Company’s Annual Report on Form 10-K for the year ended March 31, 2003.

To date, inflation has not had a significant impact on the Company’s operating results.

Financial Outlook for Fiscal Year 2004

The Company continues to experience limited visibility pertaining to customer demand and ordering patterns for its communications products resulting from shortened order-to-delivery times, quickly turning orders placed and shipped within the same quarter, and uncertainties associated with future capital expenditures by communications carriers and enterprise spending. These factors may continue to put further downward pressure on demand for equipment and products sold by the Company’s customers. The Company expects that video, imaging and other revenue will continue to decline due to anticipated decreases in imaging product sales resulting from Hewlett-Packard’s product transitions and competing sources. The Company may not be able to sustain or grow its communications revenue significantly to offset the anticipated decline in its video, imaging and other revenue. As a result, the Company’s future results of operations and financial condition may be negatively impacted.

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

Critical Accounting Policies and Use of Estimates

The SEC has released FR-60 “Cautionary Advice Regarding Disclosure About Critical Accounting Policies,” which encourages companies to disclose critical accounting policies, judgments and uncertainties affecting the application of those policies and the likelihood that materially different financial results would be reported under different conditions or with the use of different assumptions. Such critical accounting policies, as defined by the SEC, are those that are both most significant to the depiction of a company’s financial condition and results and require the use of difficult, subjective and complex judgment by management, often as a result of the need to make estimates about the effect of matters that are uncertain.

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

Exar’s most critical accounting policies relate to: (1) net sales; (2) reserves for excess inventories; (3) income taxes; and (4) investments in non-public entities. Should any of the estimates embedded within the Company’s accounting policies prove to be inaccurate, the Company’s Condensed Consolidated Financial Statements could be negatively impacted. A further discussion can be found in Item 7., ”Management’s Discussion and Analysis of Financial Condition and Results of Operations,” of the Company’s Annual Report on Form 10-K for the fiscal year ended March 31, 2003. Management believes that the Company consistently applies these judgments and estimates, and such consistent application fairly represents the Company’s Condensed Consolidated Financial Statements and accompanying Notes for all periods presented.

Results of Operations

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


	Three Months Ended December 31,				Nine Months Ended December 31,
	2003		2002		2003		2002
Net sales	100.0	%	100.0	%	100.0	%	100.0	%
Cost of sales	35.0		42.0		35.8		47.3

Gross profit	65.0		58.0		64.2		52.7

Operating expenses:
Research and development	31.2		35.5		33.0		32.2
Selling, general and administrative	28.6		30.5		28.8		27.8

Total operating expenses	59.8		66.0		61.8		60.0

Income (loss) from operations	5.2		(8.0	)	2.4		(7.3	)
Other income (loss), net
Interest income and other, net	10.2		15.6		11.1		13.7
Loss on other long-term investments	0.0		0.0		(12.2	)	(69.1	)

Total other income (loss), net	10.2		15.6		(1.1	)	(55.4	)
Income (loss) before income taxes	15.4		7.6		1.3		(62.7	)
Provision for income taxes	2.6		2.3		2.7		1.6

Net income (loss)	12.8	%	5.3	%	(1.4	)%	(64.3	)%

Product Line Sales as a Percentage of Net Sales

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


	Three Months Ended December 31,				Nine Months Ended December 31,
	2003		2002		2003		2002
Communications	83.0	%	60.0	%	78.2	%	55.9	%
Video, Imaging and Other	17.0	%	40.0	%	21.8	%	44.1	%

	100.0	%	100.0	%	100.0	%	100.0	%

Three and Nine Months Ended December 31, 2003 compared to Three and Nine Months Ended December 31, 2002

Net sales

Net sales for the three months ended December 31, 2003 increased by 13.7% to $17.1 million compared to $15.0 million for the three months ended December 31, 2002. This increase is attributable to a 57.1% increase in communications product sales, which increased from $9.0 million for the three months ended December 31, 2002 to $14.2 million for the three months ended December 31, 2003. This increase in communications product sales was offset by a 51.6% decrease in video, imaging and other product sales from $6.0 million for the three months ended December 31, 2002 to $2.9 million for the three months ended December 31, 2003, the result of customer product transitions and competing sources. Net sales for the nine months ended December 31, 2003 decreased by 5.1% to $49.3 million compared to $52.0 million for the nine months ended December 31, 2002. This decrease resulted from a decrease of 53.1% in video, imaging and other product sales to $10.7 million from $22.9 million for the same period in the prior year, primarily the result of a decline in imaging product sales. This decline in video, imaging and other product sales for the nine months ended December 31, 2003 was offset by an increase of 32.8% in communications products sales, which increased to $38.6 million from $29.1 million for the nine months ended December 31, 2002. Included in communications products sales for the nine months ended December 31, 2003 was a one-time technology license revenue of $500,000.

For the three months ended December 31, 2003, no one customer represented 10% or more of net sales. For the three months December 31, 2002, sales to Hewlett-Packard represented 27.7% of net sales. For the nine months ended December 31, 2003 and December 31, 2002, sales to Hewlett-Packard represented 11.6% and 30.7%, respectively, of net sales, consisting of shipments of the Company’s imaging products to support Hewlett-Packard’s multifunction peripheral products.

The Company expects that video, imaging and other revenue will continue to decline due to anticipated decreases in imaging and video product sales resulting from customer product transitions and competing sources. Although the Company anticipates increased communications product sales, these increases may not be sufficient to offset the expected decline in video and imaging product sales. If communications product sales do not increase to offset such anticipated decline, the Company’s financial condition and results of operations may be adversely impacted.

For the three months ended December 31, 2003, sales to domestic customers increased by 31.8% to $8.0 million, compared to $6.0 million for the same period in the prior year. The increase was primarily due to higher unit sales of communications products. International sales remained constant with last year’s amount at $9.1 million for the three months ended December 31, 2003. For the nine months ended December 31, 2003, sales to domestic customers increased 6.6% to $21.7 million from $20.3 million for the nine months ended December 31, 2002, primarily the result of increased communications product sales. For the nine months ended December 31, 2003, international sales decreased by 12.5% to $27.7 million from $31.6 million for the nine months ended December 31, 2002, the result of decreased imaging product sales.

Gross Profit

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

•

the cost of purchasing the finished silicon wafers manufactured by independent foundries;

•

costs associated with assembly, packaging, test, quality assurance and product yields;

•

the cost of personnel and equipment associated with manufacturing support and manufacturing engineering; and

•

provisions for excess inventory.

Gross profit as a percentage of net sales for the three months ended December 31, 2003 was 65.0% compared to 58.0% for the same period last year. The increase in gross profit as a percentage of net sales was the result of changes in product mix from lower-margin video, imaging and other product sales, which represented 40.0% of net sales for the three months ended December 31, 2002, to higher-margin communications product sales, representing 83.0% of net sales for the three months ended December 31, 2003. For the nine months ended December 31, 2003, gross profit as a percentage of net sales increased to 64.2% from 52.7% for the same period in the prior year. In addition to the factors mentioned above gross profit increase for the nine months ended December 31, 2003 when compared to the same period in the prior fiscal year included the benefit of one-time technology license revenue of $500,000 recorded in the three months ended June 30, 2003. Additionally, gross margin for the nine months ended December 31, 2002 included a $2.3 million inventory provision taken in the three months ended September 30, 2002. The Company anticipates that gross profit will continue to fluctuate as a percentage of net sales due to future fluctuations in net sales, manufacturing cost fluctuations, competitive pricing strategies, changes in product mix and other factors.

Due to the proprietary nature of the Company’s products, price changes have not had a material effect on net sales or gross margins. However, the Company has experienced pricing pressures earlier in the communications products sales cycle. Historically, pricing pressures, if they occurred at all, occurred at the time that the products were in production whereas such pressures in the current environment are occurring much earlier in the design cycle.

Total operating expenses

Total operating expenses for the three months ended December 31, 2003 increased by 2.9% to $10.2 million from $9.9 million for the same period last year, primarily the result of increased professional fees. For the nine months ended December 31, 2003, total operating expenses decreased 2.2% to $30.5 million from $31.2 million for the same period last year. The decrease in total operating expenses for the nine months ended December 31, 2003 as compared to the same period last year resulted from reductions in research and development and selling, general and administrative expenses reflecting, in part, the realization of cost benefits associated with cost containment measures undertaken by the Company during the second half of the fiscal year ended March 31, 2003. These factors were offset by an increase in professional fees for the period as described above.

Research and development

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

•

the salaries and related expenses of engineering employees engaged in research, design and development activities;

•

costs related to design tools, supplies and services; and

•

facilities expenses.

R&D expenses for the three months ended December 31, 2003 were $5.3 million, or 31.2% of net sales, compared to $5.3 million, or 35.6% of net sales, for the three months ended December 31, 2002. For the nine months ended December 31, 2003, R&D expenses were $16.3 million, or 33.0% of net sales, compared to $16.7 million, or 32.2% of net sales, for the same period last year. The decrease in R&D expenses in absolute dollars for the nine months ended December 31, 2003 when compared to December 31, 2002 is due, in part, to cost containment measures undertaken by the Company in the second half of the fiscal year ended March 31, 2003. The Company expects that R&D expenses in absolute dollars will increase in the future as the Company continues to enhance its product offerings.

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

Selling, general and administrative

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

•

salaries and related expenses;

•

sales commissions;

•

professional fees; and

•

facilities expenses.

SG&A expenses for the three months ended December 31, 2003 were $4.9 million, or 28.6% of net sales, compared to $4.6 million, or 30.5% of net sales, for the three months ended December 31, 2002. The increase in SG&A expenses in absolute dollars for the three months ended December 31, 2003 was primarily the result of increased professional expenses associated with pending legal matters. For the nine months ended December 31, 2003, SG&A expenses were $14.2 million, or 28.8% of net sales, compared to $14.4 million, or 27.8% of net sales, for the same period last year. The decrease in SG&A spending for the nine months ended December 31, 2003 when compared to the same period last year was primarily the result of containment measures undertaken by the Company in the second half of the fiscal year ended March 31, 2003 and reduced sales commissions, partially offset by increased medical and workers compensation-related expenses and certain professional fees.

It is possible that future SG&A expenses in absolute dollars will increase as a result of possible future expansion of the Company’s infrastructure to support potential acquisition and integration activities, and a general expansion of the Company’s operations. The Company continues to assess its cost structure and other programs to improve operational efficiencies. In the short-term, many of the SG&A expenses are fixed, which will result in a decline in SG&A expense as a percentage of net sales in periods of increasing net sales and an increase as a percentage of net sales when net sales decrease.

Other income (loss), net

Other income (loss), net primarily consists of:

•

interest income;

•

realized gains on marketable securities; and

•

losses, including charges for other than temporary decline in value of other long-term investments.

For the three months ended December 31, 2003, other income, net was $1.7 million, or 10.2% of net sales, as compared to $2.3 million, or 15.6% of net sales, for the same period last year. The decrease in other income, net is the result of declining reinvestment yields on the Company’s maturing investments. For the nine months ended December 31, 2003, the net loss on other long-term investments decreased due primarily to a decrease in impairment charges to $6.0 million from $35.9 million for the same periods last year, relating to the Company’s equity investment in Internet Machines Corporation and venture capital investment in the TechFarm Fund.

Provision for income taxes

The Company’s effective income tax rate for the three months ended December 31, 2003 was 17% compared to the federal statutory rate of 35%. The Company did not recognize an income tax benefit related to the $6.0 million asset impairment charge recorded by the Company during the three months ended September 30, 2003 against its carrying value for its investment in Internet Machines Corporation and the TechFarm Fund, as it is not deductible against ordinary taxable income. The Company lowered its provisional tax rate from the 22% recorded for the six months ended September 30, 2003 to a 20% effective rate for the nine months ended December 31, 2003 due to the release of previously impaired tax attributes. The provision for income taxes for the three and nine months ended December 31, 2003 differs from the amount computed by applying the statutory federal rate principally due to R&D credits, tax-exempt interest and the acquired-company NOL utilizations, which were partially offset by state income taxes.

Liquidity and Capital Resources

The Company does not have any off-balance sheet arrangements, investments in special purpose entities, variable interest entities or undisclosed borrowings or debt. Additionally, the Company is not a party to any derivative contracts, nor does it have any synthetic leases. At December 31, 2003, the Company had no foreign currency contracts outstanding.

The Company’s principal source of liquidity in the nine months ended December 31, 2003 were cash and cash equivalents, short-term marketable securities and long-term marketable securities which, in the aggregate, increased by $9.8 million to $431.9 million at December 31, 2003 from $422.1 million at March 31, 2003. Cash and cash equivalents increased by $69.8 million during the nine months ended December 31, 2003 primarily resulting from net cash provided by investing activities of $55.2 million, by operating activities of $8.9 million and by financing activities of $5.6 million.

The Company generated net cash flows from operating activities of $8.9 million during the nine months ended December 31, 2003 as compared to $11.3 million in the same period in 2002. The Company’s net loss for the nine months ended December 31, 2003, was offset by the $6.0 million impairment charge and other non-cash charges including, $5.5 million for depreciation and amortization, deferred income taxes, and the provision for doubtful accounts receivable and sales returns. Offsetting the cash flow from operations during the nine months ended December 31, 2003 was a $1.0 million net decrease in accounts payable, other accrued expenses, accrued sales commissions and income taxes payable, coupled with a net $2.9 million increase in accounts receivable, inventory and other prepaid expenses. For the nine months ended December 31, 2002, the net loss of $33.4 million was offset by non-cash charges of approximately $47.1 million related to the impairment charge, depreciation and amortization, deferred taxes and the provision for doubtful accounts.

The Company generated net cash flows from investing activities of $55.2 million during the nine months ended December 31, 2003 as compared to the use of $103.4 million in the same period in 2002. Net cash provided by investing activities during the nine months ended December 31, 2003 resulted from $230.9 million in net proceeds from maturities of short-term and long-term marketable securities offset by the reinvestment of $171.4 million of those proceed to purchase short-term marketable securities. The purchase of property, plant and equipment, net of a rebate provided to the Company from the California Energy Commission of $926,000 in connection with the Company’s on-site power generation equipment, was $3.7 million during the nine months ended December 31, 2003. Net cash used in investing activities during the nine months ended December 31, 2002 resulted from $182.8 million in net purchases of

short-term and long-term marketable securities and $4.5 million in purchases of property, plant and equipment, offset by $84.1 million of proceeds from maturities of short-term and long-term marketable securities.

As of December 31, 2003, the Company had funded $1.4 million of its $5.0 million committed capital in the Skypoint Fund. The Company is obligated to contribute its remaining committed capital of approximately $3.6 million as requested by Skypoint Fund’s General Manager per the limited partnership agreement with the Skypoint Fund. To meet its capital commitment to the Skypoint Fund, the Company may need to use its existing cash, cash equivalents and marketable securities.

Net cash provided by financing activities totaled $5.6 million in the nine months ended December 31, 2003 as compared to $5.8 million in the same period last year, representing proceeds from the issuance of shares of common stock upon the exercise of stock options under the Company’s stock option plans and the purchase of shares of common stock under the Company’s Employee Stock Participation Plan.

In March 2001, the Board of Directors authorized a stock repurchase program to acquire outstanding common stock in the open market. Under this program, the Board of Directors authorized the acquisition of up to $40.0 million of Exar’s common stock. During the fiscal year ended March 31, 2001, the Company acquired 245,000 shares of its common stock for $4.6 million. The Company repurchased 2,110 shares of its outstanding common stock from an employee in connection with a provision in its 2000 Equity Incentive Plan during the three months ended December 31, 2003. In the future, the Company may utilize the stock repurchase program to acquire additional shares of its outstanding common stock, which would reduce cash, cash equivalents and/or marketable securities available to fund future operations and meet other liquidity requirements.

The following table summarizes the Company’s contractual payment obligations and commitments as of December 31, 2003 (in thousands):


	Fiscal Year
	Remaining 2004		2005		2006		2007		2008		Thereafter		Total
Contractual Obligations
Purchase Obligations⁽¹⁾	$	7,165	$	2,069	$	61	$	11	$	—	$	—	$	9,306
Venture Investment Commitments (Skypoint Fund) ⁽²⁾		3,601		—		—		—		—		—		3,601
Property Lease Obligations		55		72		12		12		12		3		166

Total	$	10,821	$	2,141	$	73	$	23	$	12	$	3	$	13,073

⁽¹⁾	The Company places purchase orders with wafer foundries and other vendors as part of its normal course of business. The Company expects to receive and pay for wafers, capital equipment and various service contracts over the next 12 to 18 months from its existing cash balances.

⁽²⁾

The Company anticipates that it will continue to finance its operations with cash flows from operations, existing cash and investment balances, and some combination of long-term debt and/or lease financing and additional sales of equity securities. The combination and sources of capital will be determined by management based on the Company’s then current needs and prevailing market conditions. The Company believes that its cash and cash equivalents, short-term marketable securities and cash flows from operations will be sufficient to satisfy working capital requirements and capital equipment needs for at least the next 12 months. However, should the demand for the Company’s products decrease in the future, the availability of cash flows from operations may be limited, thus possibly having a material adverse effect on

the Company’s financial condition or results of operations for that period. From time to time, the Company evaluates potential acquisitions and equity investments complementary to its design expertise and market strategy. To the extent that the Company pursues or positions itself to pursue these transactions, the Company may seek additional equity or debt financing. There can be no assurance that additional financing could be obtained on terms acceptable to the Company, if at all. The sale of additional equity or convertible debt could result in dilution to the Company’s stockholders.

RISK FACTORS

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

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

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

Although the Company’s revenue from the sale of its communications products is expected to grow in the long term, it may not grow fast enough to offset the expected decline in revenue from non-communications products. The Company is continuing to focus a significant portion of its research and sales resources on the communications market. As a result, the Company’s dependence on this market, as compared to the Company’s dependence on other markets, such as video and imaging, continues to increase. Given the Company’s increasing dependence on the communications market to support revenue growth, the Company must continue to generate additional sales from this market, by taking market share from competitors, by successful introduction of new products or by maintaining market share in a growing market. If the Company is unable to generate significant revenue in the communications market, the Company’s business, financial condition and results of operations will be materially and adversely impacted.

THE UNCERTAINTY IN THE U.S. AND GLOBAL ECONOMIES, AS WELL AS THE COMMUNICATION EQUIPMENT MARKET, MAY CONTINUE TO ADVERSELY AFFECT THE COMPANY’S BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

Consumer confidence, reduced corporate profits, corporate improprieties, lower capital spending, the impact of the conflicts in the Middle East, the outbreak of communicable diseases and other geopolitical factors have had, and may continue to have, a negative impact on the U.S. and global economies. The Company’s revenue and profitability have been adversely affected by the communications equipment industry’s extended downturn. This downturn has severely affected carrier capital equipment spending, which in turn has affected the demand for the Company’s customers’ products, thus adversely affecting the Company’s revenues and profitability. Communications service providers continue to face significant financial and operating challenges and, therefore, may continue to delay or further reduce their spending on the Company’s customers’ products. These challenges have been exacerbated by disclosures of accounting or corporate irregularities by communications service providers and other large public companies.

The extent, severity and unpredictability of this past economic downturn, and the uncertainty of the geopolitical environment, in conjunction with actual and anticipated declines in demand for the Company’s products, have made it difficult for the Company to predict when and if demand for its products will increase. Additionally, capital spending among service providers may not increase in the near future. Due to this, among other factors, the Company does not

know when or how quickly its customers will place new orders. Therefore, the Company’s revenues may fail to increase in the future, which could materially and adversely impact the Company’s business, financial condition and results of operations.

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

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

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changing technologies;

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evolving and competing industry standards;

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changing customer requirements;

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emerging competition;

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frequent new product introductions and enhancements;

•

long design-to-production cycles; and/or

•

increasing functional integration.

The Company’s success depends in part on the successful development of new products for the Company’s target markets. The Company must (i) be able to anticipate customer and market requirements and changes in technology and industry standards; (ii) be able to accurately define and develop new products; (iii) be able to gain access to and use technologies in a cost-effective manner; (iv) continue to expand its technical and design expertise; (v) be able to timely complete and cost-effectively market new products; (vi) be able to differentiate its products from its competitors offerings; and (vii) gain customer acceptance of its products. In addition, the Company must continue to have its products designed into its customers’ future products and maintain close working relationships with key customers in order to develop new products that meet their changing needs. Moreover, the Company must be able to respond to changing market demands, the trend towards increasing functional integration and other changes in a rapid and cost-effective manner.

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

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

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

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

•

the Company’s difficulty in predicting revenues due to limited visibility being provided by customers and channel partners;

•

the reduction, rescheduling, cancellation or timing of orders by the Company’s customers;

•

changes in sales and implementation cycles for the Company’s products;

•

the Company’s ability to maintain adequate inventory levels and purchase commitments;

•

the availability and cost of materials and services, including foundry, assembly and test capacity, needed by the Company from its foundries and suppliers;

•

fluctuations in the manufacturing output, yields and capacity of the Company’s suppliers;

•

problems or delays that the Company may face in shifting its products to smaller geometry process technologies and in achieving higher levels of design and device integration;

•

the ability of the Company’s suppliers, customers and communications service providers to obtain financing or to fund capital expenditures;

•

changes in the mix of products that the Company’s customers purchase;

•

the Company’s ability to successfully introduce new products and/or integrate new technologies;

•

the announcement or introduction of products by the Company’s competitors;

•

competitive pressures on selling prices or product availability;

•

erosion of average selling prices as a product matures coupled with the inability to sell newer products with higher average selling prices, resulting in lower overall revenue and margins;

•

the amount and timing of costs associated with product warranties and returns;

•

the amount and timing of the Company’s investments in research and development;

•

market and/or customer acceptance of the Company’s products;

•

consolidation among the Company’s competitors and/or its customers;

•

changes in the Company’s customers’ end user concentration or requirements;

•

loss of one or more current customers;

•

build-up of customer and/or channel inventory;

•

the inability of the Company’s customers to obtain components from their other suppliers;

•

disruption in the sales or distribution channels;

•

the timing and amount of employer payroll tax to be paid on the Company’s employees’ gains on stock options exercised;

•

changes in accounting or other regulatory rules, such as the possible future requirement to record expenses for employee stock option grants; and/or

•

fluctuations in market values of the Company’s investments.

As a consequence, operating results for a particular future period are difficult to predict, and prior results are not necessarily indicative of results to be expected in the future. Any of the foregoing factors, or any other factors discussed elsewhere herein, could have a material adverse effect on the Company’s business, financial condition and results of operations.

INCREASING COMPETITION IN THE MARKETS THAT THE COMPANY PARTICIPATES IN WILL MAKE IT MORE DIFFICULT FOR THE COMPANY TO SECURE DESIGN WINS.

The Company faces increased competition at the design stage, where customers evaluate alternative solutions based on a number of factors, including but not limited to, price, performance and product features. The Company has experienced increased pressure on pricing from some competitors that seek to enter the markets in which the Company participates. Such circumstances may make some of the Company’s products unattractive due to price or performance measures. These circumstances may result in the Company loosing design opportunities or may decrease its revenue as a result of the increased price competition.

IF THE COMPANY IS UNABLE TO CONVERT A SIGNIFICANT PORTION OF ITS DESIGN WINS INTO ACTUAL REVENUE, THE COMPANY’S BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS COULD BE MATERIALLY AND ADVERSELY IMPACTED.

The Company has secured a significant number of design wins for new and existing products. Such design wins are necessary for revenue growth of the Company. However, many of the Company’s design wins may never generate revenues, if their end-customer projects are unsuccessful in the market place. Additionally, some of the Company’s design wins are with privately-held, early-stage companies that may fail to bring their equipment to market. If design wins do generate revenue, the time lag between the design win and meaningful revenue may be in excess of 12 to 18 months. If the Company fails to convert a significant portion of its design wins into substantial revenue, it could materially and adversely impact the Company’s business, financial condition and results of operations.

THE COMPANY’S OPERATING RESULTS MAY VARY SIGNIFICANTLY BECAUSE OF THE CYCLICAL NATURE OF THE SEMICONDUCTOR INDUSTRY, AND SUCH VARIATIONS COULD MATERIALLY AND ADVERSELY AFFECT THE DEMAND FOR THE COMPANY’S PRODUCTS.

The Company competes primarily in the communications market within the semiconductor sector, both of which are cyclical and subject to technological change, evolving standards, price erosion and fluctuations in product supply and demand. At the same time, the semiconductor industry is subject to increases in demand in a strong economic environment, potentially leading to production capacity constraints. These constraints could materially and adversely affect the Company’s ability to ship products and meet customer demand in future periods as well as harm the Company’s operating results by increasing its product costs.

In addition, since 2000 the semiconductor industry, in particular the communications sector, has experienced a significant downturn characterized by diminished product demand, excess production capacity, high inventory levels and accelerated erosion of average selling prices. These factors, among others, have caused significant fluctuations in the Company’s revenues and results of operations. If the communication equipment market fails to recover, the Company’s business, financial condition and results of operations could be materially and adversely impacted.

THE COMPANY DEPENDS IN PART ON THE CONTINUED SERVICE OF ITS KEY ENGINEERING AND MANAGEMENT PERSONNEL AND ITS ABILITY TO IDENTIFY, HIRE AND RETAIN QUALIFIED PERSONNEL. IF THE COMPANY LOST KEY EMPLOYEES OR FAILED TO IDENTIFY, HIRE AND RETAIN THESE INDIVIDUALS, THE COMPANY’S BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS COULD BE MATERIALLY AND ADVERSELY IMPACTED.

The Company’s future success depends, in part, on the continued service of its key design engineering, technical, sales, marketing and executive personnel and its ability to identify, hire and retain other qualified personnel.

In the future, the Company may not be able to continue to attract and retain qualified personnel, including executive officers and other key management and technical personnel necessary for the development of its business. Competition for skilled employees having unique technical capabilities and industry-specific expertise continues to be a considerable risk inherent in the markets in which the Company competes. Volatility or lack of positive performance in the Company’s stock price may also adversely affect the Company’s ability to retain key employees, most of whom have been granted stock options. With respect to the Company’s management, the Company’s anticipated future growth is expected to place additional demands on management resources and, therefore, will likely require the addition of new management personnel as well as the development of additional expertise by existing management personnel. The failure to retain and recruit key design engineers, technical, sales, marketing and executive personnel could harm the Company’s business, financial condition and results of operations.

THE COMPANY DEPENDS ON THIRD PARTY FOUNDRIES TO MANUFACTURE ITS ICs. ANY DISRUPTION IN OR LOSS OF THE FOUNDRIES’ CAPACITY TO MANUFACTURE THE COMPANY’S PRODUCTS SUBJECTS IT TO A NUMBER OF RISKS, INCLUDING THE POTENTIAL FOR AN INADEQUATE SUPPLY OF PRODUCTS AND HIGHER MATERIALS COSTS. THESE RISKS MAY LEAD TO DELAYED PRODUCT DELIVERY OR INCREASED COSTS, WHICH COULD MATERIALLY AND ADVERSELY AFFECT THE COMPANY’S BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The Company does not own or operate a semiconductor fabrication facility (known as “foundry”), for wafer fabrication services. Most of the Company’s products are based on CMOS processes. A single foundry located outside of the United States manufactures greater than 90% of the Company’s wafer requirements based on CMOS processes. That foundry is discontinuing manufacturing products in its six-inch wafer manufacturing facility and transferring the existing business to one of its eight-inch wafer manufacturing facilities. This requires the qualification and transfer of many of the Company’s products over the next several quarters, which may result in additional costs, harm its ability to deliver its products on a timely basis and divert management’s time from other Company matters.

Many of the Company’s new products are designed to take advantage of smaller geometry manufacturing processes. Due to the complexity of migrating to smaller geometries, the Company may experience problems, which could result in design and production delays of the Company’s products. If such delays occur, the Company’s products may have delayed market acceptance or customers may select the Company’s competitors’ products during the design process.

The Company does not have long-term wafer supply agreements with its foundries that would guarantee wafer or product quantities, prices, and delivery or lead times. Rather, the foundries manufacture the Company’s products on a purchase order basis. The Company provides these foundries with rolling forecasts of its production requirements. However, the ability of each foundry to provide wafers to the Company is limited by the foundry’s available capacity, which appears to be more constrained in the current environment. In addition, the Company cannot be certain that it will continue to do business with its foundries on terms as favorable as its current terms. Significant risks associated with the Company’s reliance on third party foundries include:

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the lack of assured wafer supply;

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limited control over delivery schedules;

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limited manufacturing capacity of the third party foundries;

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limited control over quality assurance, manufacturing yields and production costs; and/or

•

potential misappropriation of the Company’s intellectual property.

The Company could experience a substantial delay or interruption in the shipment of its products or an increase in its costs due to any of the following:

•

a manufacturing disruption experienced by one or more of the Company’s foundries or sudden reduction or elimination of any existing source or sources of semiconductor manufacturing materials or processes, which might include the potential closure, change of ownership, change of management or consolidation by one or more of the Company’s foundries;

•

extended time required to identify and qualify alternative manufacturing sources for existing or new products;

•

failure of the Company’s suppliers to obtain the raw materials and equipment used in the production of its ICs;

•

qualification and transfer of products to another wafer manufacturing facility;

•

excess inventory associated with the transfer of product from one manufacturing facility to another, including the transfer of the Company’s products by one foundry from a six-inch to an eight-inch manufacturing facility;

•

acts of terrorism or civil unrest or an unanticipated shut-down due to communicable diseases; and/or

•

a sudden, sharp increase in demand for semiconductor devices, which could strain foundries’ manufacturing resources and cause delays in manufacturing and shipment of the Company’s products.

IF THE COMPANY’S FOUNDRIES DISCONTINUE THE MANUFACTURING PROCESSES NEEDED TO MEET THE COMPANY’S DEMANDS OR FAIL TO UPGRADE THE TECHNOLOGIES NEEDED TO MANUFACTURE THE COMPANY’S PRODUCTS, THE COMPANY MAY FACE PRODUCTION DELAYS, WHICH COULD MATERIALLY AND ADVERSELY IMPACT THE COMPANY’S BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The Company’s wafer requirements typically represent a small portion of the total production of the foundries that manufacture its products. As a result, the Company is subject to the risk that a foundry may cease production of a wafer fabrication process used to produce parts supplied to the Company. Additionally, the Company cannot be certain that its foundries will continue to devote resources to the production of its products or continue to advance the process design technologies on which the manufacturing of the Company’s products are based. Each of these events could increase the Company’s costs and harm its ability to deliver its products on time, thereby materially and adversely affecting the Company’s business, financial condition and results of operations.

TO SECURE FOUNDRY CAPACITY, THE COMPANY MAY BE REQUIRED TO ENTER INTO FINANCIAL AND OTHER ARRANGEMENTS WITH FOUNDRIES, WHICH COULD RESULT IN THE DILUTION OF ITS EARNINGS OR OTHERWISE HARM ITS OPERATING RESULTS.

Allocation of a foundry’s manufacturing capacity may be influenced by a foundry customer’s size or the existence of a long-term agreement with the foundry. To address foundry capacity constraints, the Company and other semiconductor companies that rely on third-party foundries have utilized various arrangements, including equity investments in or loans to foundries in exchange for guaranteed production capacity, joint ventures to own and operate foundries, or “take or pay” contracts that commit a company to purchase specified quantities of wafers over extended periods. While the Company is not currently a party to any of these arrangements, it may decide to enter into these arrangements in the future. The Company cannot be sure, however, that these arrangements will be available to it on acceptable terms, if at

all. Any of these arrangements could require the Company to commit substantial capital and, accordingly, could require it to reduce its cash holdings, incur additional debt or secure equity financing. This could result in the dilution of its earnings or the ownership of its stockholders or otherwise harm its operating results.

THE COMPANY’S DEPENDENCE ON THIRD-PARTY SUBCONTRACTORS TO ASSEMBLE AND TEST ITS PRODUCTS SUBJECTS IT TO A NUMBER OF RISKS, INCLUDING THE POTENTIAL FOR AN INADEQUATE SUPPLY OF PRODUCTS AND HIGHER MATERIALS COSTS. THESE RISKS MAY LEAD TO DELAYED PRODUCT DELIVERY OR INCREASED COSTS, WHICH COULD MATERIALLY AND ADVERSELY AFFECT THE COMPANY’S BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The Company depends on independent subcontractors in Asia for the majority of the assembly and testing of its products. The Company’s reliance on these subcontractors involves the following significant risks:

•

the Company’s reduced control over manufacturing yields, production schedules and product quality;

•

the potential closure, change of ownership, change in business conditions or relationships, change of management or consolidation by one or more of the Company’s subcontractors;

•

delayed deliveries due to the outbreak of communicable diseases;

•

difficulties in selecting, qualifying and integrating new subcontractors;

•

limited manufacturing capacity of the subcontractors;

•

limited warranties from the subcontractors for products assembled and tested for the Company;

•

the possible unavailability of qualified assembly or test services;

•

potential increases in assembly and test prices; and/or

•

potential misappropriation of the Company’s intellectual property.

These risks may lead to delays in the delivery of the Company’s products or increased costs for the finished products, either of which could harm the Company’s business, financial condition and results of operations.

THE COMPANY’S RELIANCE ON FOREIGN SUPPLIERS EXPOSES IT TO RISKS ASSOCIATED WITH INTERNATIONAL OPERATIONS, ANY OF WHICH COULD MATERIALLY AND ADVERSELY IMPACT ITS BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The Company uses semiconductor wafer foundries and assembly and test subcontractors throughout Asia to manufacture the majority of its products. The Company’s dependence on these subcontractors involves the following risks:

•

political, civil and economic instability;

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disruption to transportation to and from Asia;

•

embargoes or other regulatory limitations affecting the availability of raw materials, equipment or services;

•

changes in tax laws, tariffs and freight rates; and/or

•

compliance with local or foreign regulatory requirements.

These risks may lead to delays in product delivery or increased costs, either of which could harm the Company’s profitability and customer relationships, thereby materially and adversely impacting the Company’s business, financial condition and results of operations.

THE COMPANY’S RELIANCE ON FOREIGN CUSTOMERS COULD CAUSE FLUCTUATIONS IN ITS OPERATING RESULTS, WHICH COULD MATERIALLY AND ADVERSELY IMPACT THE COMPANY’S BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

International sales accounted for 53.5% and 56.1% of net sales for the three and nine months ended December 31, 2003, respectively. International sales will likely continue to account for a significant portion of the Company’s revenues, which would subject the Company to the following risks:

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changes in regulatory requirements;

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tariffs and other barriers;

•

timing and availability of export licenses;

•

political, civil and economic instability;

•

disruptions to customer operations due to the outbreak of communicable diseases;

•

difficulties in accounts receivable collections;

•

difficulties in staffing and managing foreign subsidiary and branch operations;

•

difficulties in managing distributors;

•

difficulties in obtaining governmental approvals for communications and other products;

•

limited intellectual property protection;

•

foreign currency exchange fluctuations;

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the burden of complying with and the risk of violating a wide variety of complex foreign laws and treaties; and/or

•

potentially adverse tax consequences.

In addition, because sales of the Company’s products have been denominated primarily in United States dollars, increases in the value of the United States dollar could increase the relative price of the Company’s products such that they become more expensive to customers in the local currency of a particular country. Increased international activity in the future may result in increased foreign currency denominated sales. Furthermore, because some of the Company’s customers’ purchase orders and agreements are governed by foreign laws, the Company may be limited in its ability to enforce its rights under these agreements and to collect damages, if awarded.

IF THE COMPANY’S DISTRIBUTORS OR SALES REPRESENTATIVES STOPPED SELLING, OR FAILED TO SUCCESSFULLY PROMOTE, THE COMPANY’S PRODUCTS, THE COMPANY’S BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS COULD BE HARMED.

The Company sells many of its products through two non-exclusive domestic distributors and numerous sales representatives. The Company’s non-exclusive domestic distributors and sales representatives could reduce or discontinue sales of the Company’s products. They may not devote the resources necessary to sell the Company’s products in the volumes and within the time frames that the Company expects. In addition, the Company depends on the continued viability and financial resources of these distributors and sales representatives, some of which are small organizations with limited working capital. In turn, these distributors and sales representatives are subject to general economic and semiconductor industry conditions. The Company believes that its success will continue to depend on these distributors and sales representatives. If some or all of the Company’s distributors and sales representatives experience financial difficulties, or otherwise become unable or unwilling to promote and sell the Company’s products, the Company’s business, financial condition and results of operations could be harmed.

BECAUSE THE COMPANY’S COMMUNICATIONS ICs TYPICALLY HAVE LENGTHY SALES CYCLES, THE COMPANY MAY EXPERIENCE SUBSTANTIAL DELAYS BETWEEN INCURRING EXPENSES RELATED TO RESEARCH AND DEVELOPMENT AND THE GENERATION OF REVENUE DERIVED FROM THESE PRODUCTS.

Due to the communications IC equipment product cycle, the Company has typically experienced 12 to 18 months or longer to realize volume shipments after its initial contact with a customer. The Company first works with customers to achieve a design win, which may take six months or longer. The Company’s customers then complete the design, testing and evaluation process and begin to ramp-up production, a period which typically lasts an additional six months or longer. As a result, a significant period of time may elapse between the Company’s research and development efforts and its realization of revenue, if any, from volume purchasing of the Company’s communications products by its customers.

THE COMPANY’S BACKLOG MAY NOT RESULT IN FUTURE REVENUE.

Due to possible customer changes in delivery schedules and quantities actually purchased, cancellation of orders, distributor returns or price reductions, the Company’s backlog at any particular date is not necessarily indicative of actual sales for any succeeding period. A reduction of the order backlog during any particular period, or the failure of the Company’s backlog to result in future revenue, could negatively impact the Company’s business, financial condition and results of operations.

FIXED OPERATING EXPENSES AND THE COMPANY’S PRACTICE OF ORDERING MATERIALS IN ANTICIPATION OF FUTURE CUSTOMER DEMAND COULD MAKE IT DIFFICULT FOR THE COMPANY TO RESPOND EFFECTIVELY TO SUDDEN SWINGS IN DEMAND. SUCH SUDDEN SWINGS IN DEMAND COULD THEREFORE HAVE A MATERIALLY ADVERSE IMPACT ON THE COMPANY’S BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The Company’s operating expenses are relatively fixed in the short to medium term, and, therefore, it has limited ability to reduce expenses quickly and sufficiently in response to any revenue shortfalls. Consequently, the Company’s operating results will be harmed if it does not meet its revenue projections.

In addition, the Company typically plans its production and inventory levels based on internal forecasts of customer demand, which are highly unpredictable and can fluctuate substantially. From time to time, in response to anticipated long lead times to obtain inventory and materials from the Company’s outside suppliers and foundries, the Company may order materials in advance of anticipated customer demand. This advance ordering may result in excess inventory levels or unanticipated inventory write-downs if expected orders fail to materialize. This incremental cost could have a materially adverse impact on the Company’s business, financial condition and results of operations.

THE COMPANY HAS MADE AND MAY IN THE FUTURE MAKE ACQUISITIONS AND SIGNIFICANT STRATEGIC EQUITY INVESTMENTS, WHICH MAY INVOLVE A NUMBER OF RISKS; IF THE COMPANY IS UNABLE TO ADDRESS THESE RISKS SUCCESSFULLY, SUCH ACQUISITIONS AND INVESTMENTS COULD HAVE A MATERIALLY ADVERSE IMPACT ON THE COMPANY’S BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The Company has undertaken a number of strategic acquisitions and investments in the past and may do so from time to time in the future. The risks involved with these acquisitions and investments include, among others:

•

the possibility that the Company may not receive a favorable return on its investment, the original investment may become impaired, and/or the Company may incur losses from these investments;

•

the Company’s assumption of known or unknown liabilities or other unanticipated events or circumstances; and/or

•

the diversion of management’s attention from normal daily operations of the business.

Additional risks involved with acquisitions include, among others:

•

difficulties in integrating the operations, technologies, products and personnel of the acquired companies;

•

failure to retain key personnel;

•

difficulties in entering markets in which the Company has no or limited direct prior experience and where competitors in such markets may have stronger market positions;

•

insufficient revenues to offset increased expenses associated with acquisitions;

•

under-performance problems with an acquired company;

•

issuance of common stock that would dilute the Company’s current stockholders’ percentage ownership;

•

recording of goodwill and non-amortizable intangible assets that will be subject to periodic impairment testing and potential impairment charges against the Company’s future earnings;

•

incurring amortization expenses related to certain intangible assets;

•

the opportunity cost associated with committing capital in such investments;

•

incurring large and immediate write-offs; and/or

•

becoming subject to litigation.

The risks involved with strategic equity investments include, among others:

•

the possibility of litigation resulting from these types of investments;

•

the possibility that the Company may not receive a favorable return on its investments, the original investment may become impaired, and/or incur losses from these investments; and/or

•

the opportunity cost associated with committing capital in such investments.

The Company cannot assure that it will be able to address these risks successfully without substantial expense, delay or other operational or financial problems. Any delays or other such operations or financial problems could adversely impact the Company’s business, financial condition and results of operations.

THE COMPANY MAY BE UNABLE TO PROTECT ITS INTELLECTUAL PROPERTY RIGHTS, WHICH COULD HARM THE COMPANY’S COMPETITIVE POSITION.

The Company’s ability to compete is affected by its ability to protect its intellectual property rights. The Company relies on a combination of patents, trademarks, copyrights, mask work registrations, trade secrets, confidentiality procedures and non-disclosure and licensing arrangements to protect its intellectual property rights. Despite these efforts, the Company may be unable to protect its proprietary information. Moreover, the Company cannot be certain that its competitors will not independently develop technology that is substantially similar or superior to the Company’s technology.

More specifically, the Company cannot be sure that its pending patent applications or any future applications will be approved, or that any issued patents will provide it with competitive advantages or will not be challenged by third parties. Nor can the Company be sure that, if challenged, the Company’s patents will be found to be valid or enforceable, or that the patents of others will not have an adverse effect on the Company’s ability to do business. Furthermore, others may

independently develop similar products or processes, duplicate the Company’s products or processes or design around any patents that may be issued to the Company.

THE COMPANY COULD BE REQUIRED TO PAY SUBSTANTIAL DAMAGES OR COULD BE SUBJECT TO VARIOUS EQUITABLE REMEDIES IF IT WERE PROVEN THAT IT INFRINGED ON THE INTELLECTUAL PROPERTY RIGHTS OF OTHERS.

As a general matter, the semiconductor industry is characterized by substantial litigation regarding patents and other intellectual property rights. If a third party were to prove that the Company’s technology infringed a third party’s intellectual property rights, the Company could be required to pay substantial damages for past infringement and could be required to pay license fees or royalties on future sales of the Company’s products. If the Company were required to pay such license fees whenever it sold its products, such fees could exceed the Company’s revenue. In addition, if it were proven that the Company willfully infringed a third party’s proprietary rights, the Company could be held liable for three times the amount of the damages that the Company would otherwise have to pay. Such intellectual property litigation could also require the Company to:

•

stop selling, incorporating or using its products that use the infringed intellectual property;

•

obtain a license to make, sell or use the relevant technology from the owner of the infringed intellectual property, which license may not be available on commercially reasonable terms, if at all; and/or

•

redesign the Company’s products so as not to use the infringed intellectual property, which may not be technically or commercially feasible.

Furthermore, the defense of infringement claims and lawsuits, regardless of their outcome, would likely be expensive to resolve and could require a significant portion of management’s time. In addition, rather than litigating an infringement matter, the Company may determine that it is in the Company’s best interests to settle the matter. Terms of a settlement may include the payment of damages and the Company’s agreement to license technology in exchange for a license fee and ongoing royalties. These fees could be substantial. If the Company were required to pay damages or otherwise became subject to such equitable remedies, its business, financial condition and results of operations would suffer. Similarly, if the Company were required to pay license fees to third parties based on a successful infringement claim brought against it, such fees could exceed the Company’s revenue.

EARTHQUAKES AND OTHER NATURAL DISASTERS MAY DAMAGE THE COMPANY’S FACILITIES OR THOSE OF ITS SUPPLIERS.

The Company’s corporate headquarters in Fremont, California is located near major earthquake faults that have experienced seismic activity. In addition, some of the Company’s suppliers are located near fault lines. In the event of a major earthquake or other natural disaster near its headquarters, the Company’s operations could be disrupted. Similarly, a major earthquake or other natural disaster near one or more of the Company’s major suppliers could adversely impact the operations of those suppliers, which could limit the supply of the Company’s products and harm its business.

THE COMPANY’S STOCK PRICE IS VOLATILE.

The market price of the Company’s common stock has fluctuated significantly to date. In the future, the market price of its common stock could be subject to significant fluctuations due to:

•

the Company’s anticipated or actual operating results;

•

announcements or introductions of new products;

•

technological innovations by the Company or its competitors;

•

product delays or setbacks by the Company, its customers or its competitors;

•

potential supply disruptions;

•

sales channel interruptions;

•

concentration of sales among a small number of customers;

•

conditions in the communications and semiconductor markets;

•

the commencement of litigation;

•

changes in estimates of the Company’s performance by securities analysts;

•

decreases in the value of its investments, thereby requiring an asset impairment charge against earnings;

•

announcements of merger or acquisition transactions; and/or

•

general global economic and market conditions.

In the past, securities and class action litigation has been brought against companies following periods of volatility in the market prices of their securities. The Company may be the target of one or more of these class action suits, which could result in significant costs and divert management’s attention, thereby harming the Company’s business, results of operations and financial condition.

In addition, in recent years the stock market has experienced extreme price and volume fluctuations that have affected the market prices of many high technology companies, including semiconductor companies, and that have often been unrelated or disproportionate to the operating performance of those companies. These fluctuations may harm the market price of the Company’s common stock.

THE ANTI-TAKEOVER PROVISIONS OF THE COMPANY’S CERTIFICATE OF INCORPORATION AND OF THE DELAWARE GENERAL CORPORATION LAW MAY DELAY, DEFER OR PREVENT A CHANGE OF CONTROL.

The Company’s Board of Directors has the authority to issue up to 2,250,000 shares of preferred stock and to determine the price, rights, preferences and privileges and restrictions, including voting rights, of those shares without any further vote or action by its stockholders. The rights of the holders of common stock will be subject to, and may be harmed by, the rights of the holders of any shares of preferred stock that may be issued in the future. The issuance of preferred stock may delay, defer or prevent a change in control. The terms of the preferred stock that might be issued could potentially prohibit the Company’s consummation of any merger, reorganization, sale of substantially all of its assets, liquidation or other extraordinary corporate transaction without the approval of the holders of the outstanding shares of common stock. In addition, the issuance of preferred stock could have a dilutive effect on the Company’s stockholders.

The Company’s stockholders must give 120 days advance notice prior to any stockholders meeting at which a stockholder intends to nominate a candidate for director or present a proposal to the Company’s stockholders for approval. These notice requirements could inhibit a takeover by delaying stockholder action. The Company has in place a stockholder rights plan, or “poison pill,” that may result in substantial dilution to a potential acquirer of the Company in the event that the Company’s Board of Directors does not agree to an acquisition proposal. The rights plan may make it more difficult and costly to acquire the Company. The Delaware anti-takeover law restricts business combinations with some stockholders once the stockholder acquires 15% or more of the Company’s common stock. The Delaware statute makes it more difficult for the Company to be acquired without the consent of its Board of Directors.

ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Foreign Currency Fluctuations. The Company is exposed to foreign currency fluctuations primarily through its foreign operations. This exposure is the result of foreign operating expenses being denominated in foreign currency. Operational currency requirements are typically forecasted for a three-month period. If there is a need to hedge this risk, the Company will enter into transactions to purchase currency in the open market or enter into forward currency exchange contracts.

If the Company’s foreign operations forecasts are overstated or understated during periods of currency volatility, the Company could experience unanticipated currency gains or losses. For the three and nine months ended December 31, 2003, the Company did not have significant foreign currency denominated net assets or net liabilities positions, and had no foreign currency contracts outstanding.

Interest Rate Sensitivity. The Company maintains investment portfolio holdings of various issuers, types, and maturity dates with various banks and investment banking institutions. The market value of these investments on any given day during the investment term may vary as a result of market interest rate fluctuations. This exposure is not hedged because a hypothetical 10% movement in interest rates during the investment term would not likely have a material impact on investment income. The actual impact on investment income in the future may differ materially from this analysis, depending on actual balances and changes in the timing and the amount of interest rate movements.

Both short-term and long-term investments are classified as “available-for-sale” securities and the cost of securities sold is based on the specific identification method. At December 31, 2003, short-term investments consisted of auction rate securities, government and corporate securities of $131.1 million. The Company did not have long-term investments at December 31, 2003. At December 31, 2003, the difference between the fair market value and the underlying cost of such investments was an unrealized loss of $180,000, before the effect of income taxes.

The Company’s net income is dependent on, among other factors, interest income and realized gains from the sale of marketable investments. If interest rates continue to decline or the Company is not able to realize gains from the sale of marketable securities, the Company’s net income may be negatively impacted.

ITEM 4.

CONTROLS AND PROCEDURES

a)	Disclosure Controls and Procedures.

Evaluation of Disclosure Controls and Procedures (“Disclosure Controls”). The Company evaluated the effectiveness of the design and operation of its Disclosure Controls, as defined by the rules and regulations of the SEC (the “Evaluation”), as of the end of the period covered by this Report. This Evaluation was performed under the supervision and with the participation of management, including the Chief Executive Officer (the “CEO”) and Chief Financial Officer (the “CFO”). Rules adopted by the SEC require that in this section of this Report the Company present conclusions of the CEO and the CFO about the effectiveness of its Disclosure Controls based on the Evaluation and as of the date of the end of the period covered by this Report.

CEO and CFO Certifications. Attached as Exhibits 31.1 and 31.2 of this Report are the certifications of the CEO and the CFO in compliance with Section 302 of the Sarbanes-Oxley Act of 2002 (the “Certifications”). This section of the Report provides information concerning the Evaluation referred to in the Certifications and should be read in conjunction with the Certifications.

Disclosure Controls. Disclosure Controls are controls and procedures designed to ensure that information required to be disclosed in the reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods as specified in the SEC’s rules and forms. In addition, Disclosure Controls are designed to allow for the accumulation and communication of information to the Company’s management, including the CEO and CFO, to allow timely decisions regarding required disclosures. The Company’s Disclosure

Controls include, among other, components of the Company’s internal controls over financial reporting, which is comprised of processes that are designed to provide reasonable assurance regarding the reliability of the Company’s financial reporting and the preparation of financial statements in accordance with GAAP.

Limitations on the Effectiveness of Disclosure Controls. The Company’s management, including the CEO and CFO, does not expect that the Disclosure Controls will prevent all errors and all fraud. Disclosure Controls, no matter how well conceived, managed, utilized and monitored, can provide only reasonable assurance that the objectives of such controls are met. Therefore, because of the inherent limitation of the Disclosure Controls, no evaluation of such controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.

Scope of Evaluation. The CEO and CFO, in conjunction with the Company’s Disclosure Control Committee, have conducted an Evaluation of the Company’s Disclosure Controls, which included a review of the Disclosure Controls effect of such controls on the information considered for use and inclusion in this Report.

Conclusion. Based on the Evaluation, the CEO and CFO have concluded that, subject to the limitations noted above, the Company’s Disclosure Controls are effective, as of the end of the period covered by this Report, to provide for reasonable assurance that material information relating to the Company is made known to management, including the CEO and CFO, particularly during the period this Report was being prepared.

b)	Changes in Internal Control Over Financial Reporting.

Internal Control Over Financial Reporting. There was no change in the Company’s internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

c)	Non-Audit Services.

In accordance with Section 10A of the Securities Exchange Act of 1934, as amended by Section 202 of the Sarbanes-Oxley Act of 2002, non-audit services approved by the Company’s Audit Committee, performed or to be performed by PricewaterhouseCoopers L.L.P., the Company’s independent auditors, are as follows: (1) corporate income tax return preparation; (2) other-tax related services; and (3) accounting advisory services with respect to filings with the SEC.

d)	Available Information.

The Company files electronically with the SEC its Annual Reports on Form 10-K, Quarterly Interim Reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. The SEC maintains an Internet site at http://www.sec.gov that contains reports, proxy and information statements and other information regarding the issuer. The Company makes available on its website at www.exar.com, free of charge, copies of these reports as soon as reasonably practicable after filing or furnishing the information to the SEC. Copies of such documents may be requested by contacting the Company’s Investors Relations department at (510) 668-7201 or by sending an e-mail through the Investors Homepage on the Company’s website: www.exar.com.

PART II – OTHER INFORMATION

ITEM 6.

EXHIBITS AND REPORTS ON FORM 8-K

(a)

Exhibits

Exhibits filed with the current Report on Form 10-Q for the quarter ended December 31, 2003 are as follows:


Exhibit Number		Description

10.10		Executive Employment Agreement between Exar Corporation and Donald L. Ciffone, Jr., dated December 6, 2000, as amended and restated on June 21, 2001, March 28, 2003, June 12, 2003 and December 3, 2003.

31.1		Chief Executive Officer Certification

31.2		Chief Financial Officer Certification

32.1		Section 906 Certification of Chief Executive Officer

32.2		Section 906 Certification of Chief Financial Officer

(b)

Reports on Form 8-K

The Company furnished a Current Report on Form 8-K on January 15, 2004 to report under Item 9. “Results of Operations and Financial Condition” announcing its results for the third fiscal quarter ended December 31, 2003.

SIGNATURES

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


	EXAR CORPORATION
	(Registrant)

February 10, 2004	By:	/s/ DONALD L. CIFFONE JR.

		(Donald L. Ciffone Jr.)
		Chairman of the Board,
		Chief Executive Officer and President
		*(Principal Executive Officer)*

February 10, 2004	By:	/s/ RONALD W. GUIRE

		(Ronald W. Guire)
		Executive Vice President, Chief Financial Officer,
		Assistant Secretary and Director
		*(Principal Financial and Accounting Officer)*

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