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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended June 30, 2004

OR

For the Transition Period from              to            

Commission File Number: 000-50391

SIGMATEL, INC.

(Exact name of registrant as specified in its charter)

3815 South Capital of Texas Highway

Building 3, Suite 300

Austin, Texas 78704

(512) 381-3700

(Address and telephone number of principal executive offices)

Indicate by check mark whether 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 Exchange Act Rule 12b-2).     Yes  ¨    No  x

The number of shares outstanding of the Registrant’s Common Stock, $0.0001 par value, was 35,348,710 as of July 15, 2004.

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SIGMATEL, INC.

FORM 10-Q

TABLE OF CONTENTS

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PART I: FINANCIAL INFORMATION

Item 1. Financial Statements

SIGMATEL, INC.

CONDENSED BALANCE SHEETS

(in thousands, except share data)

(unaudited)

The accompanying notes are an integral part of these condensed financial statements.

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SIGMATEL, INC.

CONDENSED STATEMENTS OF OPERATIONS

(in thousands, except share data)

(unaudited)

The accompanying notes are an integral part of these condensed financial statements.

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SIGMATEL, INC.

CONDENSED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

The accompanying notes are an integral part of these condensed financial statements.

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SigmaTel, Inc.

Notes to Condensed Financial Statements

1. Basis of Presentation

The accompanying unaudited condensed financial statements of SigmaTel, Inc. (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America applicable to interim financial statements. Accordingly, they do not include all of the information and notes required for complete financial statements. In the opinion of management, all adjustments and reclassifications considered necessary for a fair and comparable presentation have been included and are of a normal recurring nature. Operating results for the three month and six month periods ended June 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004.

2. Follow-on Equity Offering

On February 18, 2004, the Securities and Exchange Commission declared effective the Company’s registration statement, which the Company filed on Form S-1 under the Securities Act of 1933 in connection with a follow-on offering of its common stock. Under this registration statement, the Company registered 9,830,422 shares of its common stock, including 1,282,229 shares subject to the underwriters’ overallotment option (of which 212,229 shares were exercised), with a public offering price of $25.01 per share. The Company registered 250,000 of these shares on its behalf and 9,580,422 on behalf of certain stockholders of the Company. The Company received $5.3 million in proceeds after deducting the underwriters fees and transaction costs.

3. Significant Accounting Policies

For a description of what the Company believes to be the critical accounting policies that affect our more significant judgments and estimates used in the preparation of our financial statements, refer to our Form 10-K filed with the Securities and Exchange Commission. There have been no changes in our critical accounting policies since December 31, 2003.

Accounting for Stock-Based Compensation

Employee stock awards under the Company’s compensation plans are accounted for in accordance with Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, Financial Accounting Standards Board Interpretation No. 44, Emerging Issues Task Force (“EITF”) Issue No. 00-23, and related interpretations. The Company accounts for equity awards issued to non-employees in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, and EITF Issue No. 96-18, Accounting for Equity Instruments that are Issued to other than Employees for Acquiring, or in Conjunction with Selling Goods or Services and related interpretations. The following table illustrates the effect on net income (loss) as if the Company had applied the fair value recognition provisions of SFAS No. 123 (in thousands, except share data):

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SigmaTel, Inc.

Notes to Condensed Financial Statements-(Continued)

Comprehensive Income

Comprehensive income includes all changes in stockholders’ equity during a period from non-owner sources. For the three months and six months ended June 30, 2004 and 2003, there were no differences between the Company’s net income (loss) and its comprehensive income (loss).

Net Income (loss) per Share

Basic net income (loss) attributable to common stockholders per share is computed by dividing net income (loss) attributable to common stockholders by the weighted-average number of shares of common stock outstanding for the period. Diluted net income (loss) attributable to common stockholders per share is computed giving effect to all potential dilutive common stock, including options, warrants, common stock subject to repurchase and redeemable convertible preferred stock.

A reconciliation of the numerator and denominator used in the calculation of basic and diluted net income (loss) attributable to common stockholders per share is as follows (in thousands, except share data):

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SigmaTel, Inc.

Notes to Condensed Financial Statements-(Continued)

The following outstanding options, common stock subject to repurchase, redeemable convertible preferred stock and warrants were excluded from the computation of diluted net income (loss) per share as they had an antidilutive effect:

Included in the calculation of net income (loss) attributable to common stockholders are deemed dividends of zero and $0.1 million for the three months ended June 30, 2004 and 2003, respectively, and zero and $8.3 million for the six months ended June 30, 2004 and 2003, respectively, related to the issuance of the Company’s Series F, H and J Preferred Stock.

4. Short-term Investments

Short-term investments at June 30, 2004 and December 31, 2003, consisting of corporate, state and municipal securities, were acquired at an aggregate cost of $90.8 million and $49.4 million, respectively. The fair value of these instruments are based on market interest rates and other market information available to management as of each balance sheet date presented and was not materially different than the aggregate cost.

Short-term investments consist of the following (in thousands):

Management classifies investments in marketable securities at the time of purchase and reevaluates such classification at each balance sheet date. Securities classified as available-for-sale are stated at cost, which is not materially different than market value as of June 30, 2004. $2.1 million of investments mature beyond one year and within five years and $74.3 million of investments mature beyond five years, but have interest rate maturities of less than thirty-five days.

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SigmaTel, Inc.

Notes to Condensed Financial Statements-(Continued)

5. Inventories

Inventories consist of the following (in thousands):

At June 30, 2004 and December 31, 2003, the Company’s reserve for slow-moving and obsolete inventory was approximately $1.7 million and $1.4 million, respectively. This increase resulted from additional reserve of $0.8 million for obsolescence offset by scrap and sales of items which had previously been reserved of $0.5 million.

6. Intangible Assets

Intangible assets subject to amortization expense relate to licenses to use intellectual property in manufacturing and patents. Intangible assets consist of the following (in thousands):

Intangible asset amortization expense for the three months ended June 30, 2004 and 2003 was $0.2 million and $8,000, respectively, and for the six months ended June 30, 2004 and 2003 was $0.5 million and $8,000, respectively. Estimated aggregate intangible asset amortization expense for each of the fiscal years 2004 through 2008 is expected to be $0.9 million. The weighted average amortization period for intangible assets is five years.

7. Commitments and Contingencies

The Company leases its office space and certain office equipment under noncancelable operating leases. Total rent expense under these operating leases was approximately $0.5 million for the three months ended June 30, 2004 and 2003, respectively, and approximately $1.0 million for the six months ended June 30, 2004 and 2003, respectively. The Company earned rental income from office space subleased to third parties of $0.2 million during the three months ended June 30, 2004 and 2003, respectively, and $0.4 million during the six months ended June 30, 2004 and 2003, respectively.

In connection with a technology license agreement with Metanoia Technologies, Inc. (“Metanoia”), the Company has indemnified Metanoia with respect to the infringement of third party proprietary rights. The indemnification is limited to $2.5 million. No claims or assertions have been made against the Company in connection with this indemnification.

In the normal course of its business, the Company enters into contracts that contain a variety of representations and warranties and which provide general indemnifications. The Company’s exposure under these arrangements is unknown as this would involve future claims that might be made against the Company that have not yet occurred. However, based on experience, the Company expects the risk of any loss to be remote.

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SigmaTel, Inc.

Notes to Condensed Financial Statements-(Continued)

8. Related Party Transactions

Revenues from a significant stockholder were approximately $5.9 million and $1.0 million for the three months ended June 30, 2004 and 2003, respectively, and approximately $9.1 million and $2.2 million for the six months ended June, 2004 and 2003, respectively.

Accounts receivable from sales to an affiliated customer were approximately $4.9 million and $5.6 million as of June 30, 2004 and December 31, 2003, respectively.

The Company paid for legal services to a law firm affiliated with a stockholder of the Company of approximately $197,000 and $15,000 for the three months ended June 30, 2004 and 2003, respectively, and approximately $203,000 and $16,000 for the six months ended June 30, 2004 and 2003, respectively.

At June 30, 2004 and December 31, 2003, the Company had approximately $8,000 and $115,000, respectively, in receivables from non-executive employees to finance their purchases of restricted common stock.

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SigmaTel, Inc.

Notes to Condensed Financial Statements-(Continued)

9. Operating Segments and Geographic Information

The Company operated in a single segment, and the Company’s chief operating decision maker uses measurements aggregated at the entity-wide level to manage the business.

The following table summarizes the percentages of revenues by geographic region:

The table below summarizes the percentage of long-lived assets by geographic region:

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

Forward-looking Statements

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such statements are based upon current expectations that involve risks and uncertainties. Any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. For example, the words “believes”, “anticipates”, “plans”, “expects”, “intends” and similar expressions are intended to identify forward-looking statements. Our actual results and the timing of certain events may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such a discrepancy include, but are not limited to, those discussed in “Overview”, “Results of Operations”, “Liquidity and Capital Resources” and “Risks That May Affect Future Results” below. All forward-looking statements in this document are based on information available to us as of the date hereof and we assume no obligation to update any such forward-looking statements. The following discussion should be read in conjunction with our condensed financial statements and the accompanying notes contained in this quarterly report. Unless expressly stated or the context otherwise requires, the terms “we”, “our”, “us” and “SigmaTel” refer to SigmaTel, Inc.

Overview

We are a fabless semiconductor company that designs, develops, and markets proprietary, analog-intensive, mixed-signal ICs. We were founded in 1993 with an initial focus on providing semiconductor design services on a contract basis. We began to develop our first IC product, an AC97 audio codec for PC sound cards, in 1995 and began shipping this product in 1997. From 1997 to 2000, our annual revenues grew rapidly from $1.2 million to $47.4 million. During that time, we began to develop an asymmetric digital subscriber line, or ADSL, SoC and a portable audio SoC. Neither of these products generated revenues, which led to significant operating losses in 2000 and 2001. During 2000 and 2001, the PC audio market transitioned from sound cards to host audio solutions, which are integrated on desktop PC motherboards and in notebook PCs. As sound cards began to lose market share, we experienced a significant loss in market share and a revenue decline from 2000 to 2001.

In early 2001, we hired our current Chief Executive Officer, Ronald Edgerton, and established a new management team. This new management team stopped development of our ADSL SoC, reduced headcount, and redirected our development efforts towards host audio codecs and portable audio SoCs. Due primarily to increased sales of our portable audio SoCs, our revenues increased from $30.9 million for the year ended December 31, 2002 to $100.2 million for the year ended December 31, 2003, and our operating results improved from an operating loss of $5.6 million for the year ended December 31, 2002 to operating income of $11.3 million for the year ended December 31, 2003.

We currently offer products that serve four markets: portable compressed audio players, notebook and desktop PC audio, consumer audio, and USB peripherals. We made our first commercial shipments of PC audio codecs during 1997. We made our first commercial shipments of USB peripheral ICs in 2000, primarily targeting USB-to-Infrared wireless connectivity applications. We made our first commercial shipments of portable audio SoCs in 2001. The primary market for these products is the portable compressed audio player market. During 2001, we also began to sell our audio codecs into the consumer electronics market for products such as DVD players and set top boxes.

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As a fabless semiconductor company, our business model is less capital intensive because we rely on third parties to manufacture, assemble, and test our ICs. We principally rely on distributors to market our products. Our sales through distributors result in lower gross margins, but also lower selling expenses than are associated with direct sales to end customers. A few customers account for a substantial portion of our sales. The following table sets forth our customers that represented 10% or more of our revenues for the periods indicated:

The percentage of our revenues from customers located outside the U.S. was 99.8% for each of the three month and six month periods ended June 30, 2004 and 2003, respectively. Most of the products that use our ICs are manufactured outside of the U.S. As a result, we believe that a substantial majority of our revenues will continue to come from customers located outside of the U.S. All of our revenues to date have been denominated in U.S. dollars.

The percentages of our revenues by country are set forth in the following table:

Our sales cycles can take up to 12 months to complete and volume production of products that use our ICs can take an additional 3 to 6 months to be achieved, if at all. The lengthy sales cycles of our products make forecasting the volume and timing of orders difficult. In addition, the delays inherent in lengthy sales cycles increase the risk that customers may seek to cancel or modify their orders. Our sales are made by purchase orders. Because industry practice allows customers to reschedule or cancel orders on relatively short notice, and order lead times can vary period to period, backlog is not a good indicator of our future sales. Cancellations of customer orders or changes in product specifications could result in the loss of anticipated sales without allowing us sufficient time to reduce our inventory and operating expenses.

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Because many of our ICs are designed for use in consumer electronic products, such as portable compressed audio players, PCs, and DVD players, we expect our business to be subject to seasonality, with increased revenues in the third and fourth quarters of each year, when customers place orders to meet year-end holiday demand, and lower revenues in the first and second quarters of each year. However, our recent rapid revenue growth makes it difficult for us to assess the impact of seasonal factors on our business. In particular, strong sales of our portable audio SoCs resulted in increased revenues during the first quarter of 2003 compared to the fourth quarter of 2002, offsetting seasonal demand factors.

SigmaTel, Inc. was incorporated in Texas in 1993 and changed its state of incorporation to Delaware in August 2003 by merging into a wholly owned subsidiary. As a result of the merger, that subsidiary succeeded to all rights and obligations of the Texas corporation, and the Texas corporation ceased to exist. Prior to the merger, the Delaware subsidiary conducted no operations and had no assets or liabilities other than $1,000 of cash contributed to it by the Texas corporation.

The following describes certain line items in our statements of operations:

Revenues. Revenues consist primarily of sales of our ICs, net of sales discounts or incentives. We recognize revenues on direct sales at the time of shipment to our customers. We defer revenues on sales through distributors with rights of return or price protection until products are resold by such distributors to their customers.

Cost of Goods Sold. Cost of goods sold consists primarily of the costs of purchasing silicon wafers, and also includes costs associated with assembly, test and shipping of our ICs, costs of personnel and equipment associated with manufacturing support and quality assurance, and occupancy costs. Because we do not have long-term, fixed-price supply contracts, our wafer costs are subject to the cyclical demand for semiconductors.

Research and Development. Research and development expense consists primarily of employee, contractor, and related costs, expenses for development testing, evaluation, masking revisions, occupancy costs, and depreciation on research and development equipment. All research and development costs are expensed as incurred. We plan to continue to invest a significant amount in research and development activities to develop new products. We expect research and development expenses to increase in absolute dollars.

Selling, General and Administrative. Selling, general and administrative expense consists primarily of employee, contractor, and related costs, occupancy costs, sales commissions to independent sales representatives, professional services, and promotional and marketing expenses. We expect selling expenses will fluctuate with changes in revenues, and we expect that general and administrative expenses will increase to support our future operations as well as the additional costs of operating as a publicly traded company.

Amortization of Deferred Stock-Based Compensation. In connection with grants of stock options and the issuance of warrants as a private company between 2000 and 2003, we recorded an aggregate of $7.5 million in deferred stock-based compensation. These options and warrants are considered compensatory because the fair value of our stock determined for financial reporting purposes was greater than the fair value determined by our board of directors on the date of grant or issuance. As of June 30, 2004, we had an aggregate of $2.0 million of deferred stock-based compensation remaining to be amortized. We are amortizing deferred stock-based compensation over the vesting period of the related options and warrants, which is generally four or five years. This deferred stock-based compensation balance is expected to be amortized as follows: $2.2 million during 2004; $0.9 million during 2005 and $0.4 million during 2006.

Provision for Income Taxes. As of December 31, 2003, we had net operating loss carryforwards of approximately $36.3 million. These net operating loss carryforwards will expire at various dates beginning in 2011. We also had research and development tax credit carryforwards of approximately $2.4 million for federal income tax purposes. The federal research and development tax credit carryforward will expire at various dates beginning in 2011. The state research credit can be carried forward indefinitely. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.

Under the Internal Revenue Code, certain substantial changes in ownership could result in an annual limitation on the amount of net operating loss and credit carryforwards that can be utilized in future years to offset future taxable income. Annual limitations may result in the expiration of net operating loss and credit carryforwards before they are used. As of December 31, 2003, approximately $2.4 million of our net operating loss carryforwards was subject to limitations on the amount that can be recognized in any annual period.

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Results of Operations

The following table sets forth our statements of operations as a percentage of revenues for the periods indicated:

Comparison of Three Months Ended June 30, 2004 to Three Months Ended June 30, 2003

Revenues. Revenues for the three months ended June 30, 2004 were $36.6 million compared to $19.7 million for the three months ended June 30, 2003, an increase of 86.1%. This increase was due to an increase in revenues from portable audio SoCs and audio codecs, offset by a slight decrease in our USB peripheral ICs. The increase in revenues from our portable audio SoCs was due to the continued growth of the emerging portable compressed audio player market and our favorable competitive position within that market. Revenues from our portable audio SoCs were 85.4% of total revenues for the three months ended June 30, 2004. Our favorable competitive position in this market is primarily due to our integration of analog and digital components onto a single IC, and the resulting small form factor, low power consumption, and overall low cost to our customers. The increase in revenues from audio codecs was due to increased sales to PC manufacturers and their ODMs partially offset by decreased sales to sound card manufacturers.

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Revenues from Holystone, our largest distributor located in Taiwan, increased by $0.8 million from $5.9 million in the three months ended June 30, 2003, but decreased to 18.4% of total revenues during the three months ended June 30, 2004 from 30.0% during the three months ended June 30, 2003 due to stronger demand for our portable audio SoCs in geographic regions such as China and South Korea. Sales to Creative Technology, an affiliate, increased to 16.1% of total revenues during the three months ended June 30, 2004 from less than 10% during the three months ended June 30, 2003 due to an increase in their purchases of our portable audio SoCs. Creative Technology purchases our standard products at prices and on terms similar to other customers who buy similar products and volumes.

Gross Profit. Gross profit as a percentage of revenues, or gross margin, was 54.2% for the three months ended June 30, 2004 compared with 44.7% for the three months ended June 30, 2003. The increase in gross margin was primarily due to a favorable product mix and a reduction in manufacturing costs, which included both lower wafer costs, lower test costs and improved manufacturing yields. The favorable product mix resulted from increased revenues from our portable audio SoCs as a percentage of total revenues, as the gross margin from these products is generally higher than from our audio codecs. Also, the increase in revenues of our STMP 35XX family of products caused higher overall margins for our portable audio SoC’s. We expect our gross margins for the third quarter of 2004 to be consistent with those achieved during the second quarter of 2004. However, increased competition could adversely impact our pricing, particularly in the portable compressed audio player and USB peripherals markets, which could adversely impact our gross margins.

Research and Development. Research and development expenses increased to $7.2 million, or 19.6% of revenues, for the three months ended June 30, 2004 from $4.2 million, or 21.1% of revenues, for the three months ended June 30, 2003. This dollar increase of 72.6% was primarily due to increases in our engineering headcount, including independent contractors, as well as increases in the costs of design tools. Such increases were primarily to support hardware and software development on our latest portable audio SoCs, the STMP 35XX and STMP 36XX families of products, as well as our latest USB peripheral IC, the STBD 2010, and audio codecs targeted for applications in the PC market, including the Intel High Definition Audio standard, also known as Azalia. This increased research and development spending has resulted in substantial progress on or completion of the design of these products and the creation of several patentable inventions, enabling us to identify additional U.S. patent applications covering inventions made during the STMP 35XX and STBD 2010 design processes. We expect that research and development expenses will increase in absolute dollars in future periods as we continue to increase our staffing and associated costs to pursue additional new product development opportunities, but such expenses will fluctuate as a percentage of revenue due to changes in revenue.

Selling, General and Administrative. Selling, general and administrative expenses increased to $3.6 million, or 9.8% of revenues, for the three months ended June 30, 2004 from $2.7 million, or 13.8% of revenues, for the three months ended June 30, 2003. This dollar increase of 32.6% was due to increases in sales, marketing, and administrative personnel, as well as increases in commissions paid to independent sales representatives due to our revenue growth. We expect that selling, general and administrative expenses will increase in absolute dollars in future periods as we continue to increase our staffing and customer support and associated costs, but such expenses will fluctuate as a percentage of revenues due to changes in revenues.

Amortization of Deferred Stock-Based Compensation. We record deferred stock-based compensation for the difference between the exercise price of option grants and the fair value of our common stock at the time of such grants which resulted in amortization expense of $0.4 million and $0.9 million for the three months ended June 30, 2004, and 2003, respectively.

Interest Income. Interest income increased to $0.3 million for the three months ended June 30, 2004 from $13,000 for the three months ended June 30, 2003. This was due to increased income earned on our cash balances and investments in short-term marketable securities since the completion of our initial public offering in September 2003.

Interest Expense. Interest expense decreased to $8,000 for the three months ended June 30, 2004 from $0.3 million for the three months ended June 30, 2003. This was due to a decrease in non-cash interest charges related to warrants issued to investors for their guarantee of certain of our indebtedness from April 2001 through April 2003, as well as, decreased interest expense on lower levels of debt outstanding during the 2004 period. During the first quarter of 2003, we raised $8.1 million from sales of our preferred stock and used the proceeds to pay down

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our debt. During the third quarter of 2003, we successfully completed an initial public offering of approximately 7.4 million shares of our common stock, which resulted in net proceeds to us of approximately $101.4 million. A portion of the proceeds was used to pay off all of our existing long-term debt.

Income Taxes. Income tax expense increased to $0.2 million for the three months ended June 30, 2004 from $8,000 for the three months ended June 30, 2003. This was due to an increase in income before income taxes to $9.0 million for the three months ended June 30, 2004 compared to $0.8 million for the three months ended June 30, 2003. Our effective tax rate was 2.0% and 1.0% for the three month periods ended June 30, 2004 and 2003, respectively, which is less than the statutory rate on taxable income due to the utilization of prior period net operating losses.

Comparison of Six Months Ended June 30, 2004 to Six Months Ended June 30, 2003

Revenues. Revenues for the six months ended June 30, 2004 were $68.1 million compared to $32.5 million for the six months ended June 30, 2003, an increase of 109.3%. This increase was due to an increase in revenues from all of our product lines—portable audio SoCs, audio codecs and USB peripheral ICs. The increase in revenues from our portable audio SoCs was due to the continued growth of the emerging portable compressed audio player market and our favorable competitive position within that market. Revenues from our portable audio SoCs were 83.2% of total revenues for the six months ended June 30, 2004. Our favorable competitive position in this market is primarily due to our integration of analog and digital components onto a single IC, and the resulting small form factor, low power consumption, and overall low cost to our customers. The increase in revenues from audio codecs was due to increased sales to PC manufacturers and their ODMs partially offset by decreased sales to sound card manufacturers.

Revenues from Holystone, our largest distributor located in Taiwan, increased by $2.4 million from $12.4 million in the six months ended June 30, 2003, but decreased to 21.7% of total revenues during the six months ended June 30, 2004 from 38.2% during the six months ended June 30, 2003 due to stronger demand for our portable audio SoCs in geographic regions such as China and South Korea. Sales to Creative Technology, an affiliate, increased to 13.3% of total revenues during the six months ended June 30, 2004 from less than 10% during the six months ended June 30, 2003 due to an increase in their purchases of our portable audio SoCs. Creative Technology purchases our standard products at prices and on terms similar to other customers who buy similar products and volumes.

Gross Profit. Gross profit as a percentage of revenues, or gross margin, was 53.7% for the six months ended June 30, 2004 compared with 44.1% for the six months ended June 30, 2003. The increase in gross margin was primarily due to a favorable product mix and a reduction in manufacturing costs, which included both lower wafer costs, lower test costs and improved manufacturing yields. The favorable product mix resulted from increased revenues from our portable audio SoCs and USB peripheral ICs, as a percentage of total revenues, as the gross margin from these products is generally higher than from our audio codecs. Also, the increase in revenues of our STMP 35XX family of products caused higher overall margins for our portable audio SoC’s. We expect our gross margins for the third quarter of 2004 to be consistent with those achieved during the first half of 2004. However, increased competition could adversely impact our pricing, particularly in the portable compressed audio player and USB peripherals markets, which could adversely impact our gross margins.

Research and Development. Research and development expenses increased to $13.3 million, or 19.5% of revenues, for the six months ended June 30, 2004 from $7.8 million, or 24.0% of revenues, for the six months ended June 30, 2003. This dollar increase of 69.6% was primarily due to increases in our engineering headcount, including independent contractors, as well as increases in the costs of design tools and mask revisions. Such increases were primarily to support hardware and software development on our latest portable audio SoCs, the STMP 35XX and STMP 36XX families of products, as well as our latest USB peripheral IC, the STBD 2010, and audio codecs targeted for applications in the PC market, including the Intel High Definition Audio standard, also known as Azalia. This increased research and development spending has resulted in substantial progress on or completion of the design of these products and the creation of several patentable inventions, enabling us to identify additional U.S. patent applications covering inventions made during the STMP 35XX and STBD 2010 design processes. We expect that research and development expenses will increase in absolute dollars in future periods as we continue to increase our staffing and associated costs to pursue additional new product development opportunities, but such expenses will fluctuate as a percentage of revenue due to changes in revenue.

Selling, General and Administrative. Selling, general and administrative expenses increased to $6.5 million, or 9.5% of revenues, for the six months ended June 30, 2004 from $4.3 million, or 13.1% of revenues,

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for the six months ended June 30, 2003. This dollar increase of 52.8% was due to increases in sales, marketing, and administrative personnel, as well as increases in commissions paid to independent sales representatives due to our revenue growth. We expect that selling, general and administrative expenses will increase in absolute dollars in future periods as we continue to increase our staffing and customer support and associated costs, but such expenses will fluctuate as a percentage of revenues due to changes in revenues.

Amortization of Deferred Stock-Based Compensation. We record deferred stock-based compensation for the difference between the exercise price of option grants and the fair value of our common stock at the time of such grants which resulted in amortization expense of $1.4 million and $1.1 million for the six months ended June 30, 2004, and 2003, respectively.

Interest Income. Interest income increased to $0.7 million for the six months ended June 30, 2004 from $22,000 for the six months ended June 30, 2003. This was due to increased income earned on our cash balances and investments in short-term marketable securities since the completion of our initial public offering in September 2003.

Interest Expense. Interest expense decreased to $16,000 for the six months ended June 30, 2004 from $1.0 million for the six months ended June 30, 2003. This was due to a decrease in non-cash interest charges related to warrants issued to investors for their guarantee of certain of our indebtedness from April 2001 through April 2003, as well as, decreased interest expense on lower levels of debt outstanding during the 2004 period. During the first quarter of 2003, we raised $8.1 million from sales of our preferred stock and used the proceeds to pay down our debt. During the third quarter of 2003, we successfully completed an initial public offering of approximately 7.4 million shares of our common stock, which resulted in net proceeds to us of approximately $101.4 million. A portion of the proceeds was used to pay off all of our existing long-term debt.

Income Taxes. Income tax expense increased to $0.3 million for the six months ended June 30, 2004 from $8,000 for the six months ended June 30, 2003. This was due to an increase in income before income taxes to $16.1 million for the six months ended June 30, 2004 compared to $0.2 million for the six months ended June 30, 2003. Our effective tax rate was 2.0% and 5.0% for the six month periods ended June 30, 2004 and 2003, respectively, which is less than the statutory rate on taxable income due to the utilization of prior period net operating losses.

Liquidity and Capital Resources

As of June 30, 2004, we had $128.8 million in cash, cash equivalents and short-term investments. On September 19, 2003, we completed an initial public offering of approximately 7.4 million shares of our common stock resulting in net proceeds to us of approximately $101.4 million. On February 18, 2004, we completed a follow-on public offering of 250,000 shares of our common stock resulting in net proceeds to us of approximately $5.3 million.

Net cash provided by operating activities was $16.0 million for the six months ended June 30, 2004, while our operating activities used cash in the amount of $0.3 million during the six months ended June 30, 2003. The improvement in our operating cash flows is primarily the result of increased revenues, gross margins and net income. Our accounts receivable increased $3.2 million and $6.5 million during the six months ended June 30, 2004 and 2003, respectively. These changes are due to fluctuations in revenues and the timing of customer payments. Our inventories increased $6.6 million and $2.0 million during the six months ended June 30, 2004 and June 30, 2003, respectively. This increase in inventories in 2004 is required to support the increases in our revenues. Our reserve for slow-moving and obsolete inventory as a percentage of total inventory was 9.5% and 12.5% as of June 30, 2004 and December 31, 2003, respectively. We monitor and analyze our inventory for obsolescence and adjust this reserve accordingly. Although the reserve decreased as a percentage of total inventory, it increased by $0.3 million from $1.4 million at December 31, 2003. This was due to additional reserve of $0.8 million for obsolescence offset by scrap and sales of items which had previously been reserved of $0.5 million. Our accounts payable increased $3.1 million and $0.7 million during the six months ended June 30, 2004 and 2003, respectively. These changes are due to the timing of payments to suppliers. Our deferred revenue increased $2.9 million and $2.6 million during the six months ended June 30, 2004 and 2003, respectively, due to increases in our products held at distributors to enable them to meet increased customer demand for our products.

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Our investing activities used cash of $48.2 million and $1.5 million during the six months ended June 30, 2004 and 2003, respectively. Investing activities primarily represented purchases of capital equipment in the 2003 period and purchases of capital equipment and short-term investments in the 2004 period.

Capital expenditures were $6.6 million and $1.5 million during the six months ended June 30, 2004 and 2003, respectively. These expenditures were primarily for the purchase of design software and engineering tools and other computer equipment and software. We purchased certain intellectual property from a third party during the third quarter of 2003 that resulted in cash expenditures of $3.8 million in the six months ended June 30, 2004. Research and development resources are required to develop and expand our core technologies and proprietary product offerings. Our research and development expenses were $13.3 million and $7.8 million during the six months ended June 30, 2004 and 2003, respectively. These expenditures resulted in the enhancement of our product offerings, technological know how and inventions that have yielded several U.S. patents and pending U.S. patents. We expect to continue to incur significant research and development expenses and will fund these expenses with operating cash flow and existing cash balances.

Our financing activities provided $8.4 million and $4.0 million during the six months ended June 30, 2004 and 2003, respectively. During the first six months of 2003, we received proceeds of $8.1 million from the issuance of convertible preferred stock and $5.2 million from proceeds from long-term debt. A substantial portion of these proceeds was used to pay down and refinance our bank credit facility. On February 18, 2004, we completed a follow-on equity offering and received $5.3 million of net offering proceeds. We also received $2.1 million in proceeds from the exercise of employee stock options and $0.9 million from the purchase of stock under our Employee Stock Purchase Plan. These proceeds were invested in short-term, investment grade, interest bearing instruments, pending their use to fund working capital and capital expenditures as required.

The fair value of our investments in marketable securities at June 30, 2004 was $90.8 million. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. Our investment policy is to manage our investment portfolio to preserve principal and liquidity while maximizing the return on the investment portfolio through the full investment of available funds. We diversify the marketable securities portfolio by investing in multiple types of investment-grade securities. Our investment portfolio is primarily invested in short-term securities with at least an investment grade rating to minimize interest rate and credit risk as well as to provide for an immediate source of funds. Although changes in interest rates may affect the fair value of the investment portfolio and cause unrealized gains or losses, such gains or losses would not be realized unless the investments are sold.

We believe our existing cash balances and short-term investments, together with cash expected to be generated from operating activities, will be sufficient to meet our anticipated cash needs for at least the next 12 months. Our future capital requirements will depend on many factors, including our level of revenues, the timing and extent of spending to support product development efforts, the expansion of sales and marketing activities, the timing of introductions of new products, the costs to ensure access to adequate manufacturing capacity, and the continuing market acceptance of our products. We could be required, or could elect, to seek additional funding through public or private equity or debt financing and additional funds may not be available on terms acceptable to us or at all.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amount of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to uncollectible accounts receivable, inventories, investments, intangible assets, income taxes, financing operations, warranty obligations and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making the judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Because this can vary in each situation, actual results may differ from the estimates under different assumptions and conditions.

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We believe the following critical accounting policies affect our more significant judgments used in the preparation of our financial statements.

Revenue Recognition. We recognize revenues in accordance with Securities and Exchange Commission Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements, as amended by SAB 101A and 101B (“SAB 101”) and SAB 104, Revenue Recognition. SAB 101 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) the fee is fixed and determinable; and (4) collectibility is reasonably assured. Determination of criteria (3) and (4) are based on management’s judgment regarding the fixed nature of the fee charged for products delivered and the collectibility of those fees. Should changes in conditions cause management to determine these criteria are not met for certain future transactions, revenues recognized for any reporting period could be adversely impacted.

Revenues from product sales to customers other than distributors are recognized upon shipment and reserves are provided for estimated allowances. We defer recognition of revenues on sales to distributors with rights of return or price protection until our product has been sold by the distributor to their customers.

Short-term Investments. Short-term investments consist of corporate, state and municipal securities with readily determinable fair market values and original maturities in excess of three months. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. Our investments are classified as “available-for-sale” and accordingly are reported at fair value, with unrealized gains and losses, if material, reported as a component of stockholder’s equity. Unrealized losses are charged against income when a decline in the fair market value of an individual security is determined to be other than temporary. Realized gains and losses on investments are included in interest income.

Inventory Valuation. We value our inventory at the lower of the actual costs of our inventory or its current estimated market value. We record inventory provisions for estimated obsolescence or unmarketable inventories based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory provisions may be required.

Accounting for Stock-Based Compensation. We account for our stock-based employee compensation plans under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock issued to Employees, and related interpretations. We amortize stock-based compensation over the vesting periods of the related options, which are generally either four or five years, in accordance with FASB Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans, an interpretation of APB Opinions No. 15 and 25.

We have recorded deferred stock-based compensation representing the difference between the deemed fair value of our common stock for accounting purposes and the option exercise price. We determined the deemed fair value of our common stock based upon several factors, including trends in the broad market for technology stocks and the expected valuation we would obtain in an initial public offering. Had different assumptions or criteria been used to determine the deemed fair value of our common stock, materially different amounts of stock-based compensation could have been reported.

Pro forma information regarding net income (loss) attributable to common stockholders and net income (loss) per share attributable to common stockholders is required in order to show our net income (loss) as if we had accounted for employee stock options under the fair value method of Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation, Transition and Disclosure. This information is contained in Note 3 to our financial statements. The fair value of options and shares issued pursuant to our option plan at the grant date were estimated using the Black-Scholes option-pricing model.

Impairment of Long-lived Assets. We evaluate long-lived assets held and used by us for impairment whenever events or changes in circumstances indicate that their net book value may not be recoverable. When such factors and circumstances exist, we compare the projected undiscounted future cash flows associated with the related asset or group of assets over their estimated useful lives against their respective carrying amounts. Impairment, if any, is based on the excess of the carrying amount over the fair value, based on market value when available, or discounted expected cash flows, of those assets and is recorded in the period in which the determination is made.

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Item 3: Quantitative and Qualitative Disclosures About Market Risk

We operate in a dynamic and rapidly changing environment that involves numerous risks and uncertainties. The following section describes some, but not all, of these risks and uncertainties that we believe may adversely affect our business, financial condition or results of operations. This section should be read in conjunction with the Unaudited Condensed Financial Statements and Notes thereto, and Management’s Discussion and Analysis of Financial Condition and Results of Operations as of June 30, 2004 and for the three and six month periods then ended contained elsewhere in this Form 10-Q.

Interest Rate Risk

The primary objective of our investment activities is to preserve principal while maximizing the income without significantly increasing risk. Some of the securities in which we invest may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, government and non-government debt securities and certificates of deposit. The risk associated with fluctuating interest rates is limited to our investment portfolio and we do not believe that a 10% change in interest rates would have a significant impact on our interest income. As of June 30, 2004, all of our investments were in money market accounts or investment grade securities.

Risks That May Affect Future Results

You should carefully consider the risks described below and all of the other information contained in this quarterly report on Form 10-Q in evaluating SigmaTel and our business. The risks and uncertainties described below are not the only risks and uncertainties we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations. If any of the following risks actually occur, our business, financial condition and results of operations would suffer. In such case, the trading price of our common stock could decline, and you may lose all or part of your investment in our common stock.

Our limited history of sales of our key products makes it difficult to evaluate our prospects.

Most of our key products have only been sold in significant quantities for a short time. For example, our STMP 3410 portable audio SoC was introduced in the fourth quarter of 2001 but did not begin shipping in significant quantities until the second quarter of 2002, and production volumes of our STMP 35XX family of portable audio SoC products began shipping in the fourth quarter of 2003. Sales of both the STMP 3410 and the STMP 35XX family of products are highly dependent upon continued acceptance of portable MP3 music players by consumers. Since we cannot accurately monitor sell-through of our ultimate end customers’ MP3 players which contain our portable audio SoCs, it is possible that some of these products may not be selling through. As a result, our customers could experience inventory growth that could cause them to purchase fewer products from us or seek to return products to us in the future. There can be no assurance that our customers have not or will not place orders in excess of their requirements in response to actual or perceived shortages in the supply of our ICs. In such event, it will be more difficult for us to forecast our future revenues and budget our operating expenses, and our operating results would be adversely affected to the extent such excess orders are cancelled or rescheduled. We have limited historical financial data from which to predict our future sales and operating results for our portable audio SoCs and other key products that we have recently introduced. Our limited operating experience with these products, combined with the rapidly evolving nature of the markets in which we sell our products, and other factors which are beyond our control, limit our ability to accurately forecast quarterly or annual sales. Because most of our expenses are fixed in the short term or incurred in advance of anticipated sales, we may not be able to decrease our expenses in a timely manner to offset any shortfall in sales. We are currently expanding our staffing and increasing our expenditures to support future growth. If our growth does not materialize, our operating results would be adversely impacted.

We do not expect to sustain our recent growth rate.

Due primarily to increased sales of our portable audio SoCs, we have experienced significant revenue growth and have gained significant market share in a relatively short period of time. Specifically, our annual

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revenues increased from $30.9 million in 2002 to $100.2 million in 2003 and our revenues have increased from $32.5 million in the first six months of 2003 to $68.1 million in the first six months of 2004. However, we do not expect similar revenue growth or market share gains in future periods. Accordingly, you should not rely on the results of any prior quarterly or annual periods as an indication of our future operating performance.

We have incurred losses in prior periods and may incur losses in the future.

Although we had net income of $15.8 million for the six months ended June 30, 2004 and $10.0 million for the year ended December 31, 2003, we incurred net losses of approximately $8.3 million and $18.4 million for the years ended December 31, 2002 and 2001, respectively. As of June 30, 2004, we had an accumulated deficit of approximately $27.3 million. Despite realizing net income in the six months ended June 30, 2004 and in the year ended December 31, 2003, we may incur losses in the future. We expect our operating expenses to increase as we pursue our strategic objectives. Our results of operations for the six months ended June 30, 2004 include non-cash charges of $1.4 million related to stock based compensation. We will continue to incur stock-based compensation in the future as a result of past option grants. Our ability to maintain profitability depends on the rate of growth of our target markets, the continued market acceptance of our customers’ products, the competitive position of our products, and our ability to develop new products. Even though we have achieved profitability, we may not be able to sustain or increase profitability on a quarterly or an annual basis.

We depend on a few key customers for a substantial majority of our sales and the loss of, or a significant reduction in orders from, any of them would likely significantly reduce our revenues.

For the six months ended June 30, 2004 and 2003, sales to our top five customers accounted for approximately 74.4% and 70.7%, respectively, of our revenues. Our operating results in the foreseeable future will likely continue to depend on sales to a relatively small number of customers, as well as the ability of these customers to sell products that use our ICs. Our revenues would likely decline if one or more of these customers were to significantly reduce, delay or cancel their orders for any reason. In addition, any difficulty in collecting outstanding amounts due from our customers, particularly customers who place large orders, would harm our financial performance. Because our sales are made by means of standard purchase orders rather than long term contracts, we cannot assure you that our customers will continue to purchase our products at current levels, or at all.

We rely primarily on a small number of distributors to market and distribute our products, and if we fail to maintain or expand these sales channels, our revenues would likely decline.

Sales to a small number of distributors generate a significant amount of our revenues. Our sales through distributors accounted for 70.0% and 77.4% of our revenues for the six months ended June 30, 2004 and 2003, respectively. Our sales to Holystone, a distributor, accounted for 21.7% and 38.2% of our revenues in the six months ended June 30, 2004 and 2003, respectively, and our sales to G.M.I., also a distributor, accounted for 18.8% and 10.9% of our revenues in the six months ended June 30, 2004 and 2003, respectively. If Holystone, G.M.I. or our other distributors were to materially reduce their purchases from us, our business, financial condition and results of operations would suffer.

Our business will depend on our ability to maintain and expand our relationships with distributors, develop additional channels for the distribution and sale of our products and effectively manage these relationships. Our distributors decide whether to include our products among those that they sell and may carry and sell product lines that are competitive with ours. Because our distributors are not required to make a specified minimum level of purchases from us, we cannot be sure that they will prioritize selling our products. As we continue to expand our indirect sales capabilities, we will need to manage the potential conflicts that may arise within our indirect sales force. We also rely on our distributors to accurately and timely report to us their sales of our products and to provide certain engineering support services to customers. Our inability to obtain accurate and timely reports and to successfully manage these relationships would adversely affect our business and financial results.

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Our business is highly dependent on the consumer electronics market, which is characterized by short product life cycles, fluctuations in demand and seasonality, and subject to risks related to product transitions and supply of other components.

We derive a substantial portion of our revenues from a limited number of products that are used in consumer electronic devices. The consumer electronics market is characterized by intense competition, rapidly evolving technology, and ever-changing consumer preferences. These factors result in the frequent introduction of new products, short product life cycles and significant price competition. The dynamic nature of this market limits our, as well as our customers’, ability to accurately forecast quarterly and annual sales. If we, or our customers, are unable to manage product transitions, our business and results of operations could be negatively affected. For example, if our customers transition from one type of flash memory to another type and our product is not compatible with the new type of flash memory, sales of our ICs would be adversely affected if we were unable to update our product in a timely manner. In addition, we are subject to the risk of supply problems with other components of the end products of our customers. For example, if our customers could not obtain sufficient supplies of flash memory or hard disk drives, key components in many portable compressed audio players, the sales of our products that are also included in such devices would be adversely affected. Furthermore, continuing technological advancement in consumer electronic devices, which is a significant driver of customer demand, is largely beyond our control.

The expansion of the consumer electronics market in general, and the demand for MP3 products in particular, may be adversely impacted by the enforcement of limits on file sharing and downloadable music. The major record labels have complained about consumers downloading music off of the Internet without paying any fees or royalties to the owners of that music. In particular, the Recording Industry Association of America, a recording industry trade group, has sued numerous individuals who illegally distribute copyrighted songs over the Internet. If the record labels, other music producers, or other parties are successful in limiting the ability of consumers to obtain free music on the Internet, the demand for consumer electronic devices such as MP3 players that use our ICs may decline. Any decline in consumer spending, such as the decline in United States retail sales during June 2004 recently announced by the United States Commerce Department, whether relating to general economic conditions, future terrorist attacks or disease outbreaks, such as Severe Acute Respiratory Syndrome, or SARS, could also limit the expansion of the consumer electronics market, thus adversely affecting our business.

Because many of our ICs are designed for use in consumer electronic products, such as portable compressed audio players, PCs, and DVD players, we expect our business to be subject to seasonality, with increased revenue in the third and fourth quarters of each year, when customers place orders to meet year-end holiday demand, and lower revenue in the first and second quarters of each year. However, our recent rapid growth in revenues makes it difficult for us to assess the impact of seasonal factors on our business. In particular, strong sales of our portable audio SoCs resulted in increased revenues during the first quarter of 2003 compared to the fourth quarter of 2002, offsetting seasonal demand factors. If we or our customers are unable to ramp up production of new or existing products to meet any increases in demand due to seasonality or other factors, our revenues from such products would be adversely affected.

China and South Korea, where we have significant sales, are currently experiencing a slowdown in economic growth, which may reduce our expected revenues while the slowdown continues.

A significant portion of our sales to manufacturers of compressed digital audio players occur in China and South Korea, two countries that are currently experiencing a slowdown in economic growth. During the six months ended June 30, 2004, 28.7% of our sales occurred in China and 6.4% of our sales occurred in South Korea. While we cannot precisely determine the percentage of worldwide end user purchases of compressed digital audio players that occur in China and South Korea, some of our customers have indicated that the growth in their sales to end customers in China and South Korea will be slower than originally anticipated due to the overall slowdown in economic growth in those countries. Thus, our ability to increase revenues and grow our profits in the short term could be negatively impacted as a result of the current slowdown in economic growth in China and South Korea.

Because of the lengthy sales cycles for our products and the fixed nature of a significant portion of our expenses, we may incur substantial expenses before we earn associated revenues and may not ultimately achieve our forecasted sales for our products.

Our sales cycles can take up to 12 months to complete and volume production of products that use our ICs can take an additional 3 to 6 months to be achieved, if at all. Sales cycles for our products are lengthy for a number of reasons:

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As a result of our lengthy sales cycles, we may incur substantial expenses before we earn associated revenues because a significant portion of our operating expenses is relatively fixed and based on expected revenues. The lengthy sales cycles of our products make forecasting the volume and timing of orders difficult. In addition, the delays inherent in lengthy sales cycles raise additional risks that customers may cancel or change their orders. Our sales are made by purchase orders. Because industry practice allows customers to reschedule or cancel orders on relatively short notice, backlog is not always a good indicator of our future sales. If customer cancellations or product changes occur, this could result in the loss of anticipated sales without allowing us sufficient time to reduce our inventory and operating expenses.

We derive a substantial portion of our revenues from our portable audio SoCs, the selling prices of our products tend to decline over time, and if we are unable to develop successful new products in a timely manner, our operating results and competitive position could be harmed.

Our recent revenue growth has been primarily from sales of our portable audio SoCs. Our future success depends on our ability to develop successful new products in a timely and cost-effective manner. We are required to continually evaluate expenditures for planned product developments and choose among alternatives based upon our expectations of future market trends. We cannot assure you that we will be able to develop and introduce new or enhanced products in a timely and cost-effective manner or that our products will generate significant revenues. The development of our ICs is highly complex, and successful product development and market acceptance of our products depend on a number of factors, including: