DSP GROUP INC /DE/ - 10-Q Quarterly Report

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the Quarterly Period Ended June 30, 2004

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

For the transition period from to

Commission File Number 0-23006

DSP GROUP, INC.

(Exact name of registrant as specified in its charter)

Delaware

94-2683643

(State or other jurisdiction of

incorporation or organization)

(I.R.S. employer identification number)


3120 Scott Boulevard, Santa Clara, California		95054
(Address of Principal Executive Offices)		(Zip Code)

Registrant’s telephone number, including area code: (408) 986-4300

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 August 1, 2004, there were 28,481,519 shares of Common Stock ($.001 par value per share) outstanding.

INDEX

DSP GROUP, INC.


		Page No.
*PART I. FINANCIAL INFORMATION*
Item 1.	Financial Statements (Unaudited)	3
	Condensed consolidated balance sheets— June 30, 2004 and December 31, 2003 (audited)
	Condensed consolidated statements of income— three and six months ended June 30, 2004 and 2003	5
	Condensed consolidated statements of cash flows— six months ended June 30, 2004 and 2003	6
	Condensed consolidated statements of stockholders’ equity— three and six months ended June 30, 2004 and 2003	7
	Notes to condensed consolidated financial statements— June 30, 2004	9
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	30
Item 4.	Controls and Procedures	30

*PART II. OTHER INFORMATION*
Item 1.	Legal Proceedings	30
Item 4.	Submission of Matters to a Vote of Security Holders	30
Item 6.	Exhibits and Reports on Form 8-K	31

SIGNATURES		32

PART I. FINANCIAL INFORMATION

ITEM 1.

FINANCIAL STATEMENTS

DSP GROUP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(US dollars in thousands)


	June 30, 2004		December 31, 2003
	(Unaudited)		(Audited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	41,614	$	36,812
Marketable securities and bank deposits		39,820		42,490
Trade receivables, less allowance for returns of $123 in June 30, 2004 and December 31, 2003 and for doubtful accounts of $788 in June 30, 2004 and $708 in December 31, 2003		20,303		15,844
Deferred income taxes		1,326		1,326
Other accounts receivable and prepaid expenses		10,601		1,462
Inventories		10,134		8,466

TOTAL CURRENT ASSETS		123,798		106,400

PROPERTY AND EQUIPMENT, NET		6,908		7,108

LONG-TERM ASSETS:
Long-term marketable securities		240,112		197,071
Investments in equity securities of traded companies		19,714		47,138
Long-term prepaid expenses and lease deposits		549		513
Severance pay fund		2,846		2,360
Intangible assets, net		1,770		2,076
Goodwill		1,500		5,804

TOTAL LONG-TERM ASSETS		266,491		254,962

TOTAL ASSETS	$	397,197	$	368,470

Note: The balance sheet at December 31, 2003 has been derived from the audited financial statements at that date.

See notes to condensed consolidated financial statements.

DSP GROUP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(US dollars in thousands)


	June 30, 2004		December 31, 2003
	(Unaudited)		(Audited)
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Trade payables	$	13,447	$	11,221
Accrued compensation and benefits		7,177		9,000
Income taxes payables		19,827		11,107
Accrued expenses and other accounts payable		14,112		14,185

TOTAL CURRENT LIABILITIES		54,563		45,513
LONG-TERM LIABILITIES:
Accrued severance pay		2,959		2,555
Deferred income taxes		6,590		14,592
Other long-term liabilities		—		1,429

TOTAL LONG-TERM LIABILITIES		9,549		18,576

STOCKHOLDERS’ EQUITY:
Preferred stock, $0.001 par value -
Authorized shares - 5,000,000 at June 30, 2004 and December 31, 2003; issued and outstanding shares - none at June 30, 2004 and December 31, 2003		—		—
Common stock, $0.001 par value -
Authorized shares: 50,000,000 at June 30, 2004 and December 31, 2003; issued and outstanding shares: 29,399,367 at June 30, 2004 and 28,615,884 at December 31, 2003		29		29
Additional paid-in capital		186,359		174,700
Treasury stock		—		(1,192	)
Accumulated other comprehensive income		9,981		23,045
Retained earnings		136,716		107,799

TOTAL STOCKHOLDERS’ EQUITY		333,085		304,381

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	397,197	$	368,470

Note: The balance sheet at December 31, 2003 has been derived from the audited financial statements at that date.

See notes to condensed consolidated financial statements.

DSP GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

(US dollars in thousands, except per share amounts)


	Three Months Ended June 30,				Six Months Ended June 30,
	2004		2003		2004		2003
Product revenues and other	$	44,016	$	38,550	$	82,724	$	67,561
Cost of product revenues and other		22,918		21,206		42,776		37,983

Gross profit		21,098		17,344		39,948		29,578
Operating expenses:
Research and development		7,310		5,578		14,864		10,698
Sales and marketing		3,282		2,871		6,085		5,187
General and administrative		1,734		1,526		3,540		3,107
Impairment of goodwill		4,304		—		4,304		—
In-process research and development write-off		—		2,727		—		2,727
Total operating expenses		16,630		12,702		28,793		21,719

Operating income		4,468		4,642		11,155		7,859
Other income:
Interest and other income, net		2,159		1,909		4,284		3,833
Capital gains		7,671		241		28,988		241

Income before provision for income tax		14,298		6,792		44,427		11,933
Provision for income taxes		4,927		1,305		14,942		2,179

Net income	$	9,371	$	5,487	$	29,485	$	9,754
Net earnings per share:
Basic	$	0.32	$	0.20	$	1.02	$	0.36
Diluted	$	0.30	$	0.19	$	0.96	$	0.34
Weighted average number of shares used in per share computations of:
Basic		29,159		27,541		28,963		27,432
Diluted		30,957		29,459		30,827		28,944

See notes to condensed consolidated financial statements.

DSP GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(US dollars in thousands)


	Six Months Ended June 30,
	2004			2003
Net cash provided by operating activities	$	9,951		$	14,192
Investing activities:
Purchase of held-to-maturity marketable securities and bank deposits		(101,633	)		(84,273	)
Proceeds from sales and maturity of held-to-maturity marketable securities and bank deposits		60,216			74,588
Purchases of property and equipment		(985	)		(1,248	)
Proceeds from sale of available-for-sale marketable securities		26,420			508
Cash received from discontinued operation		—			3,284
Payment for investment in Teleman Multimedia Inc. assets		(1,450	)		(2,100	)

Net cash used in investing activities		(17,432	)		(9,241	)
Financial activities:
Issuance of Common Stock and Treasury Stock for cash upon exercise of options and upon purchase of Common Stock under employee stock purchase plan by employees		12,283			5,321
Purchase of Treasury Stock		—			(4,442	)

Net cash provided by financing activities		12,283			879
Increase in cash and cash equivalents	$	4,802		$	5,380
Cash and cash equivalents at beginning of period	$	36,812		$	39,919
Cash and cash equivalents at end of period	$	41,614		$	45,749

See notes to condensed consolidated financial statements.

DSP GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(UNAUDITED)

(US dollars in thousands)


Three Months Ended June 30, 2004	Number of Common Stock		Common Stock			Additional Paid-In Capital		Treasury Stock			Retained Earnings			Other Comprehensive Income (Loss)			Total Comprehensive Income			Total Stockholders’ Equity
Balance at March 31, 2004	28,845		$	29		$	177,350	$	—		$	127,345		$	14,127					$	318,851
Net income	—			—			—		—			9,371			—		$	9,371			9,371
Unrealized gain on available-for-sale marketable securities, net	—			—			—		—			—			(4,274	)		(4,274	)		(4,274	)
Unrealized gain from hedging activities, net	—			—			—		—			—			128			128			128

Total comprehensive income																	$	5,225
Issuance of Common Stock upon exercise of stock options by employees	554			(	*		9,009		—			—			—						9,009

Balance at June 30, 2004	29,399		$	29		$	186,359	$	—		$	136,716		$	9,981					$	333,085

Three Months Ended June 30, 2003

Balance at March 31, 2003	27,343		$	27		$	157,267	$	(85	)	$	94,927		$	672					$	252,808
Net income	—			—			—		—			5,487			—		$	5,487			5,487
Unrealized gain on available-for-sale marketable securities, net	—			—			—		—			—			5,923			5,923			5,923
Unrealized gain from hedging activities, net	—			—			—		—			—			446			446			446

Total comprehensive income																	$	11,856
Issuance of Common Stock upon exercise of stock options by employees	387			(	*		4,246		—			—			—						4,246
Purchase of Treasury Stock	(260	)		(	*		—		(5,587	)		—			—						(5,587	)
Issuance of Treasury Stock upon exercise of stock options by employees	6			(	*		—		93			(34	)		—						59

Balance at June 30, 2003	27,476		$	27		$	161,513	$	(5,579	)	$	100,380		$	7,041					$	263,382

(*	Represents an amount lower than $1.

See notes to condensed consolidated financial statements.

DSP GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(UNAUDITED)

(US dollars in thousands)


Six Months Ended June 30, 2004	Number of Common Stock		Common Stock			Additional Paid-In Capital		Treasury Stock			Retained Earnings			Other Comprehensive Income (Loss)			Total Comprehensive Income			Total Stockholders’ Equity
Balance at December 31, 2003	28,616		$	29		$	174,700	$	(1,192	)	$	107,799		$	23,045					$	304,381
Net income	—			—			—		—			29,485			—		$	29,485			29,485
Unrealized gain on available-for-sale marketable securities, net	—			—			—		—			—			(12,993	)		(12,993	)		(12,993	)
Unrealized gain from hedging activities, net	—			—			—		—			—			(71	)		(71	)		(71	)

Total comprehensive income																	$	16,421
Issuance of Treasury Stock upon exercise of stock options by employees	732			(	*		11,659		—			—			—						11,659
Issuance of Common Stock upon purchase of Common Stock under employee stock purchase plan	32			(	*		—		732			(326	)		—						406
Issuance of Treasury Stock upon exercise of stock options by employees	19			(	*		—		460			(242	)		—						218

Balance at June 30, 2004	29,399		$	29		$	186,359	$	—		$	136,716		$	9,981					$	333,085

Six Months Ended June 30, 2003

Balance at December 31, 2002	27,248		$	27		$	156,443				$	90,772		$	476					$	247,718
Net income	—			—			—		—			9,754					$	9,754			9,754
Unrealized gain on available-for-sale marketable securities, net	—			—			—		—			—			6,024			6,024			6,024
Unrealized gain from hedging activities, net	—			—			—		—			—			541			541			541

Total comprehensive income																	$	16,319
Issuance of Common Stock upon exercise of stock options by employees	464			(	*		4,772		—			—			—						4,772
Issuance of Common Stock upon purchase of Common Stock under employee stock purchase plan by employees	24			(	*		298		—			—			—						298
Purchase of Treasury Stock	(286	)		(	*		—		(5,976	)		—			—						(5,976	)
Issuance of Treasury Stock upon exercise of stock options by employees	26			(	*		—		397			(146	)		—						251

Balance at June 30, 2003	27,476		$	27		$	161,513	$	(5,579	)	$	100,380		$	7,041					$	263,382

(*	Represents an amount lower than $1.

See notes to condensed consolidated financial statements.

DSP GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2004

(UNAUDITED)

NOTE A—BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The accompanying unaudited condensed consolidated financial statements of DSP Group, Inc. (the “Company”) have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and for the six months ended June 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. For further information, reference is made to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

Impairment of VoicePump goodwill

VoicePump, Inc. (“VoicePump”), a wholly owned subsidiary of the Company, is a U.S. corporation primarily engaged in the design, research and development and marketing of software applications for Voice over Digital Subscriber Line (VoDSL) and Voice over Internet Protocol (VoIP).

The Company’s investment in VoicePump included the excess of its purchase price over the net assets acquired which was attributed to goodwill. Under Statement of Financial Accounting Standard (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”) goodwill acquired in a business combination shall not be amortized. As a result, the Company ceased amortization of the goodwill related to the acquisition of VoicePump after December 31, 2001. The book value of the goodwill was approximately $ 5.8 million as of that date.

SFAS No. 142 requires goodwill to be tested for impairment on adoption of the statement and at least annually thereafter or between annual tests in certain circumstances, and written down when impaired, rather than being amortized as previous accounting standards required. During the quarter ended June 30, 2004, the Company decided to stop developing products targeted at the VoIP gateway market and to focus its efforts on VoIP telephony products. Due to these changes, the Company re-evaluated the fair value of the goodwill associated with VoicePump and estimated the value to be approximately $1.5 million. As a result, the Company recorded a one-time expense associated with the impairment of goodwill of VoicePump in the amount of $4.3 million. The expense is included in the Company’s operating expenses for the quarter ended June 30, 2004 under “Impairment of goodwill”.

NOTE B—INVENTORIES

Inventories are stated at the lower of cost or market value. Cost is determined using the average cost method. The Company periodically evaluates the quantities on hand relative to current and historical selling prices and historical and projected sales volume. Based on these evaluations, provisions are made in each period to write inventory down to its net realizable value. Inventories are composed of the following (in thousands):


	June 30, 2004		December 31, 2003
Work-in-process	$	4,660	$	2,593
Finished goods		5,474		5,873

	$	10,134	$	8,466

NOTE C—NET EARNINGS PER SHARE

Basic net earnings per share are computed based on the weighted average number of shares of Common Stock outstanding during the period. For the same periods, diluted net earnings per share further include the effect of dilutive stock options

outstanding during the period, all in accordance with SFAS No. 128, “Earnings per Share.” The following table sets forth the computation of basic and diluted net earnings per share (in thousands, except per share amounts):


	Three months ended June 30,				Six months ended June 30,
	2004		2003		2004		2003
	Unaudited
Net income	$	9,371	$	5,487	$	29,485	$	9,754
Earnings per share:
Basic	$	0.32	$	0.20	$	1.02	$	0.36
Diluted	$	0.30	$	0.19	$	0.96	$	0.34
Weighted average number of shares of Common Stock outstanding during the period used to compute basic net earnings per share		29,159		27,541		28,963		27,432
Incremental shares attributable to exercise of outstanding options (assuming proceeds would be used to purchase Treasury Stock)		1,798		1,918		1,864		1,512

Weighted average number of shares of Common Stock used to compute diluted net earnings per share		30,957		29,459		30,827		28,944

NOTE D—INVESTMENTS IN MARKETABLE SECURITIES AND BANK DEPOSITS

The following is a summary of the held-to-maturity marketable securities and bank deposits (in thousands):


	Amortized Cost				Unrealized Gains (Loss)						Estimated Fair Value
	June 30, 2004		December 31, 2003		June 30, 2004			December 31, 2003			June 30, 2004		December 31, 2003
Obligations of states and political subdivisions	$	141,140	$	99,244	$	(2,248	)	$	(259	)	$	138,892	$	98,985
Corporate obligations		138,792		140,317		49			2,012			138,841		142,329

	$	279,932	$	239,561	$	(2,199	)	$	1,753		$	277,733	$	241,314

The amortized cost of held-to-maturity marketable securities and bank deposits at June 30, 2004 by contractual maturities are shown below (in thousands):


	Amortized Cost		Estimated Fair Value
Due in one year or less	$	39,820	$	40,200
Due after one year		240,112		237,533

	$	279,932	$	277,733

NOTE E—INCOME TAXES

The effective tax rate used in computing the provision for income taxes is based on projected fiscal year income before taxes, including estimated income by tax jurisdiction. The difference between the effective tax rate and the statutory rate is due primarily to foreign tax holiday and tax-exempt income in Israel. Tax provision for the second quarter of 2004 included the provision for taxes associated with the sale of the AudioCodes’ stock at a rate of 40% of the capital gain. Tax provision as a percentage of pre-tax income for capital gains other than those associated with AudioCodes was 17% for the three months ended June 30, 2004.

NOTE F—SIGNIFICANT CUSTOMERS

The Company sells its products to customers primarily through a network of distributors and representatives. Revenues derived from sales through one distributor, Tomen Electronics Corporation (“Tomen Electronics”), accounted for 80% and 82% of the Company’s total revenues for the three months ended June 30, 2004 and 2003, respectively. Additionally, Tomen Electronics accounted for 80% of the Company’s total revenues for the six months ended June 30, 2004 and 2003. The Japanese market and the OEMs that operate in that market are among the largest suppliers with significant market share in the U.S. market for residential wireless products. Tomen Electronics sells the Company’s products to a limited number of customers. One customer, Panasonic Communications Co., Ltd. (“Panasonic”), has continually accounted for a majority of the sales to Tomen Electronics. The loss of Tomen Electronics as a distributor and the Company’s inability to obtain a satisfactory replacement in a timely manner would harm its sales and results of operations. Additionally, the loss of Panasonic or Tomen Electronics’ inability to thereafter effectively market the Company’s products would also harm the Company’s sales and results of operations.

NOTE G—INVESTMENTS IN EQUITY SECURITIES OF TRADED COMPANIES

The following is a summary of investments in equity securities of traded companies as of June 30, 2004 and December 31, 2003 (in thousands):


	Cost				Unrealized gains				Estimated fair value
	June 30, 2004		December 31, 2003		June 30, 2004		December 31, 2003		June 30, 2004		December 31, 2003
AudioCodes Ltd. ⁽¹⁾	$	3,976	$	10,726	$	15,738	$	35,739	$	19,714	$	46,465
Tomen Corporation ⁽²⁾		—		281		—		392		—		673

	$	3,976	$	11,007	$	15,738	$	36,131	$	19,714	$	47,138

(1) AudioCodes, Ltd.: AudioCodes, Ltd. (“AudioCodes”) is an Israeli corporation primarily engaged in the design, research and development, manufacturing and marketing of hardware and software products that enable simultaneous transmission of voice and data over networks. As of April 1, 2001, the Company no longer maintains a representative on the AudioCodes’ Board of Directors, and has not been involved in any way in AudioCodes’ policy-making processes. Therefore, after April 1, 2001, the Company did not have significant influence over the operating and financial policies of AudioCodes and thus ceased accounting for this investment under the equity method of accounting. During the first quarter of 2004, the Company sold 2,000,000 shares of AudioCodes’ ordinary shares for gross proceeds of approximately $25,647,000, resulting in a capital gain of approximately $20,827,000. During the second quarter of 2004, the Company sold 801,000 shares of AudioCodes’ ordinary shares for gross proceeds of approximately $9,600,000, resulting in a capital gain of approximately $7,670,000. The Company currently owns approximately 1,650,000 shares of AudioCodes’ ordinary shares.

The condensed consolidated balance sheet as of June 30, 2004 included an unrealized gain on available-for-sale marketable securities of $9,915,000, net of unrealized tax expenses of $7,231,000, in the investment in AudioCodes. As of June 30, 2004, the fair market value of the Company’s investment in AudioCodes was approximately $19,714,000.

(2) Tomen Corporation: In September 2000, the Company invested approximately $485,000 (50.0 million Yen) in shares of its Japanese distributor’s parent company, Tomen Ltd. (“Tomen”), as part of a long strategic relationship. Tomen’s shares are traded on the Japanese stock exchange. The Company accounted for its investment in Tomen in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” as available-for-sale marketable securities. During the first quarter of 2004, the Company sold all of its holdings in Tomen for gross proceeds of approximately $773,000, resulting in a capital gain of approximately $490,000.

NOTE H—DERIVATIVE INSTRUMENTS

SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”), requires companies to recognize all of its derivative instruments as either assets or liabilities in the statement of financial position at fair value. For derivative instruments that are designated and qualify as a cash flow hedge (i.e., hedging the exposure to variability in expected future cash flows that is attributable to a particular risk), the effective portion of the gain or loss on the derivative instrument is reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Any gain or loss on a derivative instrument in excess of the

cumulative change in the present value of future cash flows of the hedged item is recognized in current earnings during the period of change.

To protect against the increase in value of forecasted foreign currency cash flow resulting from salary and rent payments in New Israeli Shekels (“NIS”) during the year, the Company has instituted a foreign currency cash flow hedging program. The Company hedges portions of the anticipated payroll and lease payments of its Israeli facilities denominated in NIS for a period of one to twelve months with put options and forward contracts. These forward contracts and put options are designated as cash flow hedges, as defined by SFAS No. 133, and are all effective as hedges of these expenses.

As of June 30, 2004 the Company recorded comprehensive income amounting to $66,000 from its put options and forward contracts in respect to anticipated payroll and rent payments expected in 2004 and 2005. Such amounts will be recorded into earnings in the remaining quarters of 2004 and in the first quarter of 2005.

NOTE I—CONTINGENCIES

The Company is involved in certain claims arising in the normal course of business. However, the Company believes that the ultimate resolution of these matters will not have a material adverse effect on its financial position, results of operations or cash flows.

NOTE J—ACCOUNTING FOR STOCK-BASED COMPENSATION

The Company accounts for stock-based compensation in accordance with the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”) and Financial Accounting Standards Board Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation” (“FIN No. 44”). Under APB No. 25, when the exercise price of an employee’s options equals or is higher than the market price of the underlying Common Stock on the date of grant, no compensation expense is recognized. Under Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”), pro-forma information regarding net income and income per share is required, and has been determined as if the Company had accounted for its employee stock options under the fair value method of SFAS No. 123.

The fair value of these options is amortized over their vesting period and estimated at the date of grant using a Black-Scholes multiple option pricing model with the following weighted average assumptions for the three and the six months periods ended June 30, 2004 and 2003:


	Three months ended June 30,				Six months ended June 30,
	2004		2003		2004		2003
	Unaudited
Risk free interest	3.2	%	1.0	%	3.2	%	1.0	%
Dividend yields	0	%	0	%	0	%	0	%
Volatility	0.30		0.26		0.30		0.26
Expected life	2.9		2.9		2.9		2.9

The following table illustrates the effect on net income and earnings per share, assuming that the Company had applied the fair value recognition provision of SFAS No. 123 on its stock-based employee compensation (in thousands, except per share amounts):


	Three months ended June 30,				Six months ended June 30,
	2004		2003		2004		2003
	Unaudited
Net income as reported	$	9,371	$	5,487	$	29,485	$	9,754

Less - stock-based compensation expense determined under fair value method for all awards, net of related tax effects:	$	3,766	$	2,184	$	7,362	$	4,557

Pro forma net income	$	5,605	$	3,303	$	22,123	$	5,197

Basic earnings per share, as reported	$	0.32	$	0.20	$	1.02	$	0.36

Pro forma basic earnings per share	$	0.19	$	0.12	$	0.76	$	0.19

Diluted earnings per share, as reported	$	0.30	$	0.19	$	0.96	$	0.34

Pro forma diluted earnings per share	$	0.18	$	0.11	$	0.72	$	0.18

NOTE K—NEW ACCOUNTING PRONOUNCEMENTS

In March 2004, the Financial Accounting Standards Board approved the consensus reached on the Emerging Issues Task Force (EITF) Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-1”). The objective of this Issue is to provide guidance for identifying impaired investments. EITF 03-1 also provides new disclosure requirements for investments that are deemed to be temporarily impaired.

The accounting provisions of EITF 03-1 are effective for all reporting periods beginning after June 15, 2004, while the disclosure requirements are effective only for annual periods ending after June 15, 2004. The Company has evaluated the impact of the adoption of EITF 03-1 and does not believe the impact will be significant to the Company’s overall results of operations or financial position.

NOTE L— SUBSEQUENT EVENTS

During July 2004, the Company purchased 1,044,000 shares of Common Stock, at an average price of $20.53 per share, for an aggregate consideration of approximately $21.43 million.

ITEM 2.

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

We have included the following overview to provide you with some perspective about the information contained in this section, as well as a better understanding of the key drivers and concerns of our business. The overview summarizes how we generate revenue and what are some of our significant expenses, as well as review the status of our business in the context of industry-wide trends and explain our management’s views on the implication and significance of these trends.

OVERVIEW

DSP Group is a fabless semiconductor company that is a leader in providing chipsets to telephone equipment manufacturers that incorporate our chipsets into consumer products for the residential wireless telecommunication market. Our chipsets incorporate advanced technologies, such as DSP processors, communications technologies, highly advanced radio frequency (RF) devices and in-house developed Voice-over-Internet-Protocol (VoIP) hardware and software technologies. Our products include 900MHz, 1.9 GHz (Digital Enhanced Cordless Telecommunications (DECT)), 2.4GHz and 5.8GHz chipsets for cordless telephones, Bluetooth for voice, data and video communication, and solutions for digital voice recorders (DVRs) and VoIP applications and other voice-over-packet applications. Our current primary focus is cordless telephony as our 2.4GHz and 5.8GHz chipsets represented approximately 87% of our total revenues for both the second quarter and the first half of 2004.

During recent years we have become a worldwide leader in developing and marketing Total Telephony Solutions^™ for a wide range of applications for wireless residential markets. The key factor that enabled us to grow our business, improve our profitability and increase our market share over the previous years is our ability to combine and integrate our expertise in DSP cores technology with proprietary advanced RF devices, communications technologies and speech-processing algorithms. We believe we were able to penetrate the residential wireless telephony market and increase our market share and customer base by taking advantage of three trends in the market: (1) the move from wired to wireless products, (2) the transformation from analog-based to digital-based technologies for telephony products, and (3) the shift in bandwidth from 900MHz to 2.4GHz technologies, as well as the recent shift from 2.4GHz to 5.8GHz technologies. Our focus on the convergence of these three trends has allowed us to offer products with more features, and better range, security and voice quality. One additional factor that contributed significantly to our revenue growth over the last years is the market acceptance of our pioneer multi-hand-set solutions.

Products that we are developing in 2004 include a DECT chipset for the European market, a new chipset that includes video capabilities for the European and U.S. market and a new Bluetooth chipset. In addition, we have started development of a new feature that will allow connectivity to cellular phones and is anticipated to be integrated into our video-Bluetooth chipset in the first half of 2005. Our planned future lines of products are intended to integrate video, voice, data as well as other communications technologies such as DECT, and help us strengthen our position as a leading supplier of multimedia communications products.

During the second quarter of 2004, our revenues increased by 14% from the second quarter of 2003, and our gross profit increased to 48% from 45% for the same period in 2003. Our net income reached a level of 21% of revenues. However, during the recent month, our distributors have decreased their projected revenue figures for our chipsets due to weaker demand for the second half of 2004. This reduction in projected revenue from our distributors is anticipated to reduce both our revenues and profitability in the third and fourth quarters of 2004 and potentially future periods. In addition, the launch of new products incorporating Bluetooth and video capabilities has been delayed.

Our second quarter 2004 results also included a one-time expense item of $4.3 million resulting from the impairment of goodwill associated with VoicePump, Inc., our wholly owned subsidiary that sells to the VoIP gateway market. As a result of our decision to stop developing products targeted at this market and to focus our efforts on VoIP telephony products, we wrote down the value of goodwill associated with the VoicePump acquisition to its estimated fair value of approximately $1.5 million.

Our total position in cash, cash equivalents, cash deposits and held to maturity marketable securities increased during the second quarter of 2004 to a total of $321.5 million as of June 30, 2004.

Despite our historical growth, our business operates in a highly competitive environment, characterized by changing standards and rapid introduction of new products. Competition has historically increased pricing pressures for our products and decreased our average selling prices. We may need to offer our products in the future at lower prices than we currently anticipate, which may result in lower profits. In addition, as we are a fabless company, global market trends such as “over-capacity” problems in fabrication facilities may increase our raw material costs and thus decrease our gross margins. We must continue to monitor and control costs, improve operating yields and maintain our current level of gross margin in order to offset future declines in average selling prices. Also, since our products are incorporated into end products of our OEM customers, we are very dependent on their ability to achieve market acceptance for their end products in consumer markets that are similarly very competitive.

There are also several emerging market trends that challenge our ability to continue to grow our business. We believe that new developments in the home residential market may adversely affect our operating results. For example, the rapid deployment of new communication access methods, including mobile, broadband, cable and VoIP connections, as well as the projected lack of growth in products using fixed-line telephony, meaning communication through phones connected to telephone lines, would reduce our revenues derived from, and unit sales of, cordless telephony products, which is currently our primary focus. Our ability to maintain our growth will depend on the expansion of our product lines to capitalize on the emerging communication access methods and on our success in developing and selling a portfolio of “system-on-a-chip” solutions that integrate video, voice, data and communication technologies in a wider multimedia market. Our business may also be affected by the outcome of the current competition between cell phone operators and fixed line operators for the provision of residential communication. Our revenues are currently primarily generated from sales of chipsets used in cordless phones that is based on fixed-line telephony. As a result, a decline in the use of fixed-line telephony for residential communication would adversely affect our financial condition and operating results. In view of the current market trends, future products are anticipated to converge cellular and cordless capabilities by enabling cellular connectivity to fixed-line phones. We plan to begin shipment of such products in the first half of 2005. However, we cannot ensure when and if the market will accept these future features and products we develop.

Moreover, in order to increase our sales volume and expand our business, we recognize that we need to penetrate new markets. Thus, we are planning to enter the European market. In 2003, we achieved the first two design wins for our new DECT products targeted for that market. We expect to begin shipping DECT products in the second half of 2004, although revenue to be generated from DECT products will be insignificant for the remainder of 2004. In addition, during the first quarter of 2004 we signed an agreement with an OEM to develop a video-telephone system for the European market. In order to enhance our development of DECT products and better penetrate the European market we will need to increase our operating expenses, mainly in research and development and applications engineering, for the remaining quarters of 2004 and potentially in future years. We also have established a strategic planning committee of the board to evaluate our growth beyond 2005. This committee is evaluating opportunities in various consumer application markets. Based on this committee’s recommendations and judgment, we may enter into additional market segments in the future. We believe that our DECT products and products with video and Bluetooth capacities will drive our growth in 2005 and 2006, and products for home communication in 2006 and beyond. However, our ability to expand into new markets may not occur or may require us to substantially increase our operating expenses. As a result, you should not rely upon our past operating results as an indication of future performance.

RESULTS OF OPERATIONS

During the second quarter of 2004, we demonstrated year-over-year revenue growth of 14%. Our net income reached a level of 21% of revenues. Our gross profit increased by 22% as compared to the second quarter of 2003. However, our operating expenses for the second quarter of 2004, which amounted to $16.6 million, increased 31% from the same period in 2003. The increase was mainly a result of the impairment of VoicePump goodwill included in our operating expenses as well as of a significant increase in research and development expenses, primary attributed to the hiring of new employees. Total number of employees increased from 178 as of June 30, 2003 to 232 as of June 30, 2004.

Total Revenues. Our total revenues were $44.0 million for the second quarter of 2004, as compared to $38.6 million for the second quarter of 2003. Total revenues for the first half of 2004 increased to $82.7 million from $67.6 million for the same period in 2003. This increase of 14% and 22% in the second quarter and the first half of 2004, respectively, was primarily as a result of strong demand from both existing and new original equipment manufacturer (OEM) customers, especially in Asia Pacific and Japan, for our 5.8GHz and 2.4GHz multi-hand-set products. Our

revenues in Asia Pacific increased by 27% and 34% during the second quarter and the first half of 2004, respectively, in comparison to the same periods in 2003. Revenues from 5.8GHz products represented 24% of our total revenues in the second quarter of 2004 as compared to 6% of total revenues in the second quarter of 2003. The revenue increase in both periods was also a result of a significant increase of sales in Asia Pacific of our 2.4GHz products. However, during the recent month, our distributors have decreased their projected revenue figures for our chipsets due to weaker demand for the second half of 2004. This reduction in projected revenue from our distributors is anticipated to reduce both our revenues and profitability in the third and fourth quarters of 2004 and potentially future periods. In addition, the launch of new products incorporating Bluetooth and video capabilities has been delayed.

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

Export sales represented approximately 99% of our total revenues in both the second quarter of 2004 and 2003 as well as in the first six months of 2004 and 2003. All export sales are denominated in U.S. dollars. The following table includes the breakdown of revenues for the periods indicated by geographic location (in thousands):


	Three months ended June 30,				Six months ended June 30,
	2004		2003		2004		2003
United States	$	179	$	236	$	493	$	579
Japan		35,266		31,633		66,355		54,173
Europe		710		485		1,305		1,965
Asia Pacific (excluding Japan)		7,861		6,196		14,571		10,844

Total revenues	$	44,016	$	38,550	$	82,724	$	67,561

As our products are generally incorporated into consumer products sold by our OEM customers, our revenues are affected by seasonal buying patterns of consumer products sold by our OEM customers that incorporate our products. The fourth quarter in any given year is usually the strongest quarter of sales for our OEM customers and, as a result, the third quarter in any given year is usually the strongest quarter for our revenues as our OEM customers request increased shipments of our products in anticipation of the fourth quarter holiday season. This trend can be observed from reviewing our quarterly information and results of operations.

Significant Customers and Products. Revenues through one distributor, Tomen Electronics, accounted for 80% and 82% of our total revenues for the three months ended June 30, 2004 and 2003, respectively. Additionally, Tomen Electronics accounted for 80% of our total revenues for the six months ended June 30, 2004 and 2003.

The Japanese market and the OEMs that operate in that market are among the largest suppliers for residential wireless products with significant market share in the U.S. market. Tomen Electronics sells our products to a limited number of customers. One customer, Panasonic Communications Co., Ltd., has continually accounted for a majority of the sales to Tomen Electronics. The loss of Tomen Electronics as a distributor and our inability to obtain a satisfactory replacement in a timely manner would harm our sales and results of operations. Additionally, the loss of Panasonic or Tomen Electronics’ inability to thereafter effectively market our products would also harm our sales and results of operations.

Revenues from our 2.4GHz and 5.8GHz digital products represented 77% of our total revenues for the period ended June 30, 2004. We believe that sales of these product lines will continue to represent a substantial percentage of our revenues in the remainder of 2004 as we are seeing a continuing decline in sales for some of our older products, including the 900 MHz. In addition, we witnessed an increase in sales of 5.8GHz products, in comparison to a decrease in 2.4GHz sales. For the long-term, we believe the rapid deployment of new communication access methods, as well as the projected lack of growth in fixed-line telephony, would reduce our total revenues derived from, and unit sales of, cordless telephony products, including future sales of our 2.4GHz and 5.8GHz products. We believe that in order to maintain our growth, we

will need to expand our product lines and develop a portfolio of “system-on-a-chip” solutions that will integrate video, voice, data and communication technologies in a wider multimedia market.

Gross Profit. Gross profit as a percentage of total revenues increased to 48% for the second quarter of 2004 from 45% for the second quarter of 2003. Gross profits as a percentage of total revenues increased to 48% for the six months ended June 30, 2004 from 44% for the same period in 2003. The increase in our gross margins in both periods in 2004 as compared to the same periods in 2003 was partially a result of a different mix of products sold during the second quarter and the first half of 2004 as compared to the same periods in 2003. In addition, the increase was due to our ability to offset the continued decline in the average selling prices of our products with a greater reduction in manufacturing costs and lower other expenses related to cost of goods sold. The reduction in costs was due to a combination of factors. The reduction in chip costs resulted partially from technological improvements, continuing improvements in our yield percentages, as well as the integration of more semiconductor content in a single system. The reduction in manufacturing costs was partially a result of reduction in our raw materials costs.

However, we cannot guarantee that our ongoing efforts in cost reduction will be successful or that they will keep pace with the anticipated continued decline in average selling prices of our processors. Our gross margin may decrease in the future due to a variety of factors, including the continued decline in the average selling prices of our products, our failure to achieve the corresponding cost reductions, roll-out of new products in any given period and our failure to introduce new engineering processes. Also, future increases in the pricing of silicon wafers may affect our ability to implement cost reductions. As we are a fabless company, global market trends such as “over-capacity” problems in fabrication facilities may also increase our raw material costs and thus decrease our gross margins.

As gross margin reflects the sale of chips and chipsets that have different margins, changes in the mix of products sold also will impact our gross margin. Moreover, penetration of new competitive markets, such as the European DECT market, could require us to reduce sale prices and harm our total gross margin.

Research and Development Expenses. Our research and development expenses increased to $7.3 million for the second quarter of 2004 from $5.6 million for the second quarter of 2003. For the first half of 2004, research and development expenses increased to $14.9 million from 10.7 million for the same period in 2003. The increase in 2004 was primarily attributed to increased salary expenses, mainly due to a greater number of research and development employees, increased allocated facilities expenses, increased project material and tape-out expenses. As of June 30, 2004, we had 149 research and development employees, as compared to 109 as of June 30, 2003. The increase was also attributed to expenses incurred by our Korean subsidiary, established in connection with the Teleman acquisition, which began its operations during June 2003. Research and development expenses for the second quarter and for the first half of 2004 also included expenses in the amount of $0.15 million and $0.3 million, respectively, related to the amortization of workforce and patents acquired from Teleman in May 2003. Our research and development expenses as a percentage of total revenues were 17% and 14% for the three months ended June 30, 2004 and 2003, respectively, and 18% and 16% for the six months ended June 30, 2004 and 2003, respectively. This increase in research and development expenses as a percentage of total revenues in both comparable periods was due to the increase in absolute dollars of the research and development expenses.

As our research and development staff is currently working on various projects simultaneously, we anticipate that we will need to hire additional research and development staff for the development of new products for the European DECT market as well as on new features for the connectivity from fixed-line telephony to cellular phones. As a result, our research and development expenses in absolute dollars and as a percentage of total revenues will increase in the remaining quarters of 2004, and potentially in future periods.

Research and development expenses consist mainly of payroll expenses to employees involved in research and development activities, expenses related to tape-out and mask work, subcontracting and engineering expenses, depreciation and maintenance fees related to equipment and software tools used in research and development and facilities expenses associated with research and development.

Sales and Marketing Expenses. Our sales and marketing expenses increased to $3.3 million in the second quarter of 2004 from $2.9 million in the second quarter of 2003. For the six months ended June 30, 2004, sales and marketing expenses were $6.1 million as compared to $5.2 million for the same period in 2003. The increase for both comparative periods was primarily attributed to higher levels of salary expenses, mainly due to a greater number of

application support employees as well as to higher travel and related expenses. Sales and marketing expenses for the six months ended June 30, 2004 also increased due to higher commissions paid to our distributors and representatives as a result of more revenue being generated during the six-month period. Our sales and marketing expenses as a percentage of total revenues were 8% and 7% for the three months ended June 30, 2004 and 2003, respectively, and 7% and 8% for the six months ended June 30, 2004 and 2003, respectively.

Sales and marketing expenses consist mainly of sales commissions to our representatives and distributors, payroll expenses to direct sales and marketing employees, trade show expenses and facilities expenses associated with sales and marketing.

General and Administrative Expenses. Our general and administrative expenses were $1.7 million for the three months ended June 30, 2004, as compared to $1.5 million for the three months ended June 30, 2003. For the first half of 2004, general and administrative expenses were $3.5 million compared to $3.1 million for the same period in 2003. The increase was attributed mainly to higher payroll and related expenses. General and administrative expenses as a percentage of total revenues were 4% for the three months ended June 30, 2004 and 2003, and 4% and 5% for the six months ended June 30, 2004 and 2003, respectively.

General and administrative expenses consist mainly of payroll for management and administrative employees, expenses related to investor relations, accounting and legal fees, as well as facilities expenses associated with general and administrative activities.

Impairment of goodwill. During the second quarter of 2004, we recorded an expense of $4.3 million resulting from the impairment of goodwill related to VoicePump, our wholly owned subsidiary that sells to the VoIP gateway market. As a result of our decision to stop developing products targeted at this market and to focus our efforts on VoIP telephony products, we wrote down the value of goodwill associated with the VoicePump acquisition from its historical book value of $5.8 million to the estimated fair value of $1.5 million.

In-Process Research and Development Write-off. During the second quarter of 2003, we recorded a one-time expense item in the amount of approximately $2.7 million related to the write–off of in-process research and development resulting from the Teleman acquisition. This amount represented research and development expenses related to technologies that did not reach technological feasibility and for which there was no future alternative use, as determined on the acquisition date.

Interest and Other Income. Interest and other income, net, for the three months ended June 30, 2004 increased to $2.2 million from $1.9 million for the three months ended June 30, 2003 and increased to $4.3 million for the six months ended June 30, 2004 from $3.8 million for the six months ended June 30, 2003. The increase for both comparative periods was primarily due to higher levels of cash, cash equivalents and held-to-maturity marketable securities.

Capital gains from sale of available-for-sale marketable securities. During the first quarter of 2004, we sold 2,000,000 shares of AudioCodes’ ordinary shares for gross proceeds of approximately $25.6 million, resulting in a capital gain of approximately $20.8 million. During the second quarter of 2004, we sold additional 801,000 shares of AudioCodes’ ordinary shares for gross proceeds of approximately $9.6 million, resulting in a capital gain of approximately $7.7 million. During the first quarter of 2004, we sold all of our holdings in Tomen Corporation for gross proceeds of approximately $0.7 million, resulting in a capital gain of approximately $0.5 million.

In May 2003, we sold our remaining holdings in Tower Semiconductor for $508,000 and recorded a capital gain of $0.2 million.

Provision for Income Taxes. Our tax provision for the second quarter of 2004 and for the first half of 2004 was $4.9 million and $14.9 million, respectively. Our tax provision for the second quarter of 2003 and for the first half of 2003 was $1.3 million and $2.2 million, respectively. Tax provision for both the second quarter and the first six months of 2004 included the provision for taxes associated with the sale of the AudioCodes’ stock at a rate of 40% of the capital gain. We expect to pay the remaining taxes associated with the sale of AudioCodes stock in future periods. Tax provision as a percentage of pre-tax income for capital gains other than those associated with AudioCodes was 17% for both the three and the six months ended June 30, 2004.

In 2004 and 2003 we benefited for tax purposes from foreign tax holiday and tax-exempt income in Israel. DSP Group Ltd., our Israeli subsidiary, was granted “Approved Enterprise” status by the Israeli government with respect to six separate investment plans. Approved Enterprise status allows our Israeli subsidiary to enjoy a tax holiday for a period of two to four years and a reduced corporate tax rate of 10%-25% for an additional six or eight years, on each investment plan’s proportionate share of taxable income. The tax benefits under these investment plans are scheduled to expire starting 2005 through to 2017.

LIQUIDITY AND CAPITAL RESOURCES

Operating Activities. We generated $9.9 million and $14.2 million of cash and cash equivalents from our operating activities during the first six months of 2004 and 2003, respectively. Net income for the first six months of 2004 was $29,485 million, as compared to $9,754 million for the same period in 2003. Excluding the capital gains resulting from the sale of the AudioCodes stock of $7,671,000 and the related taxes of $3,068,000, and the goodwill impairment charge associated with VoicePump of $4,304,000 for the first six months of 2004, and excluding the capital gains resulting from the sale of the Tower Semiconductor stock of $508,000 and the write-off of in-process research and development associated with the Teleman acquisition of $2.7 million, net of the related tax benefit of $272,000, net income was $16.4 million for the first six months of 2004, as compared to $11.9 million for the same period in 2003. The decrease in net cash provided by operating activities in the first half of 2004 as compared to the same period in 2003 resulted mainly from higher tax payments, partially due to the capital gain taxes paid on the sale of AudioCodes stock, and due to higher payments of benefits and compensation to employees in the first quarter of 2004 as compared to the same period in 2003. In addition, accrued expenses and other accounts payables decreased by $0.1 million in the first six months of 2004 as compared to an increase of $2.2 million in the same period of 2003, offset by an increase of accounts receivables in the amount of $6.8 million in the first six months of 2003 compared to an increase of $ 4.5 million in the same period in 2004.

Investing Activities. We invest excess cash in marketable securities of varying maturity, depending on our projected cash needs for operations, capital expenditures and other business purposes. During the first six months of 2004, we purchased $101.6 million of investments classified as held-to-maturity marketable securities, as compared to $84.3 million during the first six months of 2003. During the same periods, $60.2 million and $74.6 million, respectively, of investments classified as held-to-maturity marketable securities matured.

Our capital equipment purchases for the first six months of 2004, consisting primarily of research and development software and computers, totaled $1.0 million, as compared to $1.2 million for the first six months of 2003.

Cash proceeds from the sale of available-for-sale marketable securities, consisting of AudioCodes and Tomen stock, amounted to $26.4 million during the first quarter of 2004. We received the proceeds of $9.6 million resulting from the sale of 801,000 shares of AudioCodes’ ordinary shares that occurred in the second quarter of 2004 during the third quarter of 2004. Proceeds from sales of Tower Semiconductor’s common stock during the six months periods ended June 30, 2003 were $0.5 million.

As part of our acquisition of Teleman’s assets for an aggregate consideration of $5.25 million in cash, including transaction costs of approximately $0.25 million, we paid $1.45 million and $2.1 million during the periods ended June 30, 2004 and June 30, 2003, respectively. We are obligated to make one additional payment of $1.45 million on May 16, 2005.

During the six months ended June 30, 2003, we collected approximately $3.3 million from customers of the DSP cores licensing business that was transferred to Ceva, our then wholly-owned subsidiary which subsequently combined with Parthus Technology plc to form ParthusCeva, Inc., in November 2002. This amount was included under cash received from discontinued operations in our condensed consolidated statements of cash flows.

Financing Activities. During the six months ended June 30, 2004, we received $12.3 million upon the exercise of employee stock options and through purchases made by our employees pursuant to our employee stock purchase plan, as compared to $5.3 million during the six months ended June 30, 2003.

During the six months ended June 30, 2003, as authorized by our share repurchase program, we repurchased approximately 286,000 shares of our common stock, at an average purchase price of $20.90 per share, for a total

aggregate amount of approximately $6.0 million, out of which $4.4 million were paid during the second quarter of 2003. In July 2003, our board authorized the repurchase of an additional 2.5 million shares of our common stock. We did not make any repurchases in the second quarter of 2004. During July 2004 we purchased 1,044,000 shares of our common stock, at an average purchase price of $20.53 per share, for a total aggregate amount of $21.43 million.

At June 30, 2004, our principal source of liquidity consisted of cash and cash equivalents totaling approximately $41.6 million, and held-to-maturity marketable securities and cash deposits of approximately $279.9 million. The market value of securities classified as available-for-sale and cash deposits amounted to $277.7 million as of June 30, 2004.

Our working capital at June 30, 2004 was approximately $69.2 million, and our backlog as of June 30, 2004 was $48.6 million. As we generate most of our cash flows from our operating activities, we believe that our current cash, cash equivalents, cash deposits and marketable securities, and our forecasted positive cash flows for future periods, will be sufficient to meet our cash requirements for both the short and long term.

In addition, as part of our business strategy, we occasionally evaluate potential acquisitions of businesses, products and technologies. Accordingly, a portion of our available cash may be used at any time for the acquisition of complementary products or businesses. Such potential transactions may require substantial capital resources, which may require us to seek additional debt or equity financing. We cannot assure you that we will be able to successfully identify suitable acquisition candidates, complete acquisitions, integrate acquired businesses into our current operations, or expand into new markets. Furthermore, we cannot assure you that additional financing will be available to us in any required time frame and on commercially reasonable terms, if at all. See “Factors Affecting Future Operating Results—We may engage in future acquisitions that could dilute our stockholders’ equity and harm our business, results of operations and financial condition.” for more detailed information.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

Foreign Currency Exchange Rate Risk. As a significant part of our sales and expenses are denominated in U.S. dollars, we have experienced only insignificant foreign exchange gains and losses to date, and do not expect to incur significant gains and losses in 2004. However, due to the volatility in the exchange rate of the New Israeli Shekel (NIS) versus the U.S. dollar, we decided to hedge part of the risk of a devaluation of the NIS, which could have an adverse effect on the expenses that we incur in the State of Israel. For example, to protect against an increase in value of forecasted foreign currency cash flows resulting from salary payments denominated in NIS during 2004 and lease payments for our Israeli facilities, we instituted a foreign currency cash flow hedging program using put options and forward contracts.

These option and forward contracts are designated as cash flow hedges, as defined by SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, and are all effective as hedges of these expenses. For more information about our hedging activity, see Note H to the attached Notes to Consolidated Financial Statement for the period ended June 30, 2004.

FACTORS AFFECTING FUTURE OPERATING RESULTS

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

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

We sell our products to customers primarily through a network of distributors and representatives. Particularly, revenues derived from sales to our Japanese distributor, Tomen Electronics Corporation, accounted for 80% of our total

revenues for the second quarter of 2004, and 82% for the second quarter of 2003. Our future performance will depend, in part, on this distributor to continue to successfully market and sell our products. Furthermore, Tomen Electronics sells our products to a limited number of customers. One customer, Panasonic Communications Co., Ltd, has continually accounted for a majority of the sales through Tomen Electronics. The loss of Tomen Electronics as our distributor and our inability to obtain a satisfactory replacement in a timely manner would materially harm our sales and results of operations. Additionally, the loss of Panasonic and Tomen Electronics’ inability to thereafter effectively market our products would also materially harm our sales and results of operations.

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

Our products are not sold directly to the end-user; rather, they are components of end products. As a result, we rely upon original equipment manufacturers (OEMs) to incorporate our products into their end products at the design stage. Once an OEM designs a competitor’s product into its end product, it becomes significantly more difficult for us to sell our products to that OEM because changing suppliers involves significant cost, time, effort and risk for OEM. As a result, we may incur significant expenditures on the development of a new product without any assurance that an OEM will select our product for design into its end product and without this “design win,” it becomes significantly more difficult to sell our products. Moreover, even after an OEM agrees to design our product into its end product, the design cycle is long and may be delayed due to factors beyond our control, which may result in the end product incorporating our products not to reach the market until long after the initial “design win” with the OEM. For example, one of our OEM customers has decided to delay the launch of new products incorporating the Bluetooth and video products. As a result, our future revenue and profitability may be adversely affected. Furthermore, we rely on the end products of our OEM customers that incorporate our products to achieve market acceptance. Many of our OEM customers face intense competition in their markets. If end products that incorporate our products are not accepted in the marketplace, we may not achieve adequate sales volume of our products, which would have a negative effect on our results of operations.

The slow economic recovery and related uncertainties may adversely impact our revenues and profitability.

Slower economic activity, decreased consumer confidence, reduced corporate profits and capital spending, unemployment, adverse business conditions and liquidity concerns in the telecommunications, semiconductor and related industries, and recent international conflicts and terrorist and military activity have resulted in a slow economic recovery after the downturn in worldwide economic conditions. If the economy continues to recover at a slow pace, we may experience a slowdown in customer orders, an increase in the number of cancellations and rescheduling of backlog. We cannot predict the timing, strength and duration of any economic recovery in the telecommunications and semiconductor industries. In addition, the new developments with the Iraqi conflict can be expected to place further pressure on economic conditions in the United States and worldwide. These conditions make it difficult for our customers, our vendors and for us to accurately forecast and plan future business activities. If such conditions continue or worsen, our business, financial condition and results of operations may be materially and adversely affected.

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

Sales of our Integrated Digital Telephony (IDT) products comprised 93% of our total revenues for the second quarter of 2004. Specifically, sales of our 2.4GHz and 5.8GHz products comprised 87% of our total revenues for the second quarter of 2004, and we expect that our 2.4GHz and 5.8GHz products will continue to account for a substantial portion of our revenues in 2004. As a result, any adverse change in the digital IDT market or in our ability to compete and maintain our competitive position in that market would harm our business, financial condition and results of operations. The IDT market is extremely competitive and we expect that competition will only increase. Our existing and potential competitors in each of our markets include large and emerging domestic and foreign companies, many of whom have significantly high-level financial, technical, manufacturing, marketing, sale and distribution resources and management expertise. It is possible that we may one day be unable to respond to increased price competition for IDT processors or other products through the introduction of new products or reduction of manufacturing costs. This inability would have a material adverse effect on our business, financial condition and results of operations. Likewise, any

significant delays by us in developing, manufacturing or shipping new or enhanced products for the IDT market also would have a material adverse effect on our business, financial condition and results of operations.

In addition, we believe new developments in the home residential market may adversely affect the revenues we derive from our IDT products. For example, the rapid deployment of new communication access methods, including mobile, broadband, cable and VoIP connections, may reduce the market for products using fixed-line telephony, meaning communication through phones connected to telephone lines. This decrease in demand would reduce our revenues derived from, and unit sales of, our cordless telephony products. Our business may also be affected by the outcome of the current competition between cell phone operators and fixed line operators for the provision of residential communication. Our revenues are currently primarily generated from sales of chipsets used in cordless phones that is based on fixed-line telephony. As a result, a decline in the use of fixed-line telephony for residential communication would adversely affect our financial condition and operating results.

Our business may also be affected by the outcome of the current competition between cell phone operators and fixed line operators for the provision of residential communication. Our revenues are currently primarily generated from sales of chipsets used in cordless phones that is based on fixed-line telephony. As a result, a decline in the use of fixed-line telephony for residential communication would adversely affect our financial condition and operating results.

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

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

•

fluctuations in volume and timing of product orders;

•

changes in demand for our products due to seasonal consumer buying patterns and other factors;

•

timing of new product introductions by us or our customers or competitors;

•

changes in the mix of products sold by us or our competitors;

•

fluctuations in the level of sales by our OEM customers and other vendors of end products incorporating our products;

•

the timing and size of expenses, including expenses to develop new products and product improvements;

•

mergers and acquisitions by us, our competitors, and existing and potential customers; and

•

general economic conditions, including the changing economic conditions in the United States and worldwide.

Each of the above factors is difficult to forecast and could harm our business, financial condition and results of operations. Also, we sell our products to OEM customers that operate in consumer markets. As a result, our revenues are affected by seasonal buying patterns of consumer end products sold by our OEM customers that incorporate our products and the market acceptance of such products supplied by our OEM customers. The fourth quarter in any given year is usually the strongest quarter for sales by our OEM customers in the consumer markets, and thus, our third quarter in any given year is usually the strongest quarter for revenues as our OEM customers request increased shipments of our products in anticipation of the increased activity in the fourth quarter. By contrast, the first quarter in any given year is usually the weakest quarter for us.

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

We have experienced and continue to experience a decrease in the average selling prices of our IDT processors, which we have to date been able to partially offset on an annual basis through manufacturing cost reductions by achieving a higher level of product integration and improving our yield percentages. However, there is no guarantee that our ongoing efforts will be successful or that they will keep pace with the anticipated, continued decline in average selling prices of our IDT processors, which could ultimately lead to a decline in revenues and have a negative effect on our gross margins.

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

All of our integrated circuit products are manufactured by independent foundries. While these foundries have been able to adequately meet the demands of our increasing business, we are and will continue to be dependent upon these foundries to achieve acceptable manufacturing yields, quality levels and costs, and to allocate to us a sufficient portion of their foundry capacity to meet our needs in a timely manner.

A significant majority of our integrated circuit products at this time is manufactured by one independent foundry. We have entered into a short-term supply arrangement with this foundry pursuant to which it is obligated to supply a specified amount of products to us for a specific period. We may incur charges to this foundry if we fail to utilize all the quantities of products reserved for us in accordance with this arrangement, which may increase our operating expenses and adversely affect our operating profit.

While we currently believe we have adequate capacity to support our current sales levels pursuant to our arrangement with our foundries, we may encounter capacity shortage issues in the future. In the event of a worldwide shortage in foundry capacity, we may not be able to obtain a sufficient allocation of foundry capacity to meet our product needs or we may incur additional costs to ensure specified quantities of products and services. Over-capacity at the current foundries we use, or future foundries we may use, to manufacture our integrated circuit products may lead to increased operating costs and lower gross margins. In addition, such a shortage could lengthen our products’ manufacturing cycle and cause a delay in the shipment of our products to our customers. This could ultimately lead to a loss of sales of our products, harm our reputation and competitive position, and our revenues could be materially reduced. Our business could also be harmed if our current foundries terminate their relationship with us and we are unable to obtain satisfactory replacements to fulfill customer orders on a timely basis and in a cost-effective manner.

In addition, foundries in Taiwan produce a significant portion of our integrated circuit products. As a result, earthquakes, aftershocks or other natural disasters in Asia, or adverse changes in the political situation in Taiwan, could preclude us from obtaining an adequate supply of wafers to fill customer orders and could harm our reputation, business, financial condition, and results of operations.

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

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

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

•

risks due to the fact that we have reduced control over production cost, delivery schedules and product quality;

•

less recourse if problems occur as the warranties on wafers or products supplied to us are limited; and

•

increased exposure to potential misappropriation of our intellectual property.

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

Although a majority of end users of the consumer products that incorporate our products are located in the U.S., we are dependent on sales to OEM customers, located outside of the U.S., that manufacture these consumer products. We expect that international sales will continue to account for a significant portion of our net product sales for the foreseeable future. For example, export sales, primarily consisting of IDT speech processors shipped to manufacturers in Europe and Asia Pacific, including Japan, represented 99% of our total revenues for the second quarter of 2004. As a result, the occurrence of any negative international political, economic or geographic events could result in significant revenue

shortfalls. These shortfalls could cause our business, financial condition and results of operations to be harmed. Some of the risks of doing business internationally include:

•

unexpected changes in regulatory requirements;

•

fluctuations in the exchange rate for the United States dollar;

•

imposition of tariffs and other barriers and restrictions;

•

burdens of complying with a variety of foreign laws;

•

political and economic instability; and

•

changes in diplomatic and trade relationships.

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

Our principal research and development facilities are located in the State of Israel and, as a result, at June 30, 2004, 180 of our 232 employees were located in Israel, including 116 out of 149 of our research and development personnel. In addition, although we are incorporated in Delaware, a majority of our directors and executive officers are residents of Israel. Although substantially all of our sales currently are being made to customers outside of Israel, we are nonetheless directly influenced by the political, economic and military conditions affecting Israel. Since the establishment of the State of Israel in 1948, a number of armed conflicts have taken place between Israel and its Arab neighbors and a state of hostility, varying in degree and intensity, has led to security and economic problems for Israel. Israel’s economy has been subject to numerous destabilizing factors, including a period of rampant inflation in the early to mid-1980s, low foreign exchange reserves, fluctuations in world commodity prices, military conflicts and civil unrest. In addition, Israel and companies doing business with Israel have been the subject of an economic boycott by the Arab countries since Israel’s establishment. Moreover, as a result of the hostilities and unrest presently occurring within Israel, the future of the peace efforts between Israel and its Arab neighbors is uncertain. A number of our employees based in Israel are currently obligated to perform annual military reserve duty and are subject to being called to active duty at any time under emergency circumstances. Any major hostilities involving Israel, or the interruption or curtailment of trade between Israel and its present trading partners, or significant destabilization of Israel’s economy could significantly harm our business, operating results and financial condition.

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

We receive certain tax benefits in Israel, particularly as a result of the “Approved Enterprise” status of our facilities and programs. To be eligible for tax benefits, we must meet certain conditions, relating principally to adherence to the investment program filed with the Investment Center of the Israeli Ministry of Industry and Trade and to periodic reporting obligations. Although we have met such conditions in the past, should we fail to meet such conditions in the future, we would be subject to corporate tax in Israel at the standard rate of 36%, and could be required to refund tax benefits already received. We cannot assure you that such grants and tax benefits will be continued in the future at their current levels, if at all. The tax benefits under these investment plans are scheduled to expire starting in 2005 through 2017. The termination or reduction of certain programs and tax benefits (particularly benefits available to us as a result of the Approved Enterprise status of our facilities and programs) or a requirement to refund tax benefits already received may have a material adverse effect on our business, operating results and financial condition.

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

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

termination of any of these sources associated with the manufacturing processes of our OEM customers could have an adverse effect on our business and results of operations due to a delay or discontinuance of orders for our products by our OEM customers until those necessary components are available for their end products.

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

We have pursued, and will continue to pursue, growth opportunities through internal development and acquisition of complementary businesses, products and technologies. We are unable to predict whether or when any other prospective acquisition will be completed. The process of integrating an acquired business may be prolonged due to unforeseen difficulties and may require a disproportionate amount of our resources and management’s attention. We cannot assure you that we will be able to successfully identify suitable acquisition candidates, complete acquisitions, integrate acquired businesses into our operations, or expand into new markets. Further, once integrated, acquisitions may not achieve comparable levels of revenues, profitability or productivity as our existing business or otherwise perform as expected. The occurrence of any of these events could harm our business, financial condition or results of operations. Future acquisitions may require substantial capital resources, which may require us to seek additional debt or equity financing.

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

•

issuance of equity securities that would dilute our current stockholders’ percentages of ownership;

•

large one-time write-offs;

•

the incurrence of debt and contingent liabilities;

•

difficulties in the assimilation and integration of operations, personnel, technologies, products and information systems of the acquired companies;

•

diversion of management’s attention from other business concerns;

•

contractual disputes;

•

risks of entering geographic and business markets in which we have no or only limited prior experience; and

•

potential loss of key employees of acquired organizations.

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

As is typical in the semiconductor industry, we have been and may from time to time be notified of claims that we may be infringing patents or intellectual property rights owned by third parties. We also have in the past agreed to, and may from time to time in the future agree to, indemnify a licensee of our products for claims against the licensee by a third party based on claims that our products infringe patents or other intellectual property rights of that third party. Our obligation to indemnify a licensee, if valid, may result in significant expense to us, and could adversely affect our operating results for the period that such obligation matures.

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

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

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

Our success and ability to compete is in part dependent upon our internally-developed technology and other proprietary rights, which we protect through a combination of copyright, trademark and trade secret laws, as well as through confidentiality agreements and licensing arrangements with our customers, suppliers, employees and consultants. In addition, we have filed a number of patents in the United States and in other foreign countries with respect to new or improved technology that we have developed. However, the status of any patent involves complex legal and factual questions, and the breadth of claims allowed is uncertain. Accordingly, we cannot assure you that any patent application filed by us will result in a patent being issued, or that the patents issued to us will not be infringed by others. Also, our competitors and potential competitors may develop products with similar technology or functionality as our products, or they may attempt to copy or reverse engineer aspects of our product line or to obtain and use information that we regard as proprietary. Moreover, the laws of certain countries in which our products are or may be developed, manufactured or sold, including Hong Kong, Japan and Taiwan, may not protect our products and intellectual property rights to the same extent as the laws of the United States. Policing the unauthorized use of our products is difficult and may result in significant expense to us and could divert the efforts of our technical and management personnel. Even if we spend significant resources and efforts to protect our intellectual property, we cannot assure you that we will be able to prevent misappropriation of our technology. Use by others of our proprietary rights could materially harm our business and expensive litigation may be necessary in the future to enforce our intellectual property rights.

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

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

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

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

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

Furthermore, due to various new developments in the home residential market, we may be required to enter into new markets with competitors that have more established presence, and significantly greater financial, technical,

manufacturing, marketing, sales and distribution resources and management expertise than we do. For example, the rapid deployment of new communication access methods, including mobile, broadband, cable and VoIP connections, as well as the projected lack of growth in products using fixed-line telephony, meaning communication through phones connected to telephone lines, will require us to expand our current product lines and develop a portfolio of “system-on-a-chip” solutions that integrate video, voice, data and communication technologies in a wider multimedia market. The expenditure of greater resources to expand our product lines, and develop and sell a portfolio of “system-on-a-chip” solutions may increase our operating expenses and reduce our gross profit. We cannot assure you that we will succeed in developing and introducing new products that are responsive to market demands.

We face intense competition and our operating expenses may increase disproportionately as we try to penetrate the European DECT market with our new products.

As an expansion of our business, we are currently developing chipsets for the European Digital Enhanced Cordless Telecommunications (DECT) market. We face intense competition in this market from current, well-established competitors that have significant financial, technical, manufacturing, marketing, sales and distribution resources and management expertise. Although we are leveraging our expertise in developing chipsets for the U.S. market, there are key differences in technology for the European market. As with the development of any new technology, we may encounter unforeseeable delays and other problems, and thus we cannot provide any assurances that we will achieve our development milestones or our new products will gain market acceptance. As a result, the penetration of the European market is anticipated to increase our headcount and operating expenses in the remaining quarters of 2004 and potentially in future years. In 2003, we achieved our first two design wins for the incorporation of our products into OEMs’ end products targeted for the European DECT market. However, we cannot assure you that the significant expenditures we will incur will result in any additional design wins, or that such design wins, even if successful, would translate into meaningful sales and revenue for our DECT products. Also, in order to penetrate the new market, we may need to offer our products at lower prices than we currently anticipate, which may result in lower profits. Our inability to penetrate the European DECT market and recover the significant expenditures we will incur to develop products for this new market may adversely affect our business, financial condition and results of operations.

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

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

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

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

We are exposed to fluctuations in currency exchange rates.

A significant portion of our business is conducted outside the United States. Export sales to manufacturers in Europe and Asia Pacific, including Japan, represented 99% of our total revenues for the second quarter of 2004 as well as for each of fiscal 2003 and 2002. Although most of our revenue and expenses are transacted in U.S. dollars, we may be exposed to currency exchange fluctuations in the future as business practices evolve and we are forced to transact business in local currencies. Moreover, part of our expenses in Israel are paid in Israeli currency, which subjects us to the risks of foreign currency fluctuations between the U.S. dollar and the New Israeli Shekel (NIS) and to economic pressures resulting from Israel’s general rate of inflation. Our primary expenses paid in NIS are employee salaries and lease payments on our Israeli facilities. As a result, an increase in the value of Israeli currency in comparison to the U.S. dollar could increase the cost of our technology development, research and development expenses and general and administrative expenses. From time to time, we use derivative instruments in order to minimize the effects of currency fluctuations, but our hedging positions may be partial, may not exist at all in the future or may not succeed in minimizing our foreign currency fluctuation risks.

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

The markets for our products and services are characterized by rapidly changing technology, short product life cycles, evolving industry standards, changes in customer needs, demand for higher levels of integration, growing competition and new product introductions. For example, we are seeing a continuing decline in sales of some of our older products, including the 900 MHz products. Our ability to adapt to these changes and to anticipate future standards, and the rate of adoption and acceptance of those standards, will be a significant factor in maintaining or improving our competitive position and prospects for growth. If new industry standards emerge, our products or our customers’ products could become unmarketable or obsolete, and we could lose market share. We may also have to incur substantial unanticipated costs to comply with these new standards. If our product development and improvements take longer than planned, the availability of our products would be delayed. Any such delay may render our products obsolete or unmarketable, which would have a negative impact on our ability to sell our products and our results of operations.

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

•

successfully develop, introduce and market new and enhanced products at competitive prices and in a timely manner in order to meet changing customer needs;

•

convince leading OEMs to select our new and enhanced products for design into their own new products;

•

respond effectively to new technological changes or new product announcements by others;

•

effectively use and offer leading technologies; and

•

maintain close working relationships with our key customers.

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

Specifically, we believe new technological developments in the home residential market may adversely affect our operating results. For example, the rapid deployment of new communication access methods, including wireless, broadband, cable and VoIP connections, as well as the projected lack of growth in products using fixed-line telephony, meaning communication through phones connected to telephone lines, would reduce our total revenues derived from, and unit sales of, cordless telephony products. Our ability to maintain our growth will depend on the expansion of our product lines to capitalize on the emerging access methods and on our success in developing and selling a portfolio of “system-on-a-chip” solutions that integrate video, voice, data and communication technologies in a wider multimedia market, as well as on our success in developing and selling DECT and video products. We anticipate hiring additional research and development personnel to develop new products for the European DECT market, as well as new features for the

connectivity from fix-line telephony to cellular phones. As a result, our research and development expenses in absolute dollars and as a percentage from total revenues will increase in the remaining quarters of 2004, and potentially in future periods. We cannot assure you that we will generate sufficient revenues to offset the additional expenses associated with research and development. Furthermore, there are no assurances that we will succeed in expanding our product lines, or develop and sell in a timely manner a portfolio of “system-on-a-chip” solutions.

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

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

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

Our certificate of incorporation and bylaws contain provisions that may prevent or discourage a third party from acquiring us, even if the acquisition would be beneficial to our stockholders. We have a staggered board, which means it will generally take two years to change the composition of our board. Our board of directors also has the authority to fix the rights and preferences of shares of our preferred stock and to issue such shares without a stockholder vote. We also have a rights plan in place. It is possible that these provisions may prevent or discourage third parties from acquiring us, even if the acquisition would be beneficial to our stockholders. In addition, these factors may also adversely affect the market price of our common stock, and the voting and other rights of the holders of our common stock.

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

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

ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Quantitative and Qualitative Disclosures About Market Risk.”

ITEM 4.

CONTROLS AND PROCEDURES

As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in this report.

There has been no change in our internal control over financial reporting that occurred during our most recent fiscal quarter that has materially affected or is reasonably likely to materially affect our internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 1.

LEGAL PROCEEDINGS

We are involved in certain claims arising in the normal course of business. However, we believe that the ultimate resolution of these matters will not have a material adverse effect on its financial position, results of operations, or cash flows.

ITEM 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Company held its 2004 Annual Meeting of Stockholders on May 4, 2004. The following proposals were voted on by the Company stockholders and results obtained thereon:

Proposal 1: Election of Directors

The election of three Class I director was approved as follows:


	In Favor	Against	Abstentions	Non-votes
Eliyahu Ayalon	24,738,947	1,252,590	0	0
Zvi Limon	23,520,401	2,471,136	0	0
Louis Silver	22,866,909	3,124,628	0	0

Continuing as directors after the meeting are Eliyahu Ayalon, Zvi Limon, Yair Seroussi, Yair Shamir, Louis Silver and Patrick Tanguy.

Proposal 2: Ratification of Appointment of Independent Auditors

Kost, Forer, Gabbay & Kasierer, a member of Ernst & Young Global, was ratified as the Company’s independent auditors for fiscal year 2004 with 24,607,195 in favor, 1,380,343 against, and 3,999 abstentions.

ITEM 6.

EXHIBITS AND REPORTS ON FORM 8-K

(a)

Exhibits:



Exhibit 10.3		Amended and Restated 1993 Director Stock Option Plan.

Exhibit 10.43		Employment Agreement, dated June 16, 2004, by and between the Registrant and Inon Beracha.

Exhibit 31.1		Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

Exhibit 31.2		Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

Exhibit 32.1		Certification of the Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

Exhibit 32.2		Certification of the Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(b)

Reports on Form 8-K.

The Company filed a Form 8-K on April 21, 2004 announcing its first quarter 2003 earnings results.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this quarterly report on Form 10Q to be signed on its behalf by the undersigned thereunto duly authorized.


	DSP GROUP, INC. (Registrant)

Date: August 9, 2004	By:	/s/ MOSHE ZELNIK
		Moshe Zelnik, Vice President of Finance, Chief Financial Officer and Secretary
		(Principal Financial Officer and Principal Accounting Officer)

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents