SIGMATEL INC - 10-Q Quarterly Report

UNITED STATES

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 September 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: 000-50391

SIGMATEL, INC.

(Exact name of registrant as specified in its charter)

Delaware

74-2691412

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

3815 South Capital of Texas Highway

Building 3, Suite 300

Austin, Texas 78704

(512) 381-3700

(Address and telephone number of principal executive offices)

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

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

The number of shares outstanding of the Registrant’s Common Stock, $0.0001 par value, was 34,301,346 as of October 10, 2004.

SIGMATEL, INC.

FORM 10-Q

TABLE OF CONTENTS


			Page No.
PART I:		INTERIM FINANCIAL INFORMATION

Item 1.	Financial Statements

	Consolidated Condensed Balance Sheets as of September 30, 2004 and December 31, 2003		3

	Consolidated Condensed Statements of Operations for the Three and Nine months ended September 30, 2004 and September 30, 2003		4

	Consolidated Condensed Statements of Cash Flows for the Nine months ended September 30, 2004 and September 30, 2003		5

	Notes to Consolidated Condensed Financial Statements		6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		14

Item 3.	Quantitative and Qualitative Disclosures About Market Risk		25

Item 4.	Controls and Procedures		35

PART II:		OTHER INFORMATION

Item 1.	Legal Proceedings		36

Item 2.	Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities		36

Item 3.	Defaults Upon Senior Securities		37

Item 4.	Submission of Matters to a Vote of Security Holders		37

Item 5.	Other Information		37

Item 6.	Exhibits		37

Signatures			38

PART I: FINANCIAL INFORMATION

Item 1. Financial Statements

SIGMATEL, INC.

CONSOLIDATED CONDENSED BALANCE SHEETS

(in thousands, except share data)

(unaudited)


	September 30, 2004			December 31, 2003
ASSETS
Current Assets:
Cash and cash equivalents	$	37,390		$	61,841
Short-term investments		80,252			49,420
Accounts receivable, net		27,466			15,989
Inventories, net		13,591			9,904
Deferred tax asset		9,587			—
Prepaid expenses and other current assets		4,011			1,333

Total current assets		172,297			138,487

Property, equipment and software, net		4,256			3,792
Intangible assets, net		4,457			4,476
Other assets		526			122

Total assets	$	181,536		$	146,877

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
Accounts payable	$	14,571		$	13,466
Accrued payroll		2,137			870
Other accrued expenses		2,698			2,561
Deferred revenue		6,391			3,645
Current portion of capital lease obligations		54			48

Total current liabilities		25,851			20,590

Capital lease obligations, net of current portion		22			63
Other liabilities		115			116

Total liabilities		25,988			20,769

Stockholders’ equity:
Common stock, $.0001 par value; 170,000,000 shares authorized; shares issued and outstanding: 34,319,997 and 34,230,041 at 2004 and 34,270,961 and 34,181,005 at 2003, respectively		3			3
Additional paid-in capital		167,939			173,737
Notes receivable from stockholders		(7	)		(115	)
Deferred stock-based compensation		(1,618	)		(3,678	)
Treasury stock, 89,956 common shares, at cost		(741	)		(741	)
Accumulated deficit		(10,028	)		(43,098	)

Total stockholders’ equity		155,548			126,108

Total liabilities and stockholders’ equity	$	181,536		$	146,877

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

SIGMATEL, INC.

CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS

(in thousands, except share data)

(unaudited)


	Three Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004			2003
Revenues, net	$	48,112		$	32,706		$	116,220		$	65,254
Cost of goods sold ⁽¹⁾		22,033			16,988			53,595			35,196

Gross Profit		26,079			15,718			62,625			30,058

Operating Expenses:
Research and development ⁽¹⁾		8,603			4,674			21,856			12,490
Selling, general and administrative ⁽¹⁾		3,964			2,716			10,466			6,971
Amortization of deferred stock-based compensation		424			1,860			1,821			2,988
Litigation settlement (Note 8)		—			4,500			—			4,500

Total operating expenses		12,991			13,750			34,143			26,949

Operating income		13,088			1,968			28,482			3,109

Other income (expense):
Interest income		446			22			1,140			44
Interest expense		(3	)		(238	)		(19	)		(1,243	)

Total other income (expense)		443			(216	)		1,121			(1,199	)

Income before income taxes		13,531			1,752			29,603			1,910

Income tax benefit (expense)		3,787			(70	)		3,467			(78	)

Net income		17,318			1,682			33,070			1,832
Deemed dividends on preferred stock		—			(513	)		—			(8,768	)

Net income (loss) attributable to common stockholders	$	17,318		$	1,169		$	33,070		$	(6,936	)

BASIC NET INCOME (LOSS) ATTRIBUTABLE TO COMMON STOCKHOLDERS PER SHARE	$	0.50		$	0.15		$	0.95		$	(1.07	)

DILUTED NET INCOME (LOSS) ATTRIBUTABLE TO COMMON STOCKHOLDERS PER SHARE	$	0.46		$	0.04		$	0.87		$	(1.07	)

WEIGHTED AVERAGE SHARES USED TO COMPUTE:
Basic net income (loss) attributable to common stockholders per share		34,537,784			7,733,292			34,725,468			6,487,232
Diluted net income (loss) attributable to common stockholders per share		37,381,964			29,536,606			38,013,192			6,487,232

⁽¹⁾	Amounts exclude amortization of deferred stock-based compensation as follows:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2004		2003		2004		2003
Cost of goods sold	$	19	$	44	$	87	$	86
Research and development		264		577		1,150		1,236
Selling, general & administrative		141		1,239		584		1,666

Total	$	424	$	1,860	$	1,821	$	2,988

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

SIGMATEL, INC.

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)


	Nine Months Ended September 30,
	2004			2003
Cash flows from operating activities:
Net income	$	33,070		$	1,832
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		3,567			2,705
Amortization of deferred stock-based compensation		1,821			2,988
Deferred income tax benefit		(9,587	)		—
Tax benefit related to exercise of employee stock options		5,794			—
Other non-cash expenses		440			952
Changes in assets and liabilities:
Accounts receivable, net		(11,478	)		(10,106	)
Inventories, net		(3,687	)		(5,760	)
Prepaid expenses and other assets		(3,078	)		(154	)
Accounts payable		4,601			5,033
Accrued expenses		1,467			2,760
Deferred revenue and other liabilities		2,682			2,717

Net cash provided by operating activities		25,612			2,967

Cash flows from investing activities:
Maturities of short-term investments		63,251			—
Purchase of short-term investments		(94,369	)		—
Purchase of property, equipment, software and intangible assets		(7,509	)		(2,056	)

Net cash used in investing activities		(38,627	)		(2,056	)

Cash flows from financing activities:
Proceeds from long-term debt		—			5,150
Repayments under revolving line of credit, net		—			(8,923	)
Payments on long-term debt		—			(5,000	)
Payments on capital lease obligations		(35	)		(63	)
Proceeds from issuance of convertible preferred stock, net of issuance costs		—			8,090
Payments of interest on convertible notes		—			(1,564	)
Proceeds from notes receivable from stockholders		109			144
Proceeds from issuance of common stock, net of issuance costs		9,511			101,529
Purchases of treasury stock		(21,021	)		—

Net cash provided by (used in) financing activities		(11,436	)		99,363

Net increase (decrease) in cash and cash equivalents		(24,451	)		100,274
Cash and cash equivalents, beginning of period		61,841			2,859

Cash and cash equivalents, end of period	$	37,390		$	103,133

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

SigmaTel, Inc.

Notes to Consolidated Condensed Financial Statements

1. Basis of Presentation

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

In September of 2004, SigmaTel Hong Kong, Ltd. was established and incorporated in Hong Kong as a wholly owned subsidiary of SigmaTel, Inc. for the purpose of providing engineering support for product development issues to customers in Asia. It will serve customers throughout mainland China, Hong Kong and Taiwan.

2. Equity Offerings

The Securities and Exchange Commission declared the Company’s first registration statement, which the Company filed on Form S-1 (Registration No. 333-106796) under the Securities Act of 1933 in connection with the initial public offering of its common stock, effective on September 18, 2003. Under this registration statement, the Company registered 11,500,000 shares of its common stock, including 1,500,000 shares subject to the underwriters’ over-allotment option (which option was exercised in full), with an aggregate public offering price of $172.5 million. The Company registered 7,383,917 of these shares on its behalf and 4,116,083 of these shares on behalf of certain selling stockholders of the Company.

The underwriting syndicate was managed by Merrill Lynch & Co., JPMorgan, CIBC World Markets and Needham & Company, Inc. This offering terminated after the sale of all of the shares of the Company’s common stock that it registered under its registration statement on Form S-1.

The sale of shares of common stock by the Company, including the sale of 383,917 shares pursuant to the exercise of the over-allotment option by the underwriters, resulted in aggregate gross proceeds of approximately $110.8 million, approximately $7.8 million of which the Company applied to underwriting discounts and commissions and approximately $1.6 million of which the Company applied to related costs. As a result, the Company received approximately $101.4 million of the offering proceeds.

The sale of shares of common stock by the selling stockholders resulted in aggregate gross proceeds of $61.7 million, $4.3 million of which the selling stockholders applied to underwriting discounts and commissions. As a result, the selling stockholders received $57.4 million of the offering proceeds.

Upon completion of the initial public offering, 22,022,367 outstanding shares of the Company’s redeemable convertible preferred stock were converted into 19,177,818 shares of common stock.

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

SigmaTel, Inc.

Notes to Consolidated Condensed Financial Statements-(Continued)

In July of 2004, the Company’s Board of Directors authorized a share repurchase plan for up to $30 million of common stock. Under this plan, the Company used $21.0 million of cash during July and August of 2004 to purchase 1,381,991 shares of common stock. All shares purchased during the three months ended September 30, 2004 were retired during the period.

3. Significant Accounting Policies

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

Accounting for Stock-Based Compensation

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


	Three Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004			2003
Net income (loss) attributable to common stockholders, as reported	$	17,318		$	1,169		$	33,070		$	(6,936	)
Add: Stock-based employee compensation expense recognized in net income (loss) attributable to common stockholders, net of related income tax effects		424			1,768			1,821			2,737
Deduct: Stock-based employee compensation expense determined under the fair value based method for all employee awards, net of related income tax effects		(1,106	)		(1,738	)		(4,048	)		(2,693	)

Pro forma net income (loss) attributable to common stockholders	$	16,636		$	1,199		$	30,843		$	(6,892	)

Pro forma basic net income (loss) attributable to common stockholders per share, as adjusted	$	0.48		$	0.16		$	0.89		$	(1.06	)

Pro forma diluted net income (loss) attributable to common stockholders per share, as adjusted	$	0.45		$	0.04		$	0.81		$	(1.06	)

SigmaTel, Inc.

Notes to Consolidated Condensed Financial Statements-(Continued)

Comprehensive Income

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

Net Income (loss) per Share

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

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


	Three Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004			2003
Numerator:
Net income (loss) attributable to common stockholders	$	17,318		$	1,169		$	33,070		$	(6,936	)

Denominator:
Weighted-average common stock outstanding		34,576,758			7,802,305			34,775,594			6,539,747
Less: weighted-average shares subject to repurchase		(38,974	)		(69,013	)		(50,126	)		(52,515	)

Weighted-average shares used in computing basic net income (loss) attributable to common stockholders per share		34,537,784			7,733,292			34,725,468			6,487,232
Dilutive potential common shares used in computing diluted net income (loss) attributable to common stockholders per share		2,844,180			21,803,314			3,287,724			—

Total weighted-average number of shares used in computing diluted net income (loss) attributable to common stockholders per share		37,381,964			29,536,606			38,013,192			6,487,232

SigmaTel, Inc.

Notes to Consolidated Condensed Financial Statements-(Continued)

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


	Three Months Ended September 30,		Nine Months Ended September 30,
	2004	2003	2004	2003
Options to purchase common stock	1,191,906	—	552,346	3,913,893
Common stock subject to repurchase	—	—	—	52,515
Redeemable convertible preferred stock	—	—	—	19,177,818
Warrants	—	—	—	1,522,215
Convertible notes	—	1,022,102	—	1,022,102

Included in the calculation of net income (loss) attributable to common stockholders are deemed dividends of zero and $0.5 million for the three months ended September 30, 2004 and 2003, respectively, and zero and $8.8 million for the nine months ended September 30, 2004 and 2003, respectively, related to the issuance of the Company’s Series F, H and J Preferred Stock.

4. Short-term Investments

Short-term investments at September 30, 2004 and December 31, 2003, consisting of corporate, state and municipal securities, were acquired at an aggregate cost of $80.3 million and $49.4 million, respectively. The fair value of these instruments are based on market interest rates and other market information available to management as of each balance sheet date presented and was not materially different than the aggregate cost.

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


	September 30, 2004			December 31, 2003
Available-for-sale securities:
Commercial paper	$	6,587		$	19,949
U.S. agencies		10,847			—
Auction rate preferreds		61,250			44,300
Corporate notes		9,308			5,120

Total investments		87,992			69,369
Less cash equivalents		(7,740	)		(19,949	)

	$	80,252		$	49,420

Management classifies investments in marketable securities at the time of purchase and reevaluates such classification at each balance sheet date. Securities classified as available-for-sale are stated at cost, which is not materially different than market value as of September 30, 2004. $1.6 million of investments mature beyond one year and within five years and $61.3 million of investments mature beyond five years, but have interest rate maturities of less than thirty-five days.

SigmaTel, Inc.

Notes to Consolidated Condensed Financial Statements-(Continued)

5. Inventories

Inventories consist of the following (in thousands):


	September 30, 2004		December 31, 2003
Work in process	$	7,652	$	3,342
Finished goods		5,939		6,562

	$	13,591	$	9,904

At September 30, 2004 and December 31, 2003, the Company’s reserve for slow-moving and obsolete inventory was approximately $1.8 million and $1.4 million, respectively. This increase resulted from additional reserve of $1.1 million for obsolescence offset by scrap and sales of items which had previously been reserved of $0.7 million.

6. Intangible Assets

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


	September 30, 2004			December 31, 2003
Intangible assets subject to amortization:
Gross carrying amount	$	5,428		$	4,712
Accumulated amortization		(971	)		(236	)

	$	4,457		$	4,476

Intangible asset amortization expense for the three months ended September 30, 2004 and 2003 was $0.3 million and $13,000, respectively, and for the nine months ended September 30, 2004 and 2003 was $0.7 million and $13,000, respectively. Estimated aggregate intangible asset amortization expense is expected to be $1.0 million for each of the fiscal years 2004 through 2007 and $0.8 million in 2008. The weighted average amortization period for intangible assets is five years.

7. Income Taxes

The provision for income taxes has been calculated based on the Company’s estimate of its effective tax rate for the full fiscal year. At September 30, 2004, the Company increased its estimate of the effective tax rate for its year ending December 31, 2004 from 2.0% to 16.7%. The increase resulted primarily from the reversal of a valuation allowance of $8.4 million on the Company’s deferred tax asset, based on management’s belief that it is more likely than not that the net deferred tax asset will be realized after 2004 as a result of current year taxable income and expected future taxable income.

8. Commitments and Contingencies

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

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

SigmaTel, Inc.

Notes to Consolidated Condensed Financial Statements-(Continued)

Litigation

In September 1999, a suit was filed against the Company by Crystal Semiconductor, Inc. (“Crystal”) and Cirrus Logic, Inc. (“Cirrus”) (the parent company of Crystal) alleging that certain of the Company’s products infringed on two of Crystal’s patents. The Company settled the suit in November 2000. As part of the settlement, the Company issued shares of common stock to Cirrus valued at $3.0 million at the date of issuance, which was recorded as a litigation settlement expense. The Company also agreed to a perpetual contingent guarantee which provided that these shares would have a value of at least $10.5 million at the time of an initial public offering. Upon the closing of its initial public offering, the Company recorded an expense of and paid Cirrus $4.5 million in satisfaction of the contingent guarantee. In addition, Cirrus was to receive a warrant, exercisable for 60 days after the effective date of the initial public offering, to purchase shares of the Company’s common stock. In August 2003, this warrant was cancelled.

9. Related Party Transactions

Revenues from a significant stockholder were approximately $8.1 million and $6.5 million for the three months ended September 30, 2004 and 2003, respectively, and approximately $17.2 million and $8.7 million for the nine months ended September 30, 2004 and 2003, respectively.

Accounts receivable from sales to an affiliated customer were approximately $8.1 million and $5.6 million as of September 30, 2004 and December 31, 2003, respectively.

The Company paid for legal services to a law firm affiliated with a stockholder of the Company of approximately $7,000 and $0.4 million for the three months ended September 30, 2004 and 2003, respectively, and approximately $0.2 million and $0.4 million for the nine months ended September 30, 2004 and 2003, respectively.

At September 30, 2004 and December 31, 2003, the Company had approximately $7,000 and $0.1 million, respectively, in receivables from non-executive employees to finance their purchases of restricted common stock.

SigmaTel, Inc.

Notes to Consolidated Condensed Financial Statements-(Continued)

10. Operating Segments and Geographic Information

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

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


	Three Months Ended September 30,				Nine Months Ended September 30,
	2004		2003		2004		2003
Taiwan	30.2	%	46.4	%	40.5	%	50.4	%
China/Hong Kong	44.6		24.8		35.3		24.6
Singapore	18.2		19.9		16.0		13.4
South Korea	4.9		5.8		5.8		7.7
Japan	1.7		2.0		2.0		2.6
United States	0.2		0.4		0.1		0.3
Other	0.2		0.7		0.3		1.0

Total sales	100.0	%	100.0	%	100.0	%	100.0	%

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


	September 30, 2004		December 31, 2003
United States	87	%	74	%
Taiwan	3		13
Other	10		13

	100	%	100	%

SigmaTel, Inc.

Notes to Consolidated Condensed Financial Statements-(Continued)

11. Recent Accounting Pronouncements

In April 2004, the EITF released Issue No. 03-06, Participating Securities and the Two Class Method under SFAS No. 128, Earnings per Share, which addressed a number of questions regarding the computation of earnings per share by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock. It requires that undistributed earnings for the period be allocated to a participating security based on the contractual participation rights of the security to share in those earnings as if all the earnings for the period had been distributed in calculating earnings per share. EITF Issue No. 03-06 is effective for fiscal periods beginning after March 15, 2004. It requires that prior period earnings per share amounts be restated to ensure comparability year over year. The adoption of EITF Issue No. 03-06 did not have an impact on the Company’s financial position, results of operations or cash flows.

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

Forward-looking Statements

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

Overview

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

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

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

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


	Three Months Ended September 30,				Nine Months Ended September 30,
	2004		2003		2004		2003
Holystone Enterprise	17.7	%	32.4	%	20.0	%	35.3	%
G.M.I. Technology	31.0	%		*	23.9	%		*
Creative Technology⁽¹⁾	16.9	%	19.9	%	14.8	%	13.3	%

*	Less than 10%

⁽¹⁾	Creative Technology holds more than 10% of our outstanding stock and had a representative on our Board of Directors until his resignation on June 10, 2004.

The percentage of our revenues from customers located outside the U.S. was 99.8% and 99.6% for the three months ended September 30, 2004 and 2003, respectively, and 99.9% and 99.7% for the nine months ended September 30, 2004 and 2003, respectively. Most of the products that use our ICs are manufactured outside of the U.S. As a result, we believe that a substantial majority of our revenues will continue to come from customers located outside of the U.S. All of our revenues to date have been denominated in U.S. dollars.

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


	Three Months Ended September 30,				Nine Months Ended September 30,
	2004		2003		2004		2003
Taiwan	30.2	%	46.4	%	40.5	%	50.4	%
China/Hong Kong	44.6		24.8		35.3		24.6
Singapore	18.2		19.9		16.0		13.4
South Korea	4.9		5.8		5.8		7.7
Japan	1.7		2.0		2.0		2.6
United States	0.2		0.4		0.1		0.3
Other	0.2		0.7		0.3		1.0

Total	100.0	%	100.0	%	100.0	%	100.0	%

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

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

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

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

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

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

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

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

Amortization of Deferred Stock-Based Compensation. In connection with grants of stock options and the issuance of warrants as a private company between 2000 and 2003, we recorded an aggregate of $7.5 million in deferred stock-based compensation. These options and warrants are considered compensatory because the fair value of our stock determined for financial reporting purposes was greater than the fair value determined by our board of directors on the date of grant or issuance. As of September 30, 2004, we had an aggregate of $1.6 million of deferred stock-based compensation remaining to be amortized. We are amortizing deferred stock-based compensation over the vesting period of the related options and warrants, which is generally four or five years. This deferred stock-based compensation balance is expected to be amortized as follows: $2.2 million during 2004; $0.9 million during 2005 and $0.4 million during 2006.

Provision for Income Taxes. As of December 31, 2003, we had net operating loss carryforwards of approximately $36.3 million. These net operating loss carryforwards will expire at various dates beginning in 2011. We also had research and development tax credit carryforwards of approximately $2.4 million for federal income tax purposes. The federal research and development tax credit carryforward will expire at various dates beginning in 2011. The state research credit can be carried forward indefinitely. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. During the three months ended September 30, 2004, we released $8.4 million of valuation allowance based on management’s belief that it is more likely than not that this amount of deferred tax asset will be realized after 2004 as a result of current year taxable income and expected future taxable income.

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

Results of Operations

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


	Three Months Ended September 30,				Nine Months Ended September 30,
	2004		2003		2004		2003
Revenues, net	100.0	%	100.0	%	100.0	%	100.0	%
Cost of goods sold	45.8		51.9		46.1		53.9

Gross profit	54.2		48.1		53.9		46.1
Operating expenses:
Research and development	17.9		14.3		18.8		19.1
Selling, general and administrative	8.2		8.3		9.0		10.7
Amortization of deferred stock-based compensation	0.9		5.7		1.6		4.6
Litigation settlement	—		13.8		—		6.9

Total operating expenses	27.0		42.0		29.4		41.3

Operating income	27.2		6.0		24.5		4.8
Interest income	0.9		0.1		1.0		0.1
Interest expense	—		(0.7	)	—		(1.9	)

Income before income taxes	28.1		5.4		25.5		2.9
Income tax benefit (expense)	7.9		(0.2	)	3.0		(0.1	)

Net income	36.0	%	5.1	%	28.5	%	2.8	%
Deemed dividends on preferred stock	—		(1.6	)	—		(13.4	)

Net income (loss) attributable to common stockholders	36.0	%	3.6	%	28.5	%	(10.6	)%

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

Revenues. Revenues for the three months ended September 30, 2004 were $48.1 million compared to $32.7 million for the three months ended September 30, 2003, an increase of 47.1%. This increase was due to an increase in revenues from portable audio SoCs of 77.4%, offset by a 40.4% decrease in revenues from our audio codecs and a 52.8% decrease in revenues from our USB peripheral ICs. The increase in revenues from our portable audio SoCs was due to the continued growth of the emerging portable compressed audio player market and our

favorable competitive position within that market. Revenues from our portable audio SoCs were 89.9% of total revenues for the three months ended September 30, 2004. Our favorable competitive position in this market is primarily due to our integration of analog and digital components onto a single IC, and the resulting small form factor, low power consumption, and overall low cost to our customers. The decrease in revenues from our audio codecs was primarily due to the continued secular decline in sound card markets where we were shipping significant volume in the 2003 period. The decrease in revenues from our USB peripheral ICs was primarily due to competitive pressures at the low end of the market and the general softness in high-end cell phones compared to last year.

Revenues from G.M.I., a distributor in Hong Kong, increased to 31.0% of total revenues during the three months ended September 30, 2004 from less than 10% of total revenues during the three months ended September 30, 2003 due to stronger demand for our portable audio SoCs in China and Hong Kong. Revenues from Holystone, a distributor located in Taiwan, decreased by $2.1 million from $10.6 million in the three months ended September 30, 2003, and decreased to 17.7% of total revenues during the three months ended September 30, 2004 from 32.4% during the three months ended September 30, 2003, due to customers who use our portable audio SoCs being served by other distributors in geographic regions such as China and South Korea. Sales to Creative Technology, an affiliate, increased by $1.6 million from $6.5 million in the three months ended September 30, 2003 due to an increase in their purchases of portable audio SoCs, offset by a decrease in their purchases of audio codecs used in sound cards. However, sales to Creative decreased to 16.9% of total revenues during the three months ended September 30, 2004 from 19.9% during the three months ended September 30, 2003 due to stronger demand for our portable audio SoCs in geographic regions such as China and South Korea. Creative Technology purchases our standard products at prices and on terms similar to other customers who buy similar products and volumes.

Gross Profit. Gross profit as a percentage of revenues, or gross margin, was 54.2% for the three months ended September 30, 2004 compared with 48.1% for the three months ended September 30, 2003. The increase in gross margin was primarily due to a favorable product mix and a reduction in manufacturing costs, which included both lower wafer costs, lower test costs and improved manufacturing yields. The favorable product mix resulted from increased revenues from our portable audio SoCs as a percentage of total revenues, as the gross margin from these products is generally higher than from our audio codecs. Also, the increase in revenues of our STMP 35XX family of products caused higher overall margins for our portable audio SoC’s. We expect our gross margins for the fourth quarter of 2004 to be consistent with those achieved during the third quarter of 2004. However, increased competition could adversely impact our pricing, particularly in the portable compressed audio player market, which could adversely impact our gross margins.

Research and Development. Research and development expenses increased to $8.6 million, or 17.9% of revenues, for the three months ended September 30, 2004 from $4.7 million, or 14.3% of revenues, for the three months ended September 30, 2003. This dollar increase of 84.1% was primarily due to increases in our engineering headcount, including independent contractors, as well as increases in the costs of design tools and mask sets. Such increases were primarily to support hardware and software development on our latest portable audio SoCs, the STMP 35XX and the yet to be released STMP 36XX families of products, audio codecs targeted for applications in the PC market, including the Intel High Definition Audio standard, also known as Azalia, and various USB peripheral ICs. This increased research and development spending has resulted in substantial progress on or completion of the design of these products and the creation of several patentable inventions, enabling us to identify additional U.S. patent applications covering inventions made during the STMP 35XX and STMP 36XX design processes. We expect that research and development expenses will increase in absolute dollars in future periods as we continue to increase our staffing and associated costs to pursue additional new product development opportunities, but such expenses will fluctuate as a percentage of revenue due to changes in revenue.

Selling, General and Administrative. Selling, general and administrative expenses increased to $4.0 million, or 8.2% of revenues, for the three months ended September 30, 2004 from $2.7 million, or 8.3% of revenues, for the three months ended September 30, 2003. This dollar increase of 45.9% was due to increases in sales, marketing, and administrative personnel, as well as increases in commissions paid to independent sales representatives due to our revenue growth, and also due to expenses related to complying with Section 404 of the Sarbanes-Oxley act of 2002. We have entered into a new lease agreement for office space in Austin, TX which will commence in the fourth quarter of 2004. No expense has been incurred to date in connection with this lease. As a result of our office relocation, we expect to incur a one-time charge of $1.7 million in the fourth quarter of 2004. We expect that selling, general and administrative expenses will increase in absolute dollars in future periods as we continue to increase our staffing and customer support and associated costs, but such expenses will fluctuate as a percentage of revenues due to changes in revenues.

Amortization of Deferred Stock-Based Compensation. We record deferred stock-based compensation for the difference between the exercise price of option grants and the fair value of our common stock at the time of such grants which resulted in amortization expense of $0.4 million and $1.9 million for the three months ended September 30, 2004, and 2003, respectively.

Litigation. In September 1999, a suit was filed against the Company by Crystal Semiconductor, Inc. (“Crystal”) and Cirrus Logic, Inc. (“Cirrus”) (the parent company of Crystal) alleging that certain of the Company’s products infringed two of Crystal’s patents. The Company settled the suit in November 2000. As part of the settlement, the Company issued shares of common stock to Cirrus valued at $3.0 million at the date of issuance, which was recorded as litigation settlement expense. The Company also agreed to a perpetual contingent guarantee which provided that these shares would have a value of at least $10.5 million at the time of its IPO. Upon the closing of its IPO, the Company recorded an expense of and paid Cirrus $4.5 million in satisfaction of the contingent guarantee.

Interest Income. Interest income increased to $0.4 million for the three months ended September 30, 2004 from $22,000 for the three months ended September 30, 2003. This was due to increased income earned on our cash balances and investments in short-term marketable securities since the completion of our initial public offering in September 2003.

Interest Expense. Interest expense decreased to $3,000 for the three months ended September 30, 2004 from $0.2 million for the three months ended September 30, 2003, due to lower levels of debt outstanding during the 2004 period.

Income Taxes. Our income tax benefit was $3.8 million for the three months ended September 30, 2004, while we had income tax expense of $70,000 for the three months ended September 30, 2003. This was primarily due to the elimination of a valuation allowance on our deferred tax asset of $8.4 million, as well as an increase in income before income taxes to $13.5 million for the three months ended September 30, 2004 compared to $1.8 million for the three months ended September 30, 2003. The provision for income taxes has been calculated based on our estimate of our effective tax rate for the full fiscal year. At September 30, 2004, we increased our estimate of the effective tax rate for our year ending December 31, 2004 from 2.0% to 16.7%, which is less than the statutory rate on taxable income due to the utilization of prior period net operating losses. We reversed the valuation allowance of $8.4 million based on management’s belief that it is more likely than not that the net deferred tax asset will be realized after 2004 as a result of current year taxable income and expected future taxable income.

Comparison of Nine Months Ended September 30, 2004 to Nine Months Ended September 30, 2003

Revenues. Revenues for the nine months ended September 30, 2004 were $116.2 million compared to $65.3 million for the nine months ended September 30, 2003, an increase of 78.1%. This increase was due to an increase in revenues from our portable audio SoCs and USB peripheral ICs, offset by a slight decrease in revenues from our audio codecs. The increase in revenues from our portable audio SoCs was due to the continued growth of the emerging portable compressed audio player market and our favorable competitive position within that market. Revenues from our portable audio SoCs were 86.0% of total revenues for the nine months ended September 30, 2004. Our favorable competitive position in this market is primarily due to our integration of analog and digital components onto a single IC, and the resulting small form factor, low power consumption, and overall low cost to our customers. The increase in revenues from USB peripheral ICs was due to an increase in demand for our USB-to-Infrared bridge controller device in the first half of 2004.

Revenues from G.M.I., a distributor in Hong Kong, increased to 23.9% of total revenues during the nine months ended September 30, 2004 from less than 10% of total revenues during the nine months ended September 30, 2003 due to stronger demand for our portable audio SoCs in China and Hong Kong. Revenues from Holystone, a distributor located in Taiwan, increased by $0.2 million from $23.0 million in the nine months ended September 30, 2003, but decreased to 20.0% of total revenues during the nine months ended September 30, 2004 from 35.3% during the nine months ended September 30, 2003 due to stronger demand for our portable audio SoCs in geographic regions such as China and South Korea. Sales to Creative Technology, an affiliate, increased to 14.8% of total

revenues during the nine months ended September 30, 2004 from 13.3% during the nine months ended September 30, 2003 due to an increase in their purchases of our portable audio SoCs, offset by a decrease in their purchases of our audio codecs used in sound cards. Creative Technology purchases our standard products at prices and on terms similar to other customers who buy similar products and volumes.

Gross Profit. Gross profit as a percentage of revenues, or gross margin, was 53.9% for the nine months ended September 30, 2004 compared with 46.1% for the nine months ended September 30, 2003. The increase in gross margin was primarily due to a favorable product mix and a reduction in manufacturing costs, which included both lower wafer costs, lower test costs and improved manufacturing yields. The favorable product mix resulted from increased revenues from our portable audio SoCs and USB peripheral ICs, as a percentage of total revenues, as the gross margin from these products is generally higher than from our audio codecs. Also, the increase in revenues of our STMP 35XX family of products caused higher overall margins for our portable audio SoC’s. We expect our gross margins for the fourth quarter of 2004 to be consistent with those achieved during the first nine months of 2004. However, increased competition could adversely impact our pricing, particularly in the portable compressed audio player and USB peripherals markets, which could adversely impact our gross margins.

Research and Development. Research and development expenses increased to $21.9 million, or 18.8% of revenues, for the nine months ended September 30, 2004 from $12.5 million, or 19.1% of revenues, for the nine months ended September 30, 2003. This dollar increase of 75.0% was primarily due to increases in our engineering headcount, including independent contractors, as well as increases in the costs of design tools and masking costs. Such increases were primarily to support hardware and software development on our latest portable audio SoCs, the STMP 35XX and yet to be released STMP 36XX families of products and audio codecs targeted for applications in the PC market, including the Intel High Definition Audio standard, also known as Azalia. This increased research and development spending has resulted in substantial progress on or completion of the design of these products and the creation of several patentable inventions, enabling us to identify additional U.S. patent applications covering inventions made during the STMP 35XX and STMP 36XX design processes. We expect that research and development expenses will increase in absolute dollars in future periods as we continue to increase our staffing and associated costs to pursue additional new product development opportunities, but such expenses will fluctuate as a percentage of revenue due to changes in revenue.

Selling, General and Administrative. Selling, general and administrative expenses increased to $10.5 million, or 9.0% of revenues, for the nine months ended September 30, 2004 from $7.0 million, or 10.7% of revenues, for the nine months ended September 30, 2003. This dollar increase of 50.1% was due to increases in sales, marketing, and administrative personnel, as well as increases in commissions paid to independent sales representatives due to our revenue growth, and also due to expenses related to complying with Section 404 of the Sarbanes-Oxley act of 2002. We have entered into a new lease agreement for office space in Austin, TX which will commence in the fourth quarter of 2004. No expense has been incurred to date in connection with this lease. As a result of our office relocation, we expect to incur a one-time charge of $1.7 million in the fourth quarter of 2004. We expect that selling, general and administrative expenses will increase in absolute dollars in future periods as we continue to increase our staffing and customer support and associated costs, but such expenses will fluctuate as a percentage of revenues due to changes in revenues.

Amortization of Deferred Stock-Based Compensation. We record deferred stock-based compensation for the difference between the exercise price of option grants and the fair value of our common stock at the time of such grants which resulted in amortization expense of $1.8 million and $3.0 million for the nine months ended September 30, 2004 and 2003, respectively.

Interest Income. Interest income increased to $1.1 million for the nine months ended September 30, 2004 from $44,000 for the nine months ended September 30, 2003. This was due to increased income earned on our cash balances and investments in short-term marketable securities since the completion of our initial public offering in September 2003.

Interest Expense. Interest expense decreased to $19,000 for the nine months ended September 30, 2004 from $1.2 million for the nine months ended September 30, 2003. This was due to a decrease in non-cash interest charges related to warrants issued to investors for their guarantee of certain of our indebtedness from April 2001 through April 2003, as well as, decreased interest expense on lower levels of debt outstanding during the 2004 period. During the first quarter of 2003, we raised $8.1 million from sales of our preferred stock and used the proceeds to pay down our debt. During the third quarter of 2003, we successfully completed an initial public offering of approximately 7.4 million shares of our common stock, which resulted in net proceeds to us of approximately $101.4 million. A portion of the proceeds was used to pay off all of our existing long-term debt.

Income Taxes. Our income tax benefit was $3.5 million for the nine months ended September 30, 2004, while we had income tax expense of $78,000 for the nine months ended September 30, 2003. This was primarily due to eliminating a valuation allowance of $8.4 million, as well as an increase in income before income taxes to $29.6 million for the nine months ended September 30, 2004 compared to $1.9 million for the nine months ended September 30, 2003. The provision for income taxes has been calculated based on our estimate of our effective tax rate for the full fiscal year. At September 30, 2004, we increased our estimate of the effective tax rate for our year ending December 31, 2004 from 2.0% to 16.7%, which is less than the statutory rate on taxable income due to the utilization of prior period net operating losses. We reversed the valuation allowance of $8.4 million based on management’s belief that it is more likely than not that the net deferred tax asset will be realized after 2004 as a result of current year taxable income from operations and expected future taxable income from operations.

Liquidity and Capital Resources

As of September 30, 2004, we had $117.6 million in cash, cash equivalents and short-term investments. On September 19, 2003, we completed an initial public offering of approximately 7.4 million shares of our common stock resulting in net proceeds to us of approximately $101.4 million. On February 18, 2004, we completed a follow-on public offering of 250,000 shares of our common stock resulting in net proceeds to us of approximately $5.3 million.

Net cash provided by operating activities was $25.6 million and $3.0 million for the nine months ended September 30, 2004 and 2003, respectively. The improvement in our operating cash flows is primarily the result of increased revenues, gross margins and net income. Our accounts receivable increased $11.5 million and $10.1 million during the nine months ended September 30, 2004 and 2003, respectively. These changes are due to fluctuations in revenues and the timing of customer payments. Our inventories increased $3.7 million and $5.8 million during the nine months ended September 30, 2004 and September 30, 2003, respectively. This increase in inventories in 2004 is required to support the increases in our revenues. Our reserve for slow-moving and obsolete inventory as a percentage of total inventory was 11.4% and 12.5% as of September 30, 2004 and December 31, 2003, respectively. We monitor and analyze our inventory for obsolescence and adjust this reserve accordingly. Although the reserve decreased as a percentage of total inventory, it increased by $0.4 million from $1.4 million at December 31, 2003. This was due to additional reserve of $1.1 million for obsolescence offset by scrap and sales of items which had previously been reserved of $0.7 million. Our accounts payable increased $4.6 million and $5.0 million during the nine months ended September 30, 2004 and 2003, respectively. These changes generally relate to increases in our inventories and the timing of payments to suppliers. Our deferred revenue increased $2.7 million during each of the nine month periods ended September 30, 2004 and 2003 due to increases in our products held at distributors to enable them to meet increased customer demand for our products.

Our investing activities used cash of $38.6 million and $2.1 million during the nine month periods ended September 30, 2004 and September 30, 2003, respectively. Investing activities primarily represented purchases of capital equipment in the 2003 period and purchases of capital equipment and short-term investments in the 2004 period.

Capital expenditures were $7.5 million and $2.1 million during the nine months ended September 30, 2004 and 2003, respectively. These expenditures were primarily for the purchase of design software and engineering tools and other computer equipment and software. We purchased certain intellectual property from a third party during the third quarter of 2003 that resulted in cash expenditures of $3.8 million in the nine months ended September 30, 2004. Research and development resources are required to develop and expand our core technologies and proprietary product offerings. Our research and development expenses were $21.9 million and $12.5 million during the nine months ended September 30, 2004 and 2003, respectively. These expenditures resulted in the enhancement of our product offerings, technological know how and inventions that have yielded several U.S. patents and pending U.S. patents. We expect to continue to incur significant research and development expenses and will fund these expenses with operating cash flow and existing cash balances.

Our financing activities used cash of $11.4 million during the nine months ended September 30, 2004, while our financing activities provided cash of $99.4 million during the nine months ended September 30, 2003. During the first nine months of 2003, we received proceeds of $8.1 million from the issuance of convertible preferred stock and $5.2 million from proceeds from long-term debt. A substantial portion of these proceeds was used to pay down and refinance our bank credit facility. On September 19, 2003, we completed an initial public offering of 7,383,917 shares of our common stock resulting in net proceeds to the Company of approximately $101.4 million. On February 18, 2004, we completed a follow-on equity offering and received $5.3 million of net offering proceeds. We also received $2.6 million in proceeds from the exercise of employee stock options and $1.6 million from the purchase of stock under our Employee Stock Purchase Plan during the nine months ended September 30, 2004. These proceeds were invested in short-term, investment grade, interest bearing instruments, pending their use to fund working capital and capital expenditures as required. During the nine months ended September 30, 2004, we used $21.0 million to repurchase and retire 1,381,991 shares of common stock under a plan of open market purchases approved by our Board of Directors in July of 2004.

The fair value of our investments in marketable securities at September 30, 2004 was $88.0 million. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. Our investment policy is to manage our investment portfolio to preserve principal and liquidity while maximizing the return on the investment portfolio through the full investment of available funds. We diversify the marketable securities portfolio by investing in multiple types of investment-grade securities. Our investment portfolio is primarily invested in short-term securities with at least an investment grade rating to minimize interest rate and credit risk as well as to provide for an immediate source of funds. Although changes in interest rates may affect the fair value of the investment portfolio and cause unrealized gains or losses, such gains or losses would not be realized unless the investments are sold.

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

Critical Accounting Policies and Estimates

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

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

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

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

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

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

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

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

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

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

Earnings per Share

In April 2004, the EITF released Issue No. 03-06, Participating Securities and the Two Class Method under SFAS No. 128, Earnings per Share, which addressed a number of questions regarding the computation of earnings per share by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock. It requires that undistributed earnings for the period be allocated to a participating security based on the contractual participation rights of the security to share in those earnings as if all the earnings for the period had been distributed in calculating earnings per share. EITF Issue No. 03-06 is effective for fiscal periods beginning after March 15, 2004. It requires that prior period earnings per share amounts be restated to ensure comparability year over year. The adoption of EITF Issue No. 03-06 did not have an impact on our financial position, results of operations or cash flows.

Item 3: Quantitative and Qualitative Disclosures About Market Risk

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

Interest Rate Risk

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

Risks That May Affect Future Results

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

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

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

We do not expect to sustain our recent growth rate.

Due primarily to increased sales of our portable audio SoCs, we have experienced significant revenue growth and have gained significant market share in a relatively short period of time. Specifically, our annual revenues increased from $30.9 million in 2002 to $100.2 million in 2003 and our revenues have increased from $65.3 million in the first nine months of 2003 to $116.2 million in the first nine months of 2004. However, we do not expect similar revenue growth or market share gains in future periods. Accordingly, you should not rely on the results of any prior quarterly or annual periods as an indication of our future operating performance.

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

Although we had net income of $33.1 million for the nine months ended September 30, 2004 and $10.0 million for the year ended December 31, 2003, we incurred net losses of approximately $8.3 million and $18.4 million for the years ended December 31, 2002 and 2001, respectively. As of September 30, 2004, we had an accumulated deficit of approximately $10.0 million. Despite realizing net income in the nine months ended September 30, 2004 and in the year ended December 31, 2003, we may incur losses in the future. We expect our operating expenses to increase as we pursue our strategic objectives. Our results of operations for the nine months ended September 30, 2004 include non-cash charges of $1.8 million related to stock based compensation. We will continue to incur stock-based compensation in the future as a result of past option grants. Our ability to maintain profitability depends on the rate of growth of our target markets, the continued market acceptance of our customers’ products, the competitive position of our products, and our ability to develop new products. Even though we have achieved profitability, we may not be able to sustain or increase profitability on a quarterly or an annual basis.

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

For the nine months ended September 30, 2004 and 2003, sales to our top five customers accounted for approximately 74.4% and 72.0%, respectively, of our revenues. Our operating results in the foreseeable future will likely continue to depend on sales to a relatively small number of customers, as well as the ability of these customers to sell products that use our ICs. Our revenues would likely decline if one or more of these customers were to significantly reduce, delay or cancel their orders for any reason. In addition, any difficulty in collecting outstanding amounts due from our customers, particularly customers who place large orders, would harm our financial performance. Because our sales are made by means of standard purchase orders rather than long term contracts, we cannot assure you that our customers will continue to purchase our products at current levels, or at all.

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

Sales to a small number of distributors generate a significant amount of our revenues. Our sales through distributors accounted for 72.0% and 69.7% of our revenues for the nine months ended September 30, 2004 and 2003, respectively. Our sales to G.M.I., a distributor, accounted for 23.9% and less than 10.0% of our revenues in the nine months ended September 30, 2004 and 2003, respectively, and our sales to Holystone, also a distributor, accounted for 20.0% and 35.3% of our revenues in the nine months ended September 30, 2004 and 2003, respectively. If G.M.I., Holystone or our other distributors were to materially reduce their purchases from us, our business, financial condition and results of operations would suffer.

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

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

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

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

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

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

A significant portion of our sales to manufacturers of compressed digital audio players occur in China and South Korea, two countries that are currently experiencing a slowdown in economic growth. During the nine months ended September 30, 2004, 35.3% of our sales occurred in China and 5.8% of our sales occurred in South Korea. While we cannot precisely determine the percentage of worldwide end user purchases of compressed digital audio players that occur in China and South Korea, some of our customers have indicated that the growth in their sales to end customers in China and South Korea will be slower than originally anticipated due to the overall slowdown in economic growth in those countries. Thus, our ability to increase revenues and grow our profits in the short term could be negatively impacted as a result of the current slowdown in economic growth in China and South Korea.

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

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

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our customers usually complete an in-depth technical evaluation of our products before they place a purchase order;

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the commercial adoption of our products by OEMs and original device manufacturers, or ODMs, is typically limited during the initial release of their product to evaluate product performance and consumer demand;

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new product introductions often center around key trade shows and failure to deliver a product prior to such an event can seriously delay introduction of a product; and

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the development and commercial introduction of products incorporating new technology frequently are delayed.

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

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

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

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our accurate prediction of the changing requirements of our customers;

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our timely completion and introduction of new designs;

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the availability of third-party manufacturing, assembly, and test capacity;

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the ability of our foundries to achieve high manufacturing yields for our products;

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our ability to transition to smaller manufacturing process geometries;

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the quality, price, performance, power efficiency and size of our products and those of our competitors;

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our management of our indirect sales channels;

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our customer service capabilities and responsiveness;

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the success of our relationships with existing and potential customers; and

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changes in industry standards.

As is typical in the semiconductor industry, the selling price of a product tends to decline significantly over the life of the product. If we are unable to offset any reductions in the selling prices of our products by introducing new products at higher prices or by reducing our costs, our revenues, gross margins and operating results would be adversely affected.

We rely on third-party contractors to manufacture, assemble and test our products and our failure to successfully manage our relationships with these contractors could damage our relationships with our customers, decrease our sales, and limit our growth.

We rely on third-party contractors to manufacture, assemble, and test our ICs. We currently do not have long-term supply contracts with any of our third-party vendors. None of our third-party vendors are obligated to perform services or supply products to us for any specific period, or in any specific quantities, except as may be provided in a particular purchase order. There are significant risks associated with our reliance on these third-party contractors, including:

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potential price increases;

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capacity shortages;

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their inability to increase production and achieve acceptable yields on a timely basis;

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reduced control over delivery schedules and product quality;

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increased exposure to potential misappropriation of our intellectual property;

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limited warranties on wafers or products supplied to us;

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shortages of materials that foundries use to manufacture our products;

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failure to qualify a selected supplier;

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labor shortages or labor strikes; and

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actions taken by our third-party contractors that breach our agreements.

Because future foundry capacity may be limited and because we do not have long-term agreements with our foundries, we may not be able to secure adequate manufacturing capacity to satisfy the demand for our products.

Presently we utilize one principal foundry and one secondary source foundry to manufacture our portable audio SoCs, and another principal foundry to manufacture our audio codecs. In general, each of our products is primarily manufactured at a single foundry. We provide these foundries with monthly rolling forecasts of our production requirements; however, the ability of each foundry to provide wafers to us is limited by the foundry’s available capacity. Moreover, the price of our wafers will fluctuate based on changes in available industry capacity. We do not have long term supply contracts with any of our foundries. Therefore, our foundry suppliers could choose to prioritize capacity for other customers, particularly larger customers, reduce or eliminate deliveries to us on short notice or increase the prices they charge us. Accordingly, we cannot be certain that our foundries will allocate sufficient capacity to satisfy our requirements. If we are not able to obtain foundry capacity as required, our relationships with our existing customers would be harmed and our sales would likely decline.

If our foundries do not achieve satisfactory yields or quality, our sales could decrease, and our relationships with our customers and our reputation may be harmed.

Minor deviations in the IC manufacturing process can cause substantial decreases in yields, and in some cases, cause production to be suspended. For example, a design error by one of our third-party foundries during 2001 caused very low yields for several months, which negatively impacted our business. Our foundries are responsible for yield losses due to their errors, but these yield losses could cause us to delay shipments to our customers. Our

parts are qualified with our foundries, at which time a minimum acceptable yield is established. If actual yield is below the minimum, the foundry incurs the cost of the wafers. If actual yield is above the minimum, we incur the cost of the wafers. The manufacturing yields for our new products tend to be lower initially and increase as we achieve full production. Our product pricing is based on the assumption that an increase in manufacturing yields will continue, even with the increasing complexity of our ICs. Shorter product life cycles require us to develop new products faster and to manufacture these products for shorter periods of time. In many cases, these shorter manufacturing periods will not reach the longer, high volume manufacturing periods conducive to higher manufacturing yields and declining costs. As a result, if our foundries fail to deliver fabricated silicon wafers of satisfactory quality in the volume and at the price required, we will be unable to meet our customers’ demand for our products or to sell those products at an acceptable profit margin, which would adversely affect our sales and margins and damage our customer relationships.

Our third-party foundries, other subcontractors and many of our customers and end customers are located in the Pacific Rim, an area subject to significant earthquake risk and adverse consequences related to the outbreak of SARS and other public health concerns.

All of the principal foundries that manufacture our products and all of the principal subcontractors that assemble, package, and test our products are located in either South Korea, Singapore, Hong Kong, or Taiwan. Many of our customers are also located in these areas. The risk of an earthquake in these Pacific Rim locations is significant. The occurrence of an earthquake or other natural disaster near these foundries or subcontractors could result in damage, power outages and other disruptions that impair their production and assembly capacity. Any disruption resulting from such events could cause significant delays in the production or shipment of our products until we are able to shift our manufacturing, assembling, packaging or production testing from the affected contractor to another third-party vendor. While we have some foundry capacity in the United States, we may not be able to increase our foundry capacity in the United States, or obtain other alternate foundry capacity on favorable terms, if at all. The 2003 outbreak of SARS curtailed travel to and from certain countries (primarily in the Asia-Pacific region) and limited travel and shopping within those countries and any future outbreaks of SARS or other public health concerns could have similar consequences. In addition, outbreaks of disease or other disasters could limit consumer demand for our ICs or the products that use our ICs.

Our recent expansion has placed a significant strain on our management, personnel, systems and resources, and the continued success of our business depends on our ability to successfully manage any future expansion.

Our business has expanded rapidly, and we expect that further expansion will be required to address the potential growth in our customer base. This expansion has placed, and any future expansion will continue to place, a significant strain on our management, personnel, systems and resources. If we are unable to manage our growth effectively, we may not be able to take advantage of market opportunities, develop new products, enhance our technological capabilities, satisfy customer requirements, execute on our business plan or respond to competitive pressures. To successfully manage our growth, we believe we must effectively:

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hire, train, integrate and manage additional qualified engineers for research and development activities, sales and marketing personnel, and financial and information technology personnel;

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continue to enhance our customer resource management and manufacturing management systems;

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expand and upgrade our core technologies; and

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manage multiple relationships with our distributors, suppliers, and other third parties.

We may experience significant period-to-period quarterly and annual fluctuations in our revenues and operating results, which may result in volatility in our stock price.

We have in the past and may in the future experience significant period-to-period fluctuations in our revenues and operating results due to a number of factors, including:

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the timing and volume of purchase orders and cancellations from our customers;

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the rate of acceptance of our products by our customers;

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the rate of growth of the market for analog-intensive, mixed-signal ICs;

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fluctuation and seasonality in demand for our products;

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increases in prices charged by our foundries and other third-party subcontractors;

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the availability of third-party foundry capacity;

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the availability of components used in our customers’ products, such as flash memory or hard drives, which are key components in many portable compressed audio players;

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fluctuations in manufacturing yields;

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the difficulty of forecasting and managing our inventory and production levels;

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the rate at which new markets emerge for products we are currently developing or our ability to develop new products;

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our involvement in litigation;

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natural disasters, particularly earthquakes, or disease outbreaks, such as the recent outbreak of SARS, affecting countries in which we conduct our business or in which our products are manufactured, assembled, or tested;

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changes in our product mix; and

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the evolution of industry standards.

Any variations in our quarter-to-quarter performance may cause our stock price to fluctuate. It is likely that in some future period our operating results will be below the expectations of public market analysts or investors. If this occurs, our stock price may drop, perhaps significantly.

We are subject to the highly cyclical nature of the semiconductor industry.

The semiconductor industry is highly cyclical. The industry has experienced significant downturns, often in connection with, or in anticipation of, maturing product cycles (of both semiconductor companies’ and their customers’ products) and declines in general economic conditions. These downturns have been characterized by production overcapacity, high inventory levels and accelerated erosion of average selling prices. Any future downturns could significantly harm our sales or reduce our profitability for a prolonged period of time. From time to time, the semiconductor industry also has experienced periods of increased demand and production capacity constraints. We may experience substantial changes in future operating results due to general semiconductor industry conditions, general economic conditions and other factors.

Because the markets in which we compete are highly competitive and many of our competitors have greater resources than us, we cannot be certain that our products will compete favorably in the marketplace.

We face competition from a relatively large number of competitors in each of our targeted markets. In the PC and consumer audio markets, we compete primarily with AKM, Analog Devices, C-Media, Cirrus Logic, and Realtek. In the portable compressed audio market, our principal competitors include Action Semiconductor, Philips Semiconductor, PortalPlayer, Samsung, Telechips and Texas Instruments. Within the USB peripherals market, we compete primarily with Acer Labs Inc., Genesys Logic, OTI, Phison, Prolific, Standard Microsystems Corporation, and other companies providing various multi-chip solutions. We expect to face increased competition in the future from our current and emerging competitors. In addition, some of our customers have developed and other customers could develop their own internal ICs that could replace their need for our products or otherwise reduce demand for our products.

The consumer electronics market, which is a principal end market for our ICs, has historically been subject to intense price competition. In many cases, low cost, high volume producers have entered markets and driven down profit margins. If a low cost, high volume producer should develop products that are competitive with our products, our sales and profit margins would suffer.

Many of our current and potential competitors have longer operating histories, greater name recognition, access to larger customer bases and significantly greater financial, sales and marketing, manufacturing, distribution, technical and other resources than us. As a result, they may be able to respond more quickly to changing customer demands or to devote greater resources to the development, promotion and sales of their products than we can. Our current and potential competitors may develop and introduce new products that will be priced lower, provide superior performance or achieve greater market acceptance than our products. In addition, in the event of a manufacturing capacity shortage, these competitors may be able to obtain capacity when we are unable to do so. Furthermore, our current or potential competitors have established, or may establish, financial and strategic relationships among themselves or with existing or potential customers or other third parties to increase the ability of their products to address the needs of our prospective customers. Accordingly, it is possible that new competitors or alliances among competitors could emerge and rapidly acquire significant market share, which would harm our business.

We depend on our key personnel to manage our business effectively, and if we are unable to retain our current personnel and hire additional personnel, our ability to develop and successfully market our products could be harmed.

We rely heavily on the services of our key employees, including Ronald Edgerton, our Chief Executive Officer. In addition, our analog designers and other key technical personnel represent a significant asset and serve as the source of our technological and product innovations. We believe our future success will depend upon our ability to retain these key employees and our ability to attract and retain other skilled managerial, engineering and sales and marketing personnel. Any of our current employees may terminate their employment with us at any time. The competition for such personnel is intense in our industry. We may not be successful in attracting and retaining sufficient numbers of technical personnel to support our anticipated growth. The loss of any of our key employees or our inability to attract or retain qualified personnel, including engineers, could delay the development and introduction of, and negatively impact our ability to sell, our products.

Our products are complex and may require modifications to resolve undetected errors or failures in our hardware and software, which could lead to an increase in our costs, a loss of customers or a delay in market acceptance of our products.

Our ICs are complex and may contain undetected hardware and software errors or failures when first introduced or as new versions are released. These errors could cause us to incur significant re-engineering costs, divert the attention of our engineering personnel from product development efforts and cause significant customer relations and business reputation problems. If we deliver products with errors, defects or bugs, our credibility and the market acceptance and sales of our products could be harmed. Defects could also lead to liability for defective products as a result of lawsuits against us or against our customers. We have agreed to indemnify our customers in some circumstances against liability from defects in our products. A successful product liability claim could require us to make significant damage payments.

We have substantial international sales, which expose us to additional business risks including increased logistical complexity and political instability.

The percentage of our revenues from customers located outside the U.S. was 99.8% and 99.6% for the three months ended September 30, 2004 and 2003, respectively, and 99.9% and 99.7% for the nine months ended September 30, 2004 and 2003, respectively.. We plan to expand our international sales activities, but may not be able to maintain or increase international market demand for our products. Our international sales are subject to a number of risks, including:

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increased complexity and costs of managing international sales;

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protectionist laws and business practices that favor local competition in some countries;

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multiple, conflicting and changing laws, regulations and tax schemes;

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longer sales cycles;

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public health concerns, such as the SARS outbreak in 2003;

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greater difficulty in accounts receivable collection and longer collection periods; and

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political and economic instability.

To date, all of our sales to international customers and purchases of components from international suppliers have been denominated in U.S. dollars. As a result, an increase in the value of the U.S. dollar relative to foreign currencies could make our products more expensive for our international customers, thus potentially leading to a reduction in sales and profitability. Furthermore, many of our competitors are foreign companies that could benefit from such a currency fluctuation making it more difficult for us to compete with those companies.

We may be unable to effectively protect our intellectual property, which would negatively affect our ability to compete.

We believe that the protection of our intellectual property rights will continue to be important to the success of our business. We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. We also enter into confidentiality or license agreements with our employees, consultants and business partners, and control access to and distribution of our documentation and other proprietary information. Despite these efforts, unauthorized parties may attempt to copy or otherwise obtain and use our proprietary technology. Monitoring unauthorized use of our technology is difficult, and we cannot be certain that the steps we have taken will prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as do the laws of the U.S. Many U.S. companies have encountered substantial infringement problems in foreign countries, including countries in which we sell products. We do not currently hold any non-U.S. patents. We cannot be certain that patents will be issued as a result of our pending applications nor can we be certain that any issued patents would protect or benefit us or give us adequate protection from competing products. For example, issued patents may be circumvented or challenged and declared invalid or unenforceable. We also cannot be certain that others will not develop our unpatented proprietary technology or effective competing technologies on their own.

Significant litigation over intellectual property in our industry may cause us to become involved in costly and lengthy litigation, which could subject us to liability, require us to stop selling our products or force us to redesign our products.

In recent years, there has been significant litigation in the U.S. involving patents and other intellectual property rights in the semiconductor industry. In the past, we have found it necessary to engage in litigation to enforce and defend our intellectual property rights, to protect our trade secrets or to determine the validity and scope of proprietary rights of others. For example, in 2000 we settled a patent infringement and trade secret claim filed by Cirrus Logic related to our audio codec products. We believe future litigation involving intellectual property could occur.

From time to time, we receive letters from various industry participants alleging infringement of patents or trade secrets. We typically respond when appropriate and as advised by legal counsel. Any lawsuits resulting from such allegations could subject us to significant liability for damages and invalidate our proprietary rights. These lawsuits, regardless of their success, would likely be time-consuming and expensive to resolve and would divert management time and attention. Any potential intellectual property litigation also could force us to do one or more of the following:

•

stop selling products or using technology that contain the allegedly infringing intellectual property;

•

pay damages to the party claiming infringement;

•

attempt to obtain a license to the relevant intellectual property, which may not be available on reasonable terms or at all; and

•

attempt to redesign those products that contain the allegedly infringing intellectual property.

Our intellectual property indemnification practices may adversely impact our business.

We have historically indemnified our customers for certain costs and damages of patent infringement in circumstances where our product is the factor creating the customer’s infringement exposure. This practice may subject us to significant indemnification claims by our customers. In some instances, our products are designed for use in devices manufactured by our customers that comply with international standards, such as the MP3 standard. These international standards are often covered by patent rights held by third parties, which may include our competitors. The combined costs of identifying and obtaining licenses from all holders of patent rights essential to such international standards could be high and could reduce our profitability or increase our losses. The cost of not obtaining such licenses could also be high if a holder of such patent rights brings a claim for patent infringement. We are aware that certain of our customers have received a notice from a third party seeking to grant a royalty bearing patent license to those customers and claiming that those customers’ manufacture and sale of products capable of decoding MP3 files violates patents which the third party has the right to enforce. We have not received any such notice, and we are not aware of any claimed violations on our part. In the contracts under which we distribute MP3 decoding products, we generally have not agreed to indemnify our customers with respect to patent claims related to MP3 decoding technology, and none of our customers have requested indemnification relating to notices received from this third party. However, we cannot assure you that claims for indemnification will not be made or that if made, such claims would not have a material adverse effect on our business, operating results or financial condition.

The industry standards supported by our products are continually evolving, and our success depends on our ability to adapt our products to meet these changing industry standards.

Our ability to compete in the future will depend on our ability to ensure that our products are compliant with evolving industry standards, such as the introduction of new compression algorithms for compressed audio players. The emergence of new industry standards could render our products incompatible with products developed by other suppliers. As a result, we could be required to invest significant time and effort and to incur significant expense to redesign our products to ensure compliance with relevant standards. If our products are not in compliance with prevailing industry standards for a significant period of time, we could miss opportunities to achieve crucial design wins. We may not be successful in developing or using new technologies or in developing new products or product enhancements that achieve market acceptance and such efforts may require substantial time and expenses.

If securities or industry analysts do not continue to publish research or reports about our business, our stock price and trading volume could decline.

The trading market for our common stock will depend on the research and reports that industry or securities analysts publish about us or our business. We do not have any control over these analysts. If one or more of the analysts who cover us downgrade our stock, our stock price would likely decline. If one or more of these analysts cease coverage of our company or fail to regularly publish reports on us, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline.

Being a public company increases our administrative costs.

As a public company, we incur significant legal, accounting and other expenses that we did not incur as a private company. In addition, the Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the Securities and Exchange Commission and new listing requirements subsequently adopted by Nasdaq in response to Sarbanes-Oxley, have required changes in corporate governance practices of public companies. These new rules, regulations, and listing requirements have increased our legal and financial compliance costs, and made some activities more time consuming and costly. For example, as a result of becoming a public company, we have added additional independent directors, created several board committees, adopted additional internal controls and disclosure controls and procedures, retained a transfer agent and a financial printer, adopted an insider trading policy, and have all of the internal and external costs of preparing and distributing periodic public reports in

compliance with our obligations under the securities laws. These new rules and regulations have made it more difficult and more expensive for us to obtain director and officer liability insurance. These new rules and regulations could also make it more difficult for us to attract and retain qualified members of our board of directors, particularly to serve on our audit committee, and qualified executive officers.

We and our auditors are working to complete the assessment of the effectiveness of our internal controls over financial reporting and it is difficult for us and our auditors to predict how long it will take to complete this assessment.

We have been working to complete our assessment of the effectiveness of our internal controls over financial reporting by the time we are required to file our next Annual Report on Form 10-K, as required by Section 404 of the Sarbanes Oxley Act of 2002. Our auditors have likewise been working to evaluate our assessment and to test the design and operating effectiveness of our internal controls over financial reporting. Especially since this is the first year of the new Section 404 requirements, it is difficult for us or our auditors to predict how long it will take to complete the assessment of the effectiveness of our internal controls over financial reporting, including the final evaluation of the significance of control deficiencies. This results in a heightened risk of unexpected delays and obstacles to completing the project on a timely basis. Accordingly, tight project management to continually gauge the status of the effort and ensure that it stays on schedule is critical to success. It is important that we continue diligently to complete our work and provide our results and assessments to our auditors on a timely basis and in accordance with the agreed-upon time schedule in order for our auditors to have available the resources necessary to complete their work and issue their reports by the time we file our Annual Report on Form 10-K. At this point in the project, we feel that we are on track to accomplish this, but if that were to change, it could have an adverse impact on our stock price.

Item 4: Controls and Procedures

We have performed an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), of the effectiveness of our disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the Exchange Act). Based on that evaluation, our management, including our CEO and CFO, concluded that our disclosure controls and procedures were effective as of September 30, 2004 to ensure that information required to be disclosed by us in the reports filed or submitted by us under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. During our last fiscal quarter, there were no changes in our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Many participants in the semiconductor industry have a significant number of patents and have frequently demonstrated a willingness to commence litigation based on allegations of patent and other intellectual property infringement. From time to time, we have received, and expect to continue to receive, notices of claims of infringement, misappropriation or misuse of other parties’ proprietary rights. Some of these claims have led to litigation. We cannot assure you that we will prevail in these actions, or that other actions alleging infringement by us of third-party patents, misappropriation or misuse by us of third-party trade secrets, or invalidity of our patents will not be asserted or prosecuted against us, or that any assertions of infringement, misappropriation or misuse or prosecutions seeking to establish the invalidity of our patents will not materially and adversely affect our business, financial condition and results of operations. As of September 30, 2004, we were not a party to any material legal proceedings.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

(a) Not applicable.

(b) The Securities and Exchange Commission declared our first registration statement, which we filed on Form S-1 (Registration No. 333-106796) under the Securities Act of 1933 in connection with the initial public offering of our common stock, effective on September 18, 2003. Under this registration statement, we registered 11,500,000 shares of our common stock, including 1,500,000 shares subject to the underwriters’ over-allotment option, with an aggregate public offering price of $172.5 million. We registered 7,383,917 of these shares on our behalf and 4,116,083 of these shares on behalf of certain or our stockholders.

Our initial public offering commenced on September 19, 2003 and all of the shares of our common stock that we registered on our behalf and on behalf of the selling stockholders were sold for the aggregate public offering price of $172.5 million through an underwriting syndicate managed by Merrill Lynch & Co., JPMorgan, CIBC World Markets and Needham & Company, Inc. This offering terminated after the sale of all of the shares of our common stock that we registered under our registration statement on Form S-1.

The sale of 7,383,917 shares of common stock by us, including the sale of 383,917 shares pursuant to the exercise of the over-allotment option by the underwriters, resulted in aggregate gross proceeds to us of approximately $110.8 million, approximately $7.8 million of which we applied to underwriting discounts and commissions and approximately $1.6 million of which we applied to related costs. None of these expenses were direct or indirect payments to directors, officers or holders of 10% or more of any class of our equity. As a result, we received approximately $101.4 million in aggregate net proceeds from the offering.

As of September 30, 2004, we used the net proceeds of the offering as follows:

•

$4.5 million to satisfy an outstanding obligation to Cirrus Logic related to the settlement of an intellectual property dispute in 2000, which we recorded as a litigation settlement expense upon completion of the offering;

•

$4.2 million to repay existing debt under our Loan and Security Agreement with Silicon Valley Bank;

•

$1.6 million to repay accrued interest on convertible promissory notes ($1.4 million of which was paid to our affiliates as described below), the principal amount of which notes were converted into 1,022,102 shares of our common stock in connection with our initial public offering;

•

$21 million to repurchase 1,381,991 shares of our common stock in open-market transactions pursuant to a share repurchase program announced on July 27, 2004; and

•

the remaining net proceeds were invested in short-term, investment-grade, interest bearing instruments, pending their use to fund working capital and other general corporate purposes, including capital expenditures and research and development.

The affiliates who received the $1.4 million of proceeds in payment of accrued interest on their convertible promissory notes were as follows: funds affiliated with Invesco Private Capital—$0.1 million; funds affiliated with Creative Technology Ltd.—$0.9 million; funds affiliated with Battery Ventures—$0.4 million; and Mr. C. Hock Leow—$3,000.


Period	Total Number of Shares Purchased ⁽¹⁾	Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs	Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs
7/1/04 - 7/31/04	685,000	$	14.82	685,000	$	19,850,991
8/1/04 - 8/31/04	696,991	$	15.52	696,991	$	9,034,483
9/1/04 - 9/30/04	—		—	—	$	9,034,483
Total	1,381,991	$	15.17	1,381,991

⁽¹⁾	All shares were purchased in open-market transactions pursuant to our publicly announced repurchase program. Our share repurchase program was announced on July 27, 2004 and authorizes the purchase of up to $30 million worth of our common stock before December 31, 2004.

Item 3. Defaults Upon Senior Securities

Not applicable.

Item 4. Submission of Matters to a Vote of Security Holders

Not applicable.

Item 5. Other Information

(a)	Not applicable

(b)	Not applicable

Item 6. Exhibits:

(a)	See Exhibit Index

SIGMATEL, INC.

SIGNATURE

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


	SIGMATEL, INC.

Dated: October 19, 2004	By:	/s/ Ross A. Goolsby
		Ross A. Goolsby
		Vice President of Finance and Chief Financial Officer
		(Principal Financial and Accounting Officer)

EXHIBIT INDEX


Exhibit Number
3.1⁽¹⁾		Second Restated Certificate of Incorporation of SigmaTel, Inc.

3.2⁽²⁾		Amended and Restated Bylaws of SigmaTel, Inc.

4.1⁽²⁾		Specimen certificate for shares of common stock

10.17		Lease Agreement dated July 29, 2004, by and between SigmaTel, Inc. and Prentiss Properties Acquisition Partners, L.P.

31.01		Certification of Chief Executive Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.02		Certification of Chief Financial Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.01*		Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

This exhibit shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934 or otherwise subject to the liabilities of that Section, nor shall it be deemed incorporated by reference in any filings under the Securities Act of 1933 or the Securities Exchange Act of 1934, whether made before or after the date hereof and irrespective of any general incorporation language in any filings.

(1)	Incorporated by reference to Exhibit 3.3 of the Registrant’s Form S-1 Registration Statement (Registration No. 333-106796), declared effective by the Securities and Exchange Commission on September 18, 2003.

(2)	Incorporated by reference to the exhibit of the same number to the Registrant’s Form S-1 Registration Statement (Registration No. 333-106796), declared effective by the Securities and Exchange Commission on September 18, 2003.

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