CYPRESS SEMICONDUCTOR CORP /DE/ - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) The Management's Discussion and Analysis of Financial Condition and Results of Operations contain 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, that involve risks and uncertainties, which are discussed under Item 1A.

Adjustments to Previously Announced Preliminary Annual Results On January 24, 2013, we issued a press release announcing our preliminary annual results for the year ended December 30, 2012. In the press release, we reported a net loss of $24.4 million in the Consolidated Statements of Operations for the year ended December 30, 2012. Subsequent to the issuance of our press release, we recorded certain adjustments to our reported results relating to: (1) the Ramtron Acquisition, (2) impairment of investment, and (3) stock-based compensation.

Ramtron Acquisition: We recorded additional expenses related to our Ramtron acquisition for updates to estimated fair value of acquired assets and other purchase accounting and acquisition related adjustments.

Impairment of Investment: We recorded an additional $1.2 million expense due to an impairment of an investment in a privately-held company where we did not participate in the follow-on round which diluted the value of our investment.

Stock-based Compensation: We recorded a reduction in stock-based compensation of $1.1 million related to updates to the estimated fair market value of certain share-based awards.

37 -------------------------------------------------------------------------------- Table of Contents The following table presents a reconciliation of the preliminary net loss and net loss per share announced in our press release on January 24, 2013 to the final results reported in this Annual Report on Form 10-K: Year Ended December 30, 2012 (In thousands, except per- share amounts) Net loss announced on January 24, 2013 $ (24,356 ) Adjustments: Ramtron acquisition 2,033 Impairment of investments (1,180 ) Stock-based compensation 1,133 Net loss reported in Annual Report on Form 10-K $ (22,370 ) Net loss per share: Basic-announced on January 24, 2013 $ (0.16 ) Basic-reported in Annual Report on Form 10-K $ (0.15 ) Diluted-announced on January 24, 2013 $ (0.16 ) Diluted-reported in Annual Report on Form 10-K $ (0.15 ) EXECUTIVE SUMMARY General Cypress Semiconductor Corporation ("Cypress") delivers high-performance, mixed-signal, programmable solutions that provide customers with rapid time-to-market and exceptional system value. Our offerings include the flagship Programmable System-on-Chip ("PSoC ®") families and derivatives such as CapSense touch sensing and TrueTouchTM solutions for touchscreens. We are the world leader in universal serial bus ("USB") controllers, including the high-performance West Bridge solution that enhances connectivity and performance in multimedia handsets, PCs and tablets. We are also a leader in high-performance memories and programmable timing devices. We serve numerous markets including consumer, mobile handsets, computation, data communications, automotive, industrial and military.

38-------------------------------------------------------------------------------- Table of Contents As of the end of fiscal 2012, our organization included the following business segments: Business Segments Description MPD: Memory Products A division that focuses on our four static random Division access memory ("SRAM") business units, general-purpose programmable clocks and process technology licensing. Its purpose is to enhance our No. 1 position in SRAMs and invent new and related products.

DCD: Data Communications A division focused solely on USB controllers, Division WirelessUSB™ and West Bridge® peripheral controllers for handsets, PCs and tablets. Its purpose is to enhance our leading position in USB.

PSD: Programmable Systems A division focusing primarily on our PSoC®and Division PSoC-based products. This business segment focuses on (1) the PSoC platform family of devices including PSoC 1, PSoC 3 and PSoC 5 and all derivatives, (2) PSoC-based user interface products such as CapSense ® touch-sensing and TrueTouch® touchscreen products, (3) PSoC-based module solutions including Trackpad and Ovation™ Optical Navigation Sensors (ONS) and (4) automotive products. PSD is chartered to become No. 1 in CapSense and TrueTouch and is chartered to build the base PSoC franchise.

ETD: Emerging Technologies Our "startup" division, which includes AgigA Tech Division Inc. and Deca Technologies Inc., all majority-owned subsidiaries of Cypress. ETD also includes our foundry business and other development-stage activities. Note that certain businesses, such as our trackpad business, have "graduated" from ETD as it was reported in 2011 into operating divisions.

Manufacturing Strategy Our core manufacturing strategy-"flexible manufacturing"-combines capacity from foundries with output from our internal manufacturing facilities. This initiative is intended to allow us to meet rapid swings in customer demand while lessening the burden of high fixed costs, a capability that is particularly important in high-volume consumer markets that we serve with our leading programmable product portfolio.

Consistent with this strategy, in fiscal 2008 we substantially completed the exit of our manufacturing facility in Texas and transfered production to our more cost-competitive facility in Minnesota and outside foundries. We continued to hold the property for sale as of December 30, 2012.

RESULTS OF OPERATIONS Revenues Year Ended December 30, January 1, January 2, 2012 2012 2011 (In thousands) Programmable Systems Division $ 356,389 $ 482,895 $ 280,615 Memory Products Division 330,504 394,832 467,422 Data Communications Division 75,632 112,683 127,020 Emerging Technologies and Other 7,162 4,794 2,475 Total revenues $ 769,687 $ 995,204 $ 877,532 39 -------------------------------------------------------------------------------- Table of Contents We sold our image sensors product family in early 2011. The revenue pertaining to our image sensors product family for fiscal 2011 and 2010 included in the Memory Products Division segment in the table above amounted to $7.6 million and $31.4 million, respectively. There was no revenue pertaining to our image sensors product family for fiscal 2012. For additional information on the sale of Image Sensors Product Family, refer to Note 3 of Notes to Consolidated Financial Statements under Item 8.

Programmable Systems Division: Revenues from the Programmable Systems Division decreased by $126.5 million in fiscal 2012, or approximately 26.2% compared to fiscal 2011. The revenue decrease was primarily attributable to a decline in sales of our TrueTouch ® touchscreen products and a decline in sales of our PSoC platform family of devices. The decrease in our TrueTouch ® revenue was primarily due to a decrease in revenue from our handset and tablet customers and lower average selling prices.

Revenues from the Programmable System Division increased by $202.3 million in fiscal 2011, or approximately 72.1%, compared to fiscal 2010. The increase was primarily attributable to increases in sales of our PSOC family of products mainly due to higher demand in our capacitive and touchscreen applications in mobile devices. Our PSOC product families, including our touchscreen family, continued to gain new design wins, expanded our customer base and increased market penetration in a variety of end-market applications including mobile handsets, tablet computers, cameras, global positioning system devices "GPS" and other products.

Memory Products Division: Revenues from the Memory Products Division decreased by $64.3 million in fiscal 2012, or approximately 16.3%, compared to fiscal 2011. The revenue decrease was primarily due to the decrease in sales of our SRAM products driven by decreased demand from wireless and wireline end customers and due to the sale of our image sensor business unit during the first quarter of fiscal 2011 which accounted for $7.6 million of the decrease in revenue in fiscal 2012 compared to fiscal 2011.

Revenues from the Memory Products Division decreased by $72.6 million in fiscal 2011, or approximately 15.5%, compared to fiscal 2010. The revenue decrease was primarily due to the decrease in sales of our SRAM products driven by decreased demand from wireless and wireline end customers and due to the sale of our image sensor business unit during the first quarter of fiscal 2011 which accounted for a decrease of $23.8 million in revenue in fiscal 2011 compared to fiscal 2010.

Data Communications Division: Revenues from the Data Communications Division decreased by $37.1 million in fiscal 2012, or approximately 32.9%, compared to fiscal 2011. The decrease in revenue was primarily attributable to a decrease in sales of our West Bridge controllers and other USB-related products. .

Revenues from the Data Communications Division decreased by $14.3 million in fiscal 2011, or approximately 11.3%, compared to fiscal 2010. The decrease in revenue was primarily attributable to a decrease in sales of our WirelessUSB and other USB-related products.

Emerging Technologies and Other: Revenues from Emerging Technologies and Other increased by $2.4 million in fiscal 2012, or approximately 49.4%, compared to fiscal 2011. The revenue increase was primarily due to the overall increase in demand as certain of our Emerging Technologies begun having initial production ramps.

40-------------------------------------------------------------------------------- Table of Contents Revenues from Emerging Technologies and Other increased by $2.3 million in fiscal 2011, or approximately 93.7%, compared to fiscal 2010. The revenue increase was primarily attributable to an overall increase in demand as certain of our Emerging Technologies divisions, mainly driven by our Optical Finger Navigation products for mobile devices, were beginning initial production ramps.

Cost of Revenues/Gross Margin Year Ended December 30, January 1, January 2, 2012 2012 2011 (In thousands) Cost of revenues $ 376,887 $ 448,602 $ 388,359 Gross margin percentage 51.0% 54.9% 55.7% Gross margin percentage declined to 51.0% in fiscal 2012 from 54.9% in fiscal 2011 primarily due to (i) $7.7 million patent license fee recorded in fiscal 2012 related to a Patent License Agreement (See Note 18 of Notes to Consolidated Financial Statements) and (ii) the impact of the negative gross margins of our majority-owned subsidiaries (i.e., Emerging Technologies), particularly Deca Technologies, Inc. which has commenced revenue generating activities in fiscal 2012 as well as lower average selling prices, product mix and lower factory absorption. We incurred $8.3 million in cost of revenues related to Ramtron.

Gross margin percentage declined slightly to 54.9% in fiscal 2011 from 55.7% in fiscal 2010 primarily due to product mix.

Research and Development ("R&D") Year Ended December 30, January 1, January 2, 2012 2012 2011 (In thousands) R&D expenses $ 189,897 $ 189,970 $ 176,816 As a percentage of revenues 24.7% 19.1% 20.1% R&D expenditures decreased by $0.1 million in fiscal 2012, compared to fiscal 2011. The decrease was primarily attributable to a decrease in direct and indirect labor expenses, particularly variable bonus-related expenses, offset by $4.1 million in Ramtron related R&D expenses. As a percentage of revenues, R&D expenses were higher in fiscal 2012 driven by the decrease in total revenues in the same period.

R&D expenditures increased by $13.2 million in fiscal 2011, or approximately 7.4%, compared to fiscal 2010. The increase was primarily attributable to a $3.5 million increase in labor primarily driven by our new emerging technology division, Deca Technologies, Inc., a $2.8 million increase in stock-based compensation expense, $2.4 million increase in manufacturing supplies, approximately $3.0 million increase in R&D professional engineering services and approximately $1.5 million net increase in other miscellaneous R&D expenses.

Selling, General and Administrative ("SG&A") Year Ended December 30, January 1, January 2, 2012 2012 2011 (In thousands) SG&A expenses $ 211,959 $ 227,976 $ 218,490 As a percentage of revenues 27.5 % 22.9 % 24.9 % 41 -------------------------------------------------------------------------------- Table of Contents SG&A expenses decreased by $16.0 million in fiscal 2012, or approximately 7.0%, compared to fiscal 2011. The decrease was primarily attributable to $7.6 million decrease in direct and indirect labor expenses, particularly a $6.2 million decrease in variable bonus-related expenses, and a $16.7 million decrease in stock-based compensation due to our low stock price in 2012. These direct and indirect labor costs were partially offset by an increase of $2.2 million expense primarily related to an increase in the value of our deferred compensation plan. We incurred $7.2 million in SG&A expenses related to Ramtron.

SG&A expenses increased by $9.5 million in fiscal 2011, or approximately 4.3%, compared to fiscal 2010. The increase was primarily attributable to a $5.6 million increase in stock-based compensation expense, which was driven mainly by a higher average stock price, a $2.0 million impairment charge we recognized in the third quarter of fiscal 2011 related to a building which we sold in the fourth quarter of fiscal 2011, $1.4 million increase in facilities expenses and a $0.5 million increase in labor costs.

Restructuring We recorded restructuring charges of $4.3 million, $6.3 million and $3.0 million during fiscal 2012, 2011 and 2010, respectively. The determination of when we accrue for severance costs, and which accounting standard applies, depends on whether the termination benefits are provided under a one-time benefit arrangement or under an on-going benefit arrangement. The $4.3 million restructuring costs recognized in fiscal 2012 consisted primarily of personnel costs and was mainly due to the restructuring program announced in fiscal 2011.

The $6.3 million restructuring costs recognized in fiscal 2011 consisted primarily of personnel costs and was mainly due to the restructuring program announced in fiscal 2011. The $3.0 million restructuring cost recognized in fiscal 2010 was also primarily personnel costs and was due to the restructuring program announced in fiscal 2010. Refer to Note 10 of Notes to Consolidated Financial Statements under Item 8 for more detailed discussions on our restructuring programs for fiscal 2012, 2011 and 2010.

Assets Held for Sale Our Texas facility ceased operations in the fourth quarter of fiscal 2008. As management has committed to a plan to sell the assets associated with the facility, we have classified the assets as held for sale and recorded the assets at the lower of their carrying amount or estimated fair value less cost to sell.

Due to the downturn and uncertainty in the commercial real estate market, we were unable to secure a buyer for the Texas facility. In fiscal 2010, we recorded a write-down of $1.5 million related to the equipment. No write-down was recognized in fiscal 2011. However, in fiscal 2012, due to the continuing unfavorable economic and market conditions, management reassessed the fair value of the assets and recorded a write-down of $2.3 million. The net book value of the remaining assets that were classified as held for sale and included in "Other current assets" in the Consolidated Balance Sheet was $4.6 million as of December 30, 2012 and $6.9 million as of January 1, 2012 and January 2, 2011.

Refer to Note 7 of Notes to Consolidated Financial Statements under Item 8 for more information on our assets held for sale.

Divestitures On December 19, 2012, we completed the divestiture of our wholly-owned subsidiary Cypress Envirosystems ("Envirosystems") and we received nominal consideration that is dependent upon future performance. Envirosystems was an immaterial part of our ETD segment and as a result of the sale we recorded a loss of $1.6 million in "(Gain) loss on divestiture," on the Consolidated Statement of Operations.

In fiscal 2011, as part of Cypress's continued efforts to focus on programmable products including our flagship PSoC® programmable system-on-chip solutions and our TrueTouch™ touch-sensing controllers, we divested our image sensors product families and sold them to ON for a total cash consideration of $34.0 million. In connection with the divestiture, we recorded a gain of $34.3 million. We transferred approximately 42 -------------------------------------------------------------------------------- Table of Contents 80 employees to ON as part of this divestiture. Refer to Note 3 of Notes to Consolidated Financial Statements under Item 8 for more information on this transaction.

We did not have any divestitures during fiscal 2010.

Interest and Other Income, Net The following table summarizes the components of interest and other income, net: Year Ended December 30, January 1, January 2, 2012 2012 2011 (In thousands) Interest income $ 694 $ 1,466 $ 2,515 Interest expense (3,824 ) (115 ) (19 ) Changes in fair value of investments under the deferred compensation plan 3,158 (862 ) 2,653 Impairment of investments (3,200 ) (800 ) - Foreign currency exchange gains (losses), net (1,460 ) 1,124 (2,452 ) Gain on sale of equity investments 1,601 - 3,628 Others 286 1,046 (23 ) Total interest and other income, net $ (2,745 ) $ 1,859 $ 6,302 Employee Deferred Compensation Plan We have a deferred compensation plan, which provides certain key employees, including our executive management, with the ability to defer the receipt of compensation in order to accumulate funds for retirement on a tax-deferred basis. We do not make contributions to the deferred compensation plan and we do not guarantee returns on the investments. Participant deferrals and investment gains and losses remain as our liabilities and the underlying assets are subject to claims of general creditors. In fiscal 2012, 2011 and 2010, we recognized changes in fair value of the assets under the deferred compensation plan in "Interest and other income, net" of approximately $3.2 million, $(0.9) million and $2.7 million, respectively. The increase or decrease in the fair value of the investments relates to the increased or decreased performance of the portfolio on a year over year basis. Refer to Note 16 of Notes to Consolidated Financial Statements under Item 8 for more information about our deferred compensation plan.

Impairment of Investments We review our investments periodically for impairment and recognize an impairment loss when the carrying value of an investment exceeds its fair value and the decline in value is considered other-than-temporary. During fiscal 2012, two of our privately-held companies which we are invested in at a carrying value of $2.4 million, offered additional rounds of financing that we declined to participate in. Based on these new rounds of financing, we determined that our investments were impaired and wrote off the $2.4 million investment amount. One of these rounds of financing was subsequent to the fiscal year end, see to Note 20 for additional information on this subsequent event. In fiscal 2011, we recognized impairment charges totaling approximately $0.8 million. The impairment expense recognized in fiscal 2011 was related to the decline in value of our investments in non-marketable equity securities which was considered other-than-temporary. No impairment charges on our investments were recognized in fiscal 2010.

For more information about our investments, refer to Note 5 of Notes to Consolidated Financial Statements under Item 8.

43-------------------------------------------------------------------------------- Table of Contents Gain on Sale of Investments in Marketable Equity Securities In connection with the acquisition of Ramtron, we recognized a gain of $1.7 million on our initial investment of $3.4 million. For more information about our acquisition, refer to Note 2 of Notes to Consolidated Financial Statements under Item 8.

During fiscal 2010, we sold our equity investment in one publicly traded company for $4.7 million and recognized a gain of $3.6 million in "Interest and other income, net". There were no investments in marketable equity securities that were sold in fiscal 2011.

Income Taxes Our income tax expense was $2.3 million for 2012. Our income tax benefit was $11.4 million in fiscal 2011, and our tax expense was $19.3 million in fiscal 2010. The tax expense in fiscal 2012 was primarily attributable to income taxes associated with our non-U.S. operation. The tax benefit in fiscal 2011 was primarily attributable to a release of previously accrued taxes of approximately $22.4 million, partially offset by income taxes associated with our non-U.S.

operations. The tax expense in fiscal 2010 was primarily attributable to income taxes associated with our non-U.S. operations.

Our effective tax rate varies from the U.S. statutory rate primarily due to earnings of foreign subsidiaries taxed at different rates and a full valuation allowance on net operating losses incurred in the U.S. The calculation of tax liabilities involves dealing with uncertainties in the application of complex global tax regulations. We regularly assess our tax positions in light of legislative, bilateral tax treaty, regulatory and judicial developments in the many countries in which we and our affiliates do business.

Non-U.S. tax authorities have completed their income tax examinations of our subsidiary in India for fiscal years 2002-2006 and our subsidiary in the Philippines for 2008 and 2009. The proposed adjustments in India have been appealed, and we believe the ultimate outcome of these appeals will not result in a material adjustment to our tax liability. The Philippines examinations for 2008 and 2009 resulted in no material adjustments to our tax liabilities. Income tax examinations of our Philippine subsidiary for the 2010 fiscal year and our India subsidiary for the 2007-2008 fiscal years are in progress. We believe the ultimate outcome of these examinations will not result in a material adjustment to our tax liability.

International revenues account for a significant portion of our total revenues, such that a material portion of our pretax income is earned and taxed outside the U.S. at rates ranging from 0% to 25%. The impact on our provision for income taxes of foreign income being taxed at rates different than the U.S. federal statutory rate was a benefit of approximately $26.4 million, $43.6 million, and $43.4 million in 2012, 2011, and 2010, respectively. The foreign jurisdictions with lower tax rates as compared to the U.S. statutory federal rate that had the most significant impact on our provision for foreign income taxes in the periods presented include the Cayman Islands, China, Ireland, the Philippines, and Switzerland.

LIQUIDITY AND CAPITAL RESOURCES The following table summarizes our consolidated cash and investments and working capital: As of December 30, January 1, 2012 2012 (In thousands) Cash, cash equivalents and short-term investments $ 117,210 $ 166,330 Working capital $ 20,060 $ 79,190 44 -------------------------------------------------------------------------------- Table of Contents Key Components of Cash Flows Year Ended December 30, January 1, January 2, 2012 2012 2011 (In thousands) Net cash provided by operating activities $ 134,997 $ 283,808 $ 262,746 Net cash provided by (used in) investing activities $ (113,036 ) $ 69,100 $ (150,734 ) Net cash used in financing activities $ (58,475 ) $ (516,374 ) $ (92,387 ) Fiscal 2012: In fiscal 2012, cash and cash equivalents decreased by approximately $36.5 million primarily due to the $113.0 million cash used in our investing activities, principally related to the cash paid for the acquisition of Ramtron.

(See Note 2 for a detailed discussion of the Ramtron acquisition.) Cash and cash equivalents also decreased due to the $58.5 million cash used in our financing activities, principally related to our stock buyback program and payment of dividends, which were partially offset by cash received from our revolving credit facility and line of credit. Cash used in our investing and financing activities was partially offset by the cash generated from our operating activities of $135.0 million.

Operating Activities In fiscal 2012, net cash provided by operating activities was $135.0 million compared to $283.8 million in fiscal 2011. Operating cash flows for fiscal 2012 were primarily due to $138.3 million in net favorable non-cash adjustments to our net loss including stock-based compensation of $74.3 million and depreciation and amortization of $50.8 million, an increase in accounts payable and other liabilities, and a decrease in accounts receivable, partially offset by decreases in deferred income on sales to our distributors.

The significant changes in our working capital, excluding the impact of the Ramtron acquisition, as of December 30, 2012 compared to January 1, 2012 were as follows: Ÿ Accounts receivable decreased by $23.9 million due to lower revenue.

Ÿ Accounts payable and other current and long-term liabilities increased by $19.4 million due to timing of purchases and payments.

Ÿ Deferred margin on sales to distributors decreased by $19.1 million due to lower distributor shipments.

Investing Activities In fiscal 2012, net cash used in investing activities was $113.0 million compared to net cash provided by investing activities of $69.1 million in fiscal 2011. The cash we used for our investing activities in fiscal 2012 was primarily due to the purchase of investments of $112.8 million, and $100.9 million for the acquisition of Ramtron, partially offset by proceeds from the sales or maturities and purchases of available for sale investments of $139.8 million.

Financing Activities In fiscal 2012, net cash used in financing activities was $58.5 million compared to $516.4 million in fiscal 2011. The cash we used in our financing activities in fiscal 2012 was primarily due to $209.2 million cash used to repurchase shares of our stock, $22.6 million related to statutory income tax withholdings paid on vested restricted stock awards in lieu of issuing shares of stock and $63.2 million dividends paid in fiscal 2012. These amounts were partially offset by $232.0 million of borrowings under our revolving facility and line of credit, net of the repayment of our previous line of credit.

45-------------------------------------------------------------------------------- Table of Contents Fiscal 2011: In fiscal 2011, cash and cash equivalents decreased by approximately $163.5 million primarily due to the $516.4 million cash used in our financing activities, principally related to our stock buyback programs, partially offset by the cash generated from our operating and investing activities of approximately $283.8 million and $69.1 million, respectively.

Operating Activities In fiscal 2011, net cash provided by operating activities was $283.8 million compared to $262.7 million in fiscal 2010. Operating cash flows for fiscal 2011 were primarily driven by higher net income adjusted for certain non-cash items including stock-based compensation of approximately $100.8 million, depreciation and amortization of approximately $53.5 million, and partially offset by changes in our working capital. The significant changes in our working capital as of January 1, 2012 compared to January 2, 2011 were as follows: Ÿ Accounts receivable decreased by $14.2 million due to better collection efforts and the sale of our image sensors product family in early 2011.

Ÿ The cash impact from the decrease in inventories was approximately $4.3 million which was primarily driven by the increased shipments to our direct customers and distributors.

Ÿ Accounts payable decreased by $6.9 million due to timing of purchases and payments.

Ÿ Deferred margin on sales to distributors increased by $18.8 million due to higher distributor shipments.

Ÿ Income taxes payable decreased by $7.0 million primarily due to payments in fiscal 2011.

Investing Activities In fiscal 2011, net cash provided by investing activities was $69.1 million compared to net cash used in investing activities of $150.7 million in fiscal 2010. The cash we generated from our investing activities in fiscal 2011 was primarily due to $110.0 million net proceeds from the sales or maturities and purchases of available for sale investments, $34.0 million proceeds from the sale of image sensor business unit and $6.3 million proceeds from sales of certain property and equipment, partially offset by $80.6 million of property and equipment expenditures.

Financing Activities In fiscal 2011, net cash used in financing activities was $516.4 million compared to $92.4 million in fiscal 2010. The cash we used in our financing activities in fiscal 2011 was primarily due to $604.8 million cash used to repurchase shares of our stock and cash used for our yield enhancement structured agreements settling in our stock, $46.0 million related to statutory income tax withholdings paid on vested restricted stock awards in lieu of issuing shares of stock and $29.0 million dividends paid in fiscal 2011, partially offset by the net proceeds of $71.2 million from the issuance of common shares under our employee stock plans, $49.9 million net cash generated from our yield enhancement structured agreements that were settled in cash and $42.3 million cash generated from equipment loans and other financing arrangements.

Fiscal 2010: In fiscal 2010, cash and cash equivalents increased by approximately $19.6 million primarily due to the cash generated from our operating and investing of $262.7 million, partially offset by $150.7 million and $92.4 million cash used in our investing and financing activities, respectively.

46 -------------------------------------------------------------------------------- Table of Contents Operating Activities Net cash provided by operating activities increased by $173.4 million in fiscal 2010 compared to fiscal 2009. Operating cash flows in fiscal 2010 were primarily driven by net income of $74.9 million from operations adjusted for certain non-cash items including depreciation and amortization, stock-based compensation expense, restructuring charges and changes in operating assets and liabilities.

The changes in our working capital as of January 2, 2011 compared to January 3, 2010 were as follows: Ÿ Accounts receivable increased by $30.8 million due to higher distributor shipments.

Ÿ Deferred margin on sales to distributors increased by $55.9 million due to higher distributor shipments.

Ÿ The cash impact due to the increase in inventories was approximately $10.0 million and the increase in inventories was to support higher levels of sales in 2010 and a profile build out of certain products.

Investing Activities Net cash used in investing activities increased by $107.6 million in fiscal 2010 compared to fiscal 2009. During fiscal 2010, our investing activities primarily included the $50.8 million of property and equipment expenditures offset by the purchase of investments of $103.1 million, net of proceeds from sales or maturities.

Financing Activities Net cash used in financing activities increased by $85.0 million in fiscal 2010 compared to fiscal 2009. During fiscal 2010, our financing activities primarily included a net of $149.2 million used on the yield enhancement structured agreements, $25.9 million used to repurchase our common shares and partially offset by net proceeds of $82.8 million from the issuance of common shares under our employee stock plans.

Liquidity Stock Repurchase Programs: On October 21, 2010, our Board authorized a $600.0 million stock buyback program, which we completed in fiscal 2011. In fiscal 2010, we used approximately $29.0 million of this program to repurchase a total of approximately 1.7 million shares at an average share price of $17.07. In fiscal 2011, we used the remaining $571.0 million to repurchase approximately 30.9 million shares at an average share price of $18.46.

On September 20, 2011, our Board authorized a new $400.0 million stock buyback program. The program allows us to purchase our common stock or enter into equity derivative transactions related to our common stock. The timing and actual amount expended with the new authorized funds will depend on a variety of factors including the market price of our common stock, regulatory, legal, and contractual requirements, alternatives uses of cash, availability of on shore cash and other market factors. The program does not obligate us to repurchase any particular amount of common stock and may be modified or suspended at any time at our discretion. From September 2011 through the end of fiscal 2012, we used approximately $311.6 million from this program to repurchase approximately 23.1 million shares at an average share price of $13.49. As of December 30, 2012, $88.4 million remained available for future stock repurchases.

Yield Enhancement Program ("YEP"): As discussed in Item 5 above and in Note 14 of the Notes to Consolidated Financial Statements under Item 8, we have entered into yield enhanced structured agreements since fiscal 2009. In fiscal 2012, we entered into short-term yield enhanced structured agreements with maturities of 30 days or less for an aggregate price of approximately $14.5 million. Upon settlement of these agreements, we received approximately $14.9 million in cash.

In fiscal 2011, we entered into short-term yield enhanced structured agreements with maturities of 50 days or less for an aggregate price of approximately $318.4 million. Upon settlement of these agreements, we received approximately $143.8 million in cash and 9.5 million shares of common stock at an average share price of $19.01.

47 -------------------------------------------------------------------------------- Table of Contents In fiscal 2010, we entered into short-term yield enhanced structured agreements with maturities of 45 days or less for an aggregate price of approximately $322.8 million. Upon settlement of these agreements, we received approximately $217.5 million in cash and 10.0 million shares of our common stock at an average share price of $11.49. In fiscal 2010, there was a YEP agreement that we entered into for an aggregate price of approximately $43.9 million which remained unsettled as of the end of fiscal 2010. Such agreement was subsequently settled in the first quarter of fiscal 2011 for approximately $47.0 million.

Senior Secured Revolving Credit Facility On June 26, 2012, we entered into a five-year senior secured revolving credit facility ("Credit Facility") with a group of lenders led by Morgan Stanley Senior Funding, Inc. The Credit Facility enables us to borrow up to $430 million on a revolving basis. Borrowing terms vary based on the type of borrowing with all outstanding balances being due at the credit facility termination date, or June 25, 2017. Outstanding amounts may be repaid prior to maturity without penalty and are mandatory for certain asset sales and casualty events. The current outstanding borrowings bear interest at LIBOR plus 2.25% on the drawn amount. There is a commitment fee payable of 0.375% per annum on any undrawn amounts. The Credit Facility contains customary affirmative, negative and financial covenants for similarly rated companies. The financial covenants include the following conditions: 1) maximum senior secured leverage ratio of 2.00 to 1.00, 2) maximum total leverage ratio of 3.50 to 1.00 through June 30, 2013 and 3.00 to 1.00 thereafter, 3) minimum fixed charge coverage ratio of 1.20 to 1.00, and 4) minimum liquidity of at least $150 million. Borrowings are secured by substantially all assets of the company. At December 30, 2012, our outstanding borrowings of $232 million were recorded as part of long-term liabilities and are presented as "Loan payable" in the Consolidated Balance Sheet. As of December 30, 2012, we were in compliance with all of the financial covenants under the Credit Facility.

Refer to Note 14 of Notes to Consolidated Financial Statements under Item 8 for more information on our senior secured revolving credit facility.

Auction Rate Securities ("ARS"): In December 2011, we entered into a settlement and securities purchase agreement (the "Securities Agreement") with a certain financial institution. Pursuant to the terms of the Securities Agreement, we agreed to sell to the financial institution certain of our ARS investments with an aggregate par value of approximately $19.1 million and carrying value of approximately $17.3 million for an aggregate sale price of approximately $16.4 million. Under the terms of the Securities Agreement, we have the option to repurchase from the financial institution any of the ARS we sold to them until November 30, 2013 for the amount at which the related ARS were sold plus agreed upon funding costs.

Because of our ability to repurchase the ARS from the date of sale through November 30, 2013, we maintain effective control of these ARS. As such, we did not account for the transaction as a sale and recognized the consideration we received as "Advances received for the sale of ARS" under "Other long-term liabilities" in the 2012 and 2011 Consolidated Balance Sheets. We will continue to account for these ARS as if we never sold them until they are called or the expiration of our call option under the Securities Agreement.

During fiscal 2012 ARS with a par value of $10.0 million were called for redemption at par and ARS with a par value of $5.0 million were sold at 98.25 of par, which resulted in the reversal of unrealized losses of $1.3 million. These ARS were included as part of the Securities Agreement noted above.

The fair value of our investments in ARS was approximately $5.5 million as of December 30, 2012.

Refer to Note 5 of Notes to Consolidated Financial Statements under Item 8 for more information on our auction rate securities.

48-------------------------------------------------------------------------------- Table of Contents Contractual Obligations The following table summarizes our contractual obligations as of December 30, 2012: Payments Due by Years Total 2013 2014 and 2015 2016 and 2017 After 2018 (In thousands) Purchase obligations (1) $ 83,061 $ 75,754 $ 7,307 $ - $ - Operating lease commitments 22,581 5,762 9,728 6,352 739 Capital lease commitments 15,990 2,936 5,873 7,181 - Mortgage note 3,281 3,281 - - - Total contractual obligations $ 124,913 $ 87,733 $ 22,908 $ 13,533 $ 739 (1) Purchase obligations primarily include non-cancelable purchase orders for materials, services, manufacturing equipment, building improvements and supplies in the ordinary course of business. Purchase obligations are defined as enforceable agreements that are legally binding on us and that specify all significant terms, including quantity, price and timing.

As of December 30, 2012, our unrecognized tax benefits were $31.5 million, which were classified as long-term liabilities. We believe it is possible that we may recognize approximately $14.0 to $16.0 million of our existing unrecognized tax benefits within the next twelve months as a result of the lapse of statutes of limitations and the resolution of agreements with domestic and various foreign tax authorities.

Capital Resources and Financial Condition Our long-term strategy is to maintain a minimum amount of cash for operational purposes and to invest the remaining amount of our cash in interest-bearing and highly liquid cash equivalents and debt securities and the purchase of our stock through our stock buyback program and payments of regularly scheduled cash dividends. As of December 30, 2012, in addition to $63.2 million in cash and cash equivalents, we had $54.0 million invested in short-term investments for a total cash and short-term investment position of $117.2 million that is available for use in current operations.

As of December 30, 2012, approximately 15% of our cash and cash equivalents and available for sale investments are offshore funds. While these amounts are primarily invested in U.S. dollars, a portion is held in foreign currencies. All offshore balances are exposed to local political, banking, currency control and other risks. In addition, these amounts, if repatriated may be subject to tax and other transfer restrictions.

We believe that liquidity provided by existing cash, cash equivalents and investments and our borrowing arrangements will provide sufficient capital to meet our requirements for at least the next twelve months. However, should prevailing economic conditions, debt covenants constraints, and/or financial, business and other factors beyond our control adversely affect our estimates of our future cash requirements, we could be required to fund our cash requirements by alternative financing. There can be no assurance that additional financing, if needed, would be available on terms acceptable to us or at all. We may choose at any time to raise additional capital or debt to strengthen our financial position, facilitate growth, enter into strategic initiatives including the acquisition of other companies repurchases of shares of stock or payment of dividends and provide us with additional flexibility to take advantage of other business opportunities that arise.

Non-GAAP Financial Measures Regulation G, conditions for use of Non-Generally Accepted Accounting Principles ("Non-GAAP") financial measures, and other SEC regulations define and prescribe the conditions for use of certain 49-------------------------------------------------------------------------------- Table of Contents Non-GAAP financial information. To supplement our consolidated financial results presented in accordance with GAAP, we use Non-GAAP financial measures which are adjusted from the most directly comparable GAAP financial measures to exclude certain items, as described below. Management believes that these Non-GAAP financial measures reflect an additional and useful way of viewing aspects of our operations that, when viewed in conjunction with our GAAP results, provide a more comprehensive understanding of the various factors and trends affecting our business and operations. Non-GAAP financial measures used by us include gross margin, research and development expenses, selling, general and administrative expenses, operating income or loss, net income or loss and basic and diluted net income or loss per share.

Our Non-GAAP measures primarily exclude stock-based compensation, acquisition-related charges, impairments to goodwill, gain or losses on divestiture, investment-related gains and losses, discontinued operations, restructuring costs and other special charges and credits.

We use each of these non-GAAP financial measures for internal managerial purposes, when providing our financial results and business outlook to the public, to facilitate period-to-period comparisons and to formulate our formula driven cash bonus plan and any milestone based stock awards. Management believes that these non-GAAP measures provide meaningful supplemental information regarding our operational and financial performance of current and historical results. Management uses these non-GAAP measures for strategic and business decision making, internal budgeting, forecasting and resource allocation processes. In addition, these non-GAAP financial measures facilitate management's internal comparisons to our historical operating results and comparisons to competitors' operating results.

The table below shows our Non-GAAP financial measures: Year Ended December 30, January 1, January 2, 2012 2012 2011 (In thousands, except per shares amounts) Non-GAAP revenue $ 769,687 $ 995,204 $ 883,782 Non-GAAP gross margin 426,693 570,456 518,722 Non-GAAP research and development expenses 166,086 165,787 154,312 Non-GAAP selling, general and administrative expenses 163,804 167,746 163,267 Non-GAAP operating income 96,804 236,922 201,142 Non-GAAP net income attributable to Cypress 91,450 237,533 186,314 Non-GAAP diluted net income per share attributable to Cypress 0.55 1.25 0.94 We believe that providing these Non-GAAP financial measures, in addition to the GAAP financial results, are useful to investors because they allow investors to see our results "through the eyes" of management as these Non-GAAP financial measures reflect our internal measurement processes. Management believes that these Non-GAAP financial measures enable investors to better assess changes in each key element of our operating results across different reporting periods on a consistent basis and provides investors with another method for assessing our operating results in a manner that is focused on the performance of our ongoing operations.

50 -------------------------------------------------------------------------------- Table of Contents CYPRESS SEMICONDUCTOR CORPORATION RECONCILIATION OF GAAP FINANCIAL MEASURES TO NON-GAAP FINANCIAL MEASURES (In thousands, except per-share data) (Unaudited) Year Ended December 30, January 1, January 2, 2012 2012 2011 GAAP revenue $ 769,687 $ 995,204 $ 877,532 SRAM legal settlement - - 6,250 Non-GAAP revenue $ 769,687 $ 995,204 $ 883,782 GAAP gross margin $ 392,800 $ 546,602 $ 489,173 Stock-based compensation expense 18,519 23,730 22,716 Impairment of assets and others 3,581 235 213 Changes in value of deferred compensation plan (1) 372 (111 ) 370 Patent license fee 7,100 - - Acquisition-related expense 3,545 - - Divestiture expenses 776 - - SRAM legal settlement - - 6,250 Non-GAAP gross margin $ 426,693 $ 570,456 $ 518,722 GAAP research and development expenses $ 189,897 $ 189,970 $ 176,816 Stock-based compensation expense (19,800 ) (24,297 ) (21,541 ) Non-cash compensation (433 ) - - Changes in value of deferred compensation plan (1) (568 ) 114 (959 ) Divestiture expenses (307 ) - - Acquisition-related expense (2,703 ) - (4 ) Non-GAAP research and development expenses $ 166,086 $ 165,787 $ 154,312 GAAP selling, general and administrative expenses $ 211,959 $ 227,976 $ 218,490 Stock-based compensation expense (36,013 ) (52,754 ) (47,202 ) Non-cash compensation (500 ) - - Impairment of assets and others (173 ) (3,811 ) (5,295 ) Building donation - (4,125 ) - Changes in value of deferred compensation plan (1) (1,710 ) 460 (1,726 ) Acquisition-related expense (9,095 ) - - Divestiture expenses (664 ) - - SRAM legal settlement - - (1,000 ) Non-GAAP selling, general and administrative expenses $ 163,804 $ 167,746 $ 163,267 GAAP operating income (loss) $ (18,915 ) $ 153,719 $ 87,864 Stock-based compensation expense 74,332 100,781 91,459 Non-cash compensation 933 - - Gain (loss) on divestiture and expenses 3,351 (34,291 ) - Restructuring charges 4,258 6,336 2,975 Impairment of assets and others 3,758 4,045 5,511 Building donation - 4,125 - Changes in value of deferred compensation plan (1) 2,650 (685 ) 3,055 Patent license fee 7,100 - - SRAM legal settlement - - 7,250 Acquisition-related expenses 19,337 2,892 3,028 Non-GAAP operating income $ 96,804 $ 236,922 $ 201,142 (1) Consistent with the current presentation, all prior periods have been recast to reflect changes in deferred compensation plan as a Non-GAAP adjustment.

51 -------------------------------------------------------------------------------- Table of Contents CYPRESS SEMICONDUCTOR CORPORATION RECONCILIATION OF GAAP FINANCIAL MEASURES TO NON-GAAP FINANCIAL MEASURES (In thousands, except per-share data) (Unaudited) Year Ended December 30, January 1, January 2, 2012 2012 2011 GAAP net income (loss) attributable to Cypress $ (22,370 ) $ 167,839 $ 75,742 Stock-based compensation expense 74,332 100,781 91,459 Non-cash compensation 933 - - Gain (loss) on divestiture and expenses 3,351 (34,291 ) - Restructuring charges 4,258 6,336 2,975 Impairment of assets and others 3,758 4,047 5,506 Building donation - 4,125 - Changes in value of deferred compensation plan (1) (507 ) 177 402 SRAM legal settlement - - 7,250 Acquisition-related expenses 19,337 2,892 3,028 Investment-related gains 2,760 - (3,158 ) Patent license fee 7,100 - - Tax effects (1,502 ) (14,373 ) 3,110 Non-GAAP net income (loss) attributable to Cypress $ 91,450 $ 237,533 $ 186,314 GAAP net income per share attributable to Cypress-diluted $ (0.15 ) $ 0.90 $ 0.40 Stock-based compensation expense 0.45 0.53 0.45 Non-cash compensation - - - Gain (loss) on divestiture and expenses 0.02 (0.18 ) - Restructuring charges 0.03 0.04 0.01 Impairment of assets and others 0.02 0.02 0.03 Building donation - 0.02 - Changes in value of deferred compensation plan - - - SRAM legal settlement - - 0.04 Acquisition-related expense 0.12 0.02 0.01 Investment-related losses (gains) 0.02 - (0.02 ) Patent license 0.04 - - Tax effects (0.01 ) (0.08 ) 0.02 Non-GAAP share count adjustment 0.01 (0.02 ) - Non-GAAP net income per share attributable to Cypress-diluted $ 0.55 $ 1.25 $ 0.94 (1) Consistent with the current presentation, all prior periods have been recast to reflect changes in deferred compensation plan as a Non-GAAP adjustment.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements included in this Annual Report on Form 10-K and the data used to prepare them. Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States and we are required to make estimates, judgments and assumptions in the course of such preparation. Note 1 of Notes to Consolidated Financial Statements under Item 8 describes the significant accounting policies and methods used in the preparation of the consolidated financial statements. On an ongoing basis, we re-evaluate our judgments and estimates including those related to revenue recognition, allowances for doubtful accounts receivable, inventory valuation, valuation of long-lived assets, goodwill and financial instruments, stock-based compensation, litigation and settlement costs, and income taxes. We base our 52-------------------------------------------------------------------------------- Table of Contents estimates and judgments on historical experience, knowledge of current conditions and our beliefs of what could occur in the future considering available information. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies that are affected by significant estimates, assumptions and judgments used in the preparation of our consolidated financial statements are as follows: Revenue Recognition: We generate revenues by selling products to distributors, various types of manufacturers including original equipment manufacturers ("OEMs") and electronic manufacturing service providers ("EMSs"). We recognize revenue on sales to OEMs and EMSs provided that persuasive evidence of an arrangement exists, the price is fixed or determinable, title has transferred, collection of resulting receivables is reasonably assured, there are no customer acceptance requirements, and there are no remaining significant obligations.

Sales to certain distributors are made under agreements which provide the distributors with price protection, other allowances and stock rotation under certain circumstances. Given the uncertainties associated with the rights given to these distributors, revenues and costs related to distributor sales are deferred until products are sold by the distributors to the end customers.

Revenues are recognized from those distributors when the products have been sold to the end customers. Reported information includes product resale price, quantity and end customer shipment information as well as remaining inventory on hand. At the time of shipment to those distributors, we record a trade receivable for the selling price since there is a legally enforceable right to receive payment, relieve inventory for the value of goods shipped since legal title has passed to the distributors, and defer the related margin as deferred margin on sales to distributors in the Consolidated Balance Sheets. The effects of distributor price adjustments are recorded as a reduction to deferred revenue at the time the distributors sell the products to the end customers.

We record as a reduction to revenues reserves for sales returns, price protection and allowances, based upon historical experience rates and for any specific known customer amounts. We also provide certain distributors and EMSs with volume-pricing discounts, such as rebates and incentives, which are recorded as a reduction to revenues at the time of sale. Historically these volume discounts have not been significant.

Our revenue reporting is highly dependent on receiving pertinent, accurate and timely data from our distributors. Distributors provide us periodic data regarding the product, price, quantity, and end customer when products are resold as well as the quantities of our products they still have in stock.

Because the data set is large and complex and because there may be errors in the reported data, we must use estimates and apply judgments to reconcile distributors' reported inventories to their activities. Actual results could vary materially from those estimates.

Allowances for Doubtful Accounts Receivable: We maintain an allowance for doubtful accounts for losses that we estimate will arise from our customers' inability to make required payments. We make estimates of the collectability of our accounts receivable by considering factors such as historical bad debt experience, specific customer creditworthiness, the age of the accounts receivable balances and current economic trends that may affect a customer's ability to pay. If the data we use to calculate the allowance for doubtful accounts does not reflect the future ability to collect outstanding receivables, additional provisions for doubtful accounts may be needed and our results of operations could be materially affected.

Valuation of Inventories: Management periodically reviews the adequacy of our inventory reserves. We record a write-down for our inventories which have become obsolete or are in excess of anticipated demand or net realizable value. We perform a detailed review of inventories each quarter that considers multiple factors including demand forecasts, product life cycle status, product development plans and current sales levels. Inventory reserves are not relieved until the related inventory has been sold or scrapped. Our inventories may be subject to rapid technological obsolescence and are sold in a highly competitive industry. If there were a sudden and significant decrease in 53-------------------------------------------------------------------------------- Table of Contents demand for our products, or if there were a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements, we could be required to record additional write-downs, and our gross margin could be adversely affected.

Valuation of Long-Lived Assets: Our business requires heavy investment in manufacturing facilities and equipment that are technologically advanced but can quickly become significantly under-utilized or rendered obsolete by rapid changes in demand. In addition, we have recorded intangible assets with finite lives related to our acquisitions.

We evaluate our long-lived assets, including property, plant and equipment and purchased intangible assets with finite lives, for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Factors considered important that could result in an impairment review include significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of the assets or the strategy for our business, significant negative industry or economic trends, and a significant decline in our stock price for a sustained period of time. Impairments are recognized based on the difference between the fair value of the asset and its carrying value, and fair value is generally measured based on discounted cash flow analysis. If there is a significant adverse change in our business in the future, we may be required to record impairment charges on our long-lived assets.

Valuation of Goodwill: Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired in a business combination. The carrying amount of goodwill at December 30, 2012 was $64.2 million, $32.4 million in the Memory Products Division ("MPD") and $31.8 million in the Programmable System Division ("PSD"). The goodwill related to MPD was recorded as part of the acquisition of Ramtron in the fourth quarter of fiscal 2012. The goodwill related to PSD was unchanged from the balance at January 1, 2012. MPD and PSD are the only reportable business segments with goodwill.

We assess our goodwill for impairment on an annual basis and, if certain events or circumstances indicate that an impairment loss may have been incurred, on an interim basis. In accordance with ASU 2011-08, Testing Goodwill for Impairment, qualitative factors can be assessed to determine whether it is necessary to perform the current two-step test for goodwill impairment. If an entity believes, as a result of its qualitative assessment, that it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount, the quantitative impairment test is required. Otherwise, no further testing is required. The fair value of PSD was substantially in excess of its carrying amount based on the quantitative assessment of goodwill that we performed in fiscal 2010. There have been no triggering events or changes in circumstances since that quantitative analysis to indicate that the fair value of PSD would be less than its carrying amount. We performed a qualitative assessment of goodwill in fiscal 2012 and concluded that it was more likely than not that the fair value of MPD and PSD exceeded its carrying amount. In assessing the qualitative factors, we considered the impact of these key factors: (i) change in the industry and competitive environment; (ii) market capitalization; (iii) stock price; and (iv) overall financial performance such as negative or declining cash flows or a decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periods.

Based on the foregoing, the first and second steps of the goodwill impairment test were unnecessary for fiscal 2012 and goodwill was not impaired as of December 30, 2012. No goodwill impairment was recognized in fiscal 2012, 2011 and 2010.

Fair Value of Financial Instruments: Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Our financial assets and financial liabilities that require recognition under the guidance generally include available-for-sale investments, employee deferred compensation plan and foreign currency derivatives. The guidance establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs 54 -------------------------------------------------------------------------------- Table of Contents by requiring that the observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of us. Unobservable inputs are inputs that reflect our assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. As such, fair value is a market-based measure considered from the perspective of a market participant who holds the asset or owes the liability rather than an entity-specific measure. The hierarchy is broken down into three levels based on the reliability of inputs as follows: Ÿ Level 1 includes instruments for which quoted prices in active markets for identical assets or liabilities that we have the ability to access. Our financial assets utilizing Level 1 inputs include U.S. treasuries, money market funds, marketable equity securities and our employee deferred compensation plan.

Ÿ Level 2 includes instruments for which the valuations are based on quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable data for substantially the full term of the assets or liabilities. Level 2 assets consist of certain marketable debt instruments for which values are determined using inputs that are observable in the market or can be derived principally from or corroborated by observable market data. Our Level 2 instruments include certain U.S. government securities, commercial paper and corporate notes and bonds.

Ÿ Level 3 includes instruments for which the valuations are based on inputs that are unobservable and significant to the overall fair value measurement. Financial assets utilizing Level 3 inputs primarily include auction rate securities. We use an income approach valuation model to estimate the exit price of the auction rate securities, which is derived as the weighted-average present value of expected cash flows over various periods of illiquidity, using a risk adjusted discount rate that is based on the credit risk and liquidity risk of the securities.

Availability of observable inputs can vary from instrument to instrument and to the extent that valuation is based on inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment exercised by our management in determining fair value is greatest for instruments categorized in Level 3. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, for disclosure purposes the level in the fair value hierarchy within which the fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety. In regards to our auction rate securities, the income approach valuation model was based on both Level 2 (credit quality and interest rates) and Level 3 inputs. We determined that the Level 3 inputs were the most significant to the overall fair value measurement, particularly the estimates of risk adjusted discount rates and ranges of expected periods of illiquidity.

Stock-Based Compensation: Under the fair value recognition provisions of the guidance, we recognize stock-based compensation net of an estimated forfeiture rate and only recognize compensation cost for those shares expected to vest over the requisite service period of the awards. Determining the appropriate fair value model and calculating the fair value of share-based payment awards require the input of highly subjective assumptions, including measurement of level of achievement of performance milestones, the expected life of the share-based payment awards and stock price volatility. The assumptions used in calculating the fair value of share-based payment awards represent management's best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, our future stock-based compensation expense could be significantly different from what we have recorded.

Accounting for Income Taxes: Our global operations involve manufacturing, research and development and selling activities. Profits from non-U.S. activities are subject to local country taxes but are not subject to U.S. tax until repatriated to the U.S. It 55 -------------------------------------------------------------------------------- Table of Contents is our intention to permanently reinvest these earnings outside the U.S. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. We consider historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance. Should we determine that we would be able to realize deferred tax assets in the future in excess of the net recorded amount, we would record an adjustment to the deferred tax asset valuation allowance.

This adjustment would increase income in the period such determination is made.

The calculation of tax liabilities involves dealing with uncertainties in the application of complex global tax regulations. We recognize potential liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on our estimate of whether, and the extent to which, additional taxes will be due. If payment of these amounts ultimately proves to be unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period when we determine the liabilities are no longer necessary. If the estimate of tax liabilities proves to be less than the ultimate tax assessment, a further charge to expense would result.

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