QUICKLOGIC CORPORATION - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion of our financial condition and results of operations should be read in conjunction with the financial statements and related notes included in this Annual Report on Form 10-K. This discussion may contain forward-looking statements based upon current expectations that involve risks and uncertainties including those discussed under Part I, Item 1A, "Risk Factors." These risks and uncertainties may cause actual results to differ materially from those discussed in the forward-looking statements.

Overview We develop and market low power customizable semiconductor solutions that enable customers to add new differentiated features to, extend battery life in, and improve their visual experience with their mobile, consumer and enterprise products. Our targeted mobile market segments include Tablets, Smartphones, Mobile Enterprise, Pico Projectors, Broadband Access Data cards, and Secure Access Data cards. Our solutions typically fall into one of three categories: Display & Visual Enhancement, Smart Connectivity, and Security. We are a fabless semiconductor company designing Customer Specific Standard Products, or CSSPs, which are complete, customer-specific solutions that include a combination of silicon solution platforms; Proven System Blocks, or PSBs; customer-specific logic; software drivers; and firmware. Our main platform families, ArcticLink and PolarPro, are standard silicon products. PSBs that have been developed and that are available to customers include our Visual Enhancement Engine, or VEE, Display Power Optimizer, or DPO, and Background Color Compensator (BCC) technologies; SDHD/eMMC Host Controllers; USB 2.0 On-The-Go with PHY; MIPI Host/Device with DPHY, LVDS, MDDI Client with PHY; High Speed UARTs; Pulse Width Modulators; SPI and I2C hosts, display-specific functions such as RGB-split and Frame Recyclers; and Data Performance Manager, or DPM, for accelerated sideloading times. The variety of PSBs offered by us allows system designers to combine multiple discrete chips onto a single CSSP, simplifying design and board layout, lowering BOM cost, and accelerating time-to-market. The programmable logic of the platforms is used for adding differentiated features and provides flexibility to address hardware-based product requirements quickly.

Utilizing a focused customer engagement model, we market CSSPs to Original Equipment Manufacturers, or OEMs, and Original Design Manufacturers, or ODMs, that offer differentiated mobile products, and to processor vendors wishing to expand their served available market through the deployment of reference designs to their customers. Our solutions enable OEMs and ODMs to add new features, extend battery life, and improve the visual experience of their handheld mobile devices. In addition to working directly with our customers, we partner with other companies with expertise in certain technologies to develop additional intellectual property, reference platforms and system software to provide application solutions.

We also work with mobile processor manufacturers in the development of reference designs or "Catalog" CSSPs. Through reference designs that incorporate our CSSPs, we believe mobile processor manufacturers can expand the served available market for their processors. Furthermore, should a CSSP development for a processor manufacturer be applicable to a set of common OEMs or ODMs, we can amortize our R&D investment over that set of OEMs/ODMs. We call this type of solution a Catalog CSSP. The first such Catalog CSSP was developed in conjunction with Texas Instruments, and introduced to the market during the second half of 2012. We are placing a greater emphasis on developing and marketing Catalog CSSPs in the future.

In order to grow our revenue from its current level, we are dependent upon increased revenue from our new products including existing new product platforms and platforms currently in development. We expect our business growth to be driven by CSSPs and our CSSP revenue growth needs to be strong enough to enable us to sustain profitability while we continue to invest in the development, sales and marketing of our new solution platforms, PSBs and CSSPs. The gross margin associated with our CSSPs is generally lower than the gross margin of our FPGA products, due primarily to the price sensitive nature of the higher volume mobile consumer opportunities that we are pursuing with CSSPs.

During 2012, we generated total revenue of $14.9 million which represents a 29% decrease over 2011. Our new product revenue was $5.9 million which represents a 11% increase over 2011 while our mature product revenue was $9.0 million which represents a 42% decrease over 2011. We shipped our new products into all five of our targeted mobile market segments: Smartphones, Broadband Access Data Cards, Mobile Enterprise, Secured Access Data Cards, and Tablet. Although we saw demand for our mature products in 2012, we anticipate that our revenue from mature products will continue to decline. Overall, we reported a net loss of $12.3 million for 2012.

Critical Accounting Policies and Estimates The methods, estimates and judgments we use in applying our most critical accounting policies have a significant 23-------------------------------------------------------------------------------- Table of Contents impact on the results we report in our consolidated financial statements. The SEC has defined critical accounting policies as those that are most important to the portrayal of our financial condition and results of operations and require us to make our most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, our critical policies include revenue recognition including sales returns and allowances, valuation of inventories including identification of excess quantities and product obsolescence, allowance for doubtful accounts, valuation of investments, valuation of long-lived assets, measurement of stock-based compensation, accounting for income taxes, and estimating accrued liabilities. We believe that we apply judgments and estimates in a consistent manner and that such consistent application results in consolidated financial statements and accompanying notes that fairly represent all periods presented.

However, any factual errors or errors in these judgments and estimates may have a material impact on our financial statements.

Revenue Recognition We supply standard products which must be programmed before they can be used in an application. Our products may be programmed by us, distributors, end-customers or third parties. Once programmed, our parts cannot be erased and, therefore, programmed parts are generally only useful to a specific customer.

We recognize revenue as products are shipped if evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, collection of the resulting receivable is reasonably assured and product returns are reasonably estimable. Revenue is recognized upon shipment of programmed and unprogrammed parts to OEM customers, provided that legal title and risk of ownership have transferred. Parts held by distributors may be returned for quality reasons only under our standard warranty policy. Revenue is recognized upon the shipment of programmed and unprogrammed parts to distributors throughout 2012.

Valuation of Inventories Inventories are stated at the lower of standard cost or net realizable value.

Standard cost approximates actual cost on a first-in, first-out basis. We routinely evaluate quantities and values of our inventories in light of current market conditions and market trends and record reserves for quantities in excess of demand and product obsolescence. The evaluation may take into consideration historic usage, expected demand, anticipated sales price, the stage in the product life cycle of our customers' products, new product development schedules, the effect new products might have on the sale of existing products, product obsolescence, customer design activity, customer concentrations, product merchantability and other factors. Market conditions are subject to change.

Actual consumption of inventories could differ from forecasted demand and this difference could have a material impact on our gross margin and inventory balances based on additional provisions for excess or obsolete inventories or a benefit from inventories previously written down. We also regularly review the cost of inventories against estimated market value and record a lower of cost or market reserve for inventories that have a cost in excess of estimated market value, which could have a material impact on our gross margin and inventory balances based on additional write-downs to net realizable value or a benefit from inventories previously written down.

Our semiconductor products have historically had an unusually long product life cycle and obsolescence has not been a significant factor in the valuation of inventories. However, as we pursue opportunities in the mobile market and continue to develop new products, we believe our new product life cycle will be shorter and increase the potential for obsolescence. A significant decrease in demand could result in an increase in the amount of excess inventory on hand.

Although we make every effort to ensure the accuracy of our forecasts of future product demand, due to our small customer base and limited CSSP engagements, any significant unanticipated changes in demand could have a significant impact on the value of our inventory and our results of operations.

Valuation of Investments At December 30, 2012, we held 42,970 TowerJazz ordinary shares valued at approximately $345,000, all of which was recorded as an available-for-sale short-term investment. The number of TowerJazz ordinary shares held by the Company reflect the 1 to 15 reverse stock split implemented by TowerJazz effective August 3, 2012.

Our investment is marked to market on our balance sheet at the end of each reporting period with the change in unrealized market value reflected in our consolidated statement of comprehensive income. If the market value of the shares were to decline below the carrying value and if the decline is determined to be "other than temporary," we would record a write-down of marketable securities as a charge to our statement of operations and reduce the carrying value of the shares.

The TowerJazz shares which we purchased in 2001 and 2002 as part of our wafer supply agreement were obtained at an average price of $12.84 per share and $5.46 per share, respectively. We wrote down the cost of these shares due to declines 24-------------------------------------------------------------------------------- Table of Contents in their market value that we determined to be "other than temporary" by $15.1 million between 2001 and 2008. This determination included factors such as market value and the period of time that the market value had been below the carrying value. At December 30, 2012, we had a net unrealized loss of $11,000 on the value of our net investment in TowerJazz. The carrying value of the TowerJazz ordinary shares was $8.04 per share as of the end of 2012.

Valuation of Long-Lived Assets We assess annually whether the value of identifiable intangibles and long-lived assets, including property and equipment and prepaid wafer credits, has been impaired and when events or changes in circumstances indicate that the carrying value of an asset or asset group may not be recoverable. There were no significant factors that triggered an impairment review during the fiscal year 2012.

Our assessment of possible impairment is based on our ability to recover the carrying value of an asset or asset group from their expected future pre-tax cash flows, undiscounted and without interest charges, of the related operations. If these cash flows are less than the carrying value of the asset or asset group, we recognize an impairment loss for the difference between estimated fair value and carrying value, and the carrying value of the related assets is reduced by this difference. The measurement of impairment requires management to estimate future cash flows and the fair value of long-lived assets.

Stock-Based Compensation We account for stock-based compensation under the provisions of the amended authoritative guidance and related interpretations which require the measurement and recognition of expense related to the fair value of stock-based compensation awards. The fair value of stock-based compensation awards is measured at the grant date and re-measured upon modification, as appropriate. Determining the appropriate fair value model and calculating the fair value of stock-based awards at the date of grant require judgment.

We use the Black-Scholes option pricing model to estimate the fair value of employee stock options and rights to purchase shares under the Company's 2009 Stock Plan and 2009 Employee Stock Purchase Plan, or ESPP, consistent with the provisions of the amended authoritative guidance. This fair value is expensed on a straight-line basis over the requisite service period of the award. Using the Black-Scholes pricing model requires us to develop highly subjective assumptions including the expected term of awards, expected volatility of our stock, expected risk-free interest rate and expected dividend rate over the term of the award. Our expected term of awards is based primarily on our historical experience with similar grants. Our expected stock price volatility for both stock options and ESPP shares is based on the historic volatility of our stock, using the daily average of the opening and closing prices and measured using historical data appropriate for the expected term. The risk-free interest rate assumption approximates the risk-free interest rate of a Treasury Constant Maturity bond with a maturity approximately equal to the expected term of the stock option or ESPP shares.

In addition to the assumptions used in the Black-Scholes pricing model, the amended authoritative guidance requires that we recognize compensation expense only for awards ultimately expected to vest; therefore we are required to develop an estimate of the historical pre-vest forfeiture experience and apply this to all stock-based awards. The fair value of restricted stock awards, or RSAs, and restricted stock units, or RSUs, is based on the closing price of our common stock on the date of grant. RSA and RSU awards which vest with service are expensed over the requisite service period. RSAs and RSU awards which are expected to vest based on the achievement of a performance goal are expensed over the estimated vesting period. We regularly review the assumptions used to compute the fair value of our stock-based awards and we revise our assumptions as appropriate. In the event that assumptions used to compute the fair value of our stock-based awards are later determined to be inaccurate or if we change our assumptions significantly in future periods, stock-based compensation expense and our results of operations could be materially impacted. See Note 11 of our consolidated financial statements.

Accounting for Income Taxes As part of the process of preparing our financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax exposure together with assessing temporary differences resulting from different tax and accounting treatment of items, such as deferred revenue, allowance for doubtful accounts, the impact of equity awards, depreciation and amortization, and employee related accruals. These differences result in deferred tax assets and liabilities, which are included on our balance sheets. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not more likely than not, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within the tax provision in the statement of operations.

25-------------------------------------------------------------------------------- Table of Contents Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. Our deferred tax assets, consisting primarily of net operating loss carryforwards, amounted to $60.3 million as of the end of 2012. We have also recorded a valuation allowance of $60.2 million as of the end of 2012 due to uncertainties related to our ability to utilize our U.S. deferred tax assets before they expire. The valuation allowance is based on the uncertainty of our estimates of taxable income and the period over which we expect to recover our deferred tax assets.

26-------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth the percentage of revenue for certain items in our statements of operations for the periods indicated: Fiscal Years 2012 2011 2010 Statement of Operations: Revenue 100.0 % 100.0 % 100.0 % Cost of revenue 52.7 % 40.6 % 36.7 % Gross profit 47.3 % 59.4 % 63.3 % Operating expenses: Research and development 58.5 % 46.9 % 29.0 % Selling, general and administrative 70.1 % 47.5 % 38.4 % Income (loss) from operations (81.3 )% (35.0 )% (4.1 )% Gain on sale of TowerJazz Semiconductor Ltd. - % - % 3.8 % Interest expense (0.4 )% (0.2 )% (0.3 )% Interest income and other (expense), net (0.5 )% (0.8 )% (0.2 )% Income (loss) before income taxes (82.2 )% (36.0 )% (0.3 )% Provision for (benefit from) income taxes 0.1 % 0.2 % (0.7 )% Net income (loss) (82.3 )% (36.2 )% 0.4 % Fiscal Years 2012 2011 2010 Revenue by product family(1) (in thousands): New products $ 5,920 $ 5,326 $ 9,388 Mature products 9,024 15,643 16,811 Total revenue $ 14,944 $ 20,969 $ 26,199 (1) For all periods presented: New products represent products introduced since 2005, and include ArcticLink®, ArcticLink II, ArcticLink III, Eclipse™ II, PolarPro®, PolarPro II, and QuickPCI® II. Mature products include Eclipse, EclipsePlus, pASIC® 1, pASIC 2, pASIC 3, QuickFC, QuickMIPS, QuickPCI, QuickRAM®, and V3, as well as royalty revenue, programming hardware and software.

27-------------------------------------------------------------------------------- Table of Contents Comparison of Fiscal Years 2012 and 2011 Revenue. The table below sets forth the changes in revenue for fiscal year 2012 as compared to fiscal year 2011 (in thousands, except percentage data): Fiscal Years 2012 2011 % of Total % of Total Year-Over-Year Amount Revenues Amount Revenues Change Revenue by product family (1): New products $ 5,920 40 % $ 5,326 25 % $ 594 11 % Mature products 9,024 60 % 15,643 75 % (6,619 ) (42 )% Total revenue $ 14,944 100 % $ 20,969 100 % $ (6,025 ) (29 )% _________________ (1) For all periods presented: New products represent products introduced since 2005, and include ArcticLink, ArcticLink II, ArcticLink III, Eclipse II, PolarPro, PolarPro II, and QuickPCI II. Mature products include Eclipse, EclipsePlus, pASIC 1, pASIC 2, pASIC 3, QuickFC, QuickMIPS, QuickPCI, QuickRAM, and V3, as well as royalty revenue, programming hardware and software.

The decrease in revenue was mainly due to the decrease in mature product revenue. The lower mature product revenue was a result of low bookings from our customers in the aerospace, test and instrumentation sectors in 2012. One of our U.S. customers, purchasing primarily pASIC 3 devices, accounted for 14% and 15% of total revenue in fiscal years 2012 and 2011, respectively.

In order to grow our revenue from its current level, we are dependent upon increased revenue from our new products, especially revenue from CSSPs designed using our ArcticLink, ArcticLink II, ArcticLink III, PolarPro and PolarPro II solution platforms and the development of additional new products and CSSPs.

We continue to seek to expand our revenue, including pursuing high volume sales opportunities in our target market segments, by providing CSSPs incorporating intellectual property such as our VEE/DPO technologies, or industry standard interfaces such as USB 2.0 OTG, MIPI, LVDS, SDIO, Camera Interface, or CAMIF, I2C, SPI, PWM and keyboard controllers. Our industry is characterized by intense price competition and by lower margins as order volumes increase. While winning large volume sales opportunities will increase our revenue, we believe these opportunities may decrease our gross profit as a percentage of revenue.

Gross Profit. The table below sets forth the changes in gross profit for fiscal year 2012 as compared to fiscal year 2011 (in thousands, except percentage data): Fiscal Years 2012 2011 % of Total % of Total Year-Over-Year Amount Revenues Amount Revenues Change Revenue $ 14,944 100 % $ 20,969 100 % $ (6,025 ) (29 )% Cost of revenue 7,878 53 % 8,517 41 % (639 ) (8 )% Gross Profit $ 7,066 47 % $ 12,452 59 % $ (5,386 ) (43 )% The decrease in gross profit in 2012 as compared to 2011 was mainly due to lower revenue, higher unabsorbed overhead and the mix of product shipped in 2012. In addition, the decrease in gross profit was partially offset by the sale of previously reserved inventories of $599,000 and $336,000 in 2012 and 2011, respectively.

Our semiconductor products have historically had a long product life cycle and obsolescence has not been a significant factor in the valuation of inventories.

However, as we pursue opportunities in the mobile market and continue to develop new CSSPs and products, we believe our product life cycle will be shorter and increase the potential for obsolescence. We also regularly review the cost of inventories against estimated market value and record a lower of cost or market reserve for 28-------------------------------------------------------------------------------- Table of Contents inventories that have a cost in excess of estimated market value. This could have a material impact on our gross margin and inventory balances based on additional write-downs to net realizable value or a benefit from inventories previously written down.

Operating Expenses. The table below sets forth the changes in operating expenses for fiscal year 2012 as compared to fiscal year 2011 (in thousands, except percentage data): Fiscal Years 2012 2011 % of Total % of Total Year-Over-Year Amount Revenues Amount Revenues Change R&D expense $ 8,743 59 % $ 9,836 47 % $ (1,093 ) (11 )% SG&A expense 10,481 70 % 9,965 48 % 516 5 % Total operating expenses $ 19,224 129 % $ 19,801 95 % $ (577 ) (3 )% Research and Development Expense. Our research and development expenses consist primarily of personnel, overhead and other costs associated with engineering process improvements, programmable logic design, CSSP design and software development. Research and development expense was $8.7 million and $9.8 million in 2012 and 2011, respectively, which represented 59% and 47% of revenue for those periods. The $1.1 million decrease in R&D expenses in 2012 as compared to 2011 is attributable primarily to a $1.2 million decrease in outside services due to a reduction in third party chip design costs and a $465,000 decrease in intellectual property costs. These decreases were partially offset by a $544,000 increase in compensation expenses due to an increase in headcount.

Selling, General and Administrative Expense. Our selling, general and administrative expenses consist primarily of personnel and related overhead costs for sales, marketing, finance, administration, human resources and legal. Selling, general and administrative, or SG&A, expense was $10.5 million and $10.0 million in 2012 and 2011, respectively, which represented 70% and 48% of revenue for those periods. The $516,000 increase in SG&A expenses in 2012 as compared to 2011 is attributable primarily to a $351,000 increase in compensation expenses due to an increase in headcount and a $312,000 increase in stock-based compensation expenses. These increases were partially offset by a decrease of $49,000 in equipment and supplies; a $45,000 decrease in travel and entertainment expenses; and a $37,000 decrease in occupancy costs.

Interest Expense and Interest Income and Other, net The table below sets forth the changes in interest expense and interest income and other, net for 2012 as compared to 2011: Fiscal Years Change 2012 2011 Amount Percentage (in thousands) Interest expense $ (61 ) $ (36 ) $ (25 ) 69 % Interest income and other, net (77 ) (159 ) $ 82 (52 )% $ (138 ) $ (195 ) $ 57 (29 )% The increase in interest expense is due primarily to the increase of our capital lease obligation to $426,000 in 2012 from $287,000 in 2011. The change in interest income and other, net was due primarily to tax expenses from foreign jurisdictions and foreign exchange gains (losses) in 2012 as compared to 2011.

We conduct a portion of our research and development activities in Canada and India and we have sales and marketing activities in various countries outside of the United States. Most of these international expenses are incurred in local currency. Foreign currency transaction gains and losses are included in interest and other income (expense), net, as they occur. We do not use derivative financial instruments to hedge our exposure to fluctuations in foreign currency and, therefore, our results of operations are and will continue to be susceptible to fluctuations in foreign exchange gains or losses.

Provision for Income Taxes. The table below sets forth the changes in provision for (benefit from) income taxes for 2012 as compared to 2011: 29-------------------------------------------------------------------------------- Table of Contents Fiscal Years Change 2012 2011 Amount Percentage (in thousands) Income tax provision $ 18 $ 50 $ (32 ) (64 )% The income tax expense for 2012 and 2011 are primarily for our foreign operations which are cost-plus entities. As of the end of 2012, our ability to utilize our U.S. deferred tax assets in future periods is uncertain and, accordingly, we have recorded a full valuation allowance against the related U.S. tax asset. We will continue to assess the realizability of deferred tax assets in future periods.

The American Taxpayer Relief Act of 2012, which was enacted on January 2, 2013, extends the Federal research tax credit retroactively for two years from January 1, 2012 through December 31, 2013. There will be no impact to the income tax provision for the enactment in the quarter ending March 31, 2013 due to our valuation allowance recorded against its US deferred tax assets.

Stock-Based Compensation. For 2012 and 2011, stock-based compensation totaled $2.0 million and $1.7 million, respectively, and was included in the statement of operations as follows (in thousands): Fiscal Years Change 2012 2011 Amount Percentage Cost of revenue $ 179 $ 131 $ 48 37 % Research and development 455 458 (3 ) (1 )%Selling, general and administrative 1,369 1,087 282 26 % Total stock-based compensation $ 2,003 $ 1,676 $ 327 20 % In 2012, we granted fully vested restricted stock units, or RSUs to all employees. Total stock-based compensation related to RSUs was $341,000 in 2012.

We issued net shares for the vested RSUs, withholding shares in settlement of employee tax withholding obligations.

The amount of stock-based compensation included in inventories at the end of 2012 and 2011 was not material and there was no tax effect on the financial statements for all periods presented.

Comparison of Fiscal Years 2011 and 2010 Revenue. The table below sets forth the changes in revenue for fiscal year 2011 as compared to fiscal year 2010 (in thousands, except percentage data): Fiscal Years 2011 2010 Revenue by product % of Total % of Total Year-Over-Year family (1): Amount Revenues Amount Revenues Change New products $ 5,326 25 % $ 9,388 36 % $ (4,062 ) (43 )% Mature products 15,643 75 % 16,811 64 % (1,168 ) (7 )% Total revenue $ 20,969 100 % $ 26,199 100 % $ (5,230 ) (20 )% _________________ (1) For all periods presented: New products represent products introduced since 2005, and include ArcticLink, ArcticLink II, ArcticLink III, Eclipse II, PolarPro, PolarPro II, and QuickPCI II. Mature products include Eclipse, EclipsePlus, pASIC 1, pASIC 2, pASIC 3, QuickFC, QuickMIPS, QuickPCI, QuickRAM, and V3, as well as royalty revenue, programming hardware and software.

The decrease in revenue was due to decreases in new and in mature product revenue. New product revenue was negatively impacted by an over-supply of inventory already in the channel for our broadband data card and mobile enterprise customers and by reduced demand from a secure data card customer due to design changes in 2011. The mature product revenue was negatively affected by low bookings from our customers in the aerospace, test and instrumentation sectors in 2011. One of our U.S. customers, purchasing primarily pASIC 3 devices, accounted for 15% and 11% of total revenue in fiscal years 2011 and 2010, respectively.

In order to grow our revenue from its current level, we are dependent upon increased revenue from our new products, especially revenue from CSSPs designed using our ArcticLink, ArcticLink II, ArcticLink III, PolarPro and PolarPro II solution platforms and the development of additional new products and CSSPs.

We continue to seek to expand our revenue, including pursuing high volume sales opportunities in our target market segments, by providing CSSPs incorporating intellectual property such as our VEE/DPO technologies, boot from managed NAND or industry standard interfaces such as USB 2.0 OTG, SDIO and integrated drive electronics, or IDE, PS2, I2C, SPI, PWM and keyboard controllers. Our industry is characterized by intense price competition and by lower margins as order volumes increase. While winning large volume sales opportunities will increase our revenue, we believe these opportunities may decrease our gross profit as a percentage of revenue.

Gross Profit. The table below sets forth the changes in gross profit for fiscal year 2011 as compared to fiscal year 2010 (in thousands, except percentage data): Fiscal Years 2011 2010 % of Total % of Total Year-Over-Year Amount Revenues Amount Revenues Change Revenue $ 20,969 100 % $ 26,199 100 % $ (5,230 ) (20 )% Cost of revenue 8,517 41 % 9,609 37 % (1,092 ) (11 )% Gross Profit $ 12,452 59 % $ 16,590 63 % $ (4,138 ) (25 )% The $4.1 million decrease in gross profit in 2011 as compared to 2010 was mainly due to lower revenue, higher inventory reserve and higher unabsorbed overhead.

The inventory reserve was $710,000 and $112,000 in 2011 and 2010, respectively.

The increase in inventory reserve was primarily related to our PolarPro and PolarPro II product family. In addition, the decrease in gross profit was offset by the sale of previously reserved inventories of $336,000 and $580,000 in 2011 and 2010, respectively.

Our semiconductor products have historically had a long product life cycle and obsolescence has not been a significant factor in the valuation of inventories.

However, as we pursue opportunities in the mobile market and continue to develop new CSSPs and products, we believe our product life cycle will be shorter and increase the potential for obsolescence. We also regularly review the cost of inventories against estimated market value and record a lower of cost or market reserve for inventories that have a cost in excess of estimated market value.

This could have a material impact on our gross margin and inventory balances based on additional write-downs to net realizable value or a benefit from inventories previously written down.

Operating Expenses. The table below sets forth the changes in operating expenses for fiscal year 2011 as compared to fiscal year 2010 (in thousands, except percentage data): Fiscal Years 2011 2010 % of Total % of Total Year-Over-Year Amount Revenues Amount Revenues Change R&D expense $ 9,836 47 % $ 7,458 29 % $ 2,378 32 % SG&A expense 9,965 48 % 10,073 38 % (108 ) (1 )% Total operating expenses $ 19,801 95 % $ 17,531 67 % $ 2,270 13 % Research and Development Expense. Our research and development expenses consist primarily of personnel, overhead and other costs associated with engineering process improvements, programmable logic design, CSSP design and software development. Research and development expense was $9.8 million and $7.5 million in 2011 and 2010, respectively, which represented 47% and 29% of revenue for those periods. The $2.4 million increase in R&D expenses in 2011 as compared to 2010 is attributable primarily to a $1.8 million or 109% increase in outside services due to an increased level of third party chip design costs; a $308,000 increase in compensation expenses due to salary reinstatement in the second half of 2010; and a $320,000 increase in depreciation expense including a mask set write-off of $119,000; and a $114,000 increase in purchased IP.

Selling, General and Administrative Expense. Our selling, general and administrative expenses consist primarily of personnel and related overhead costs for sales, marketing, finance, administration, human resources and legal. Selling, general and administrative, or SG&A, expense was $10.0 million and $10.1 million in 2011 and 2010, respectively, which represented 48% and 38% of revenue for those periods. The $108,000 decrease in SG&A expenses in 2011 as compared to 2010 is attributable primarily to a $517,000 or 32% decrease in stock-based compensation expenses and a $100,000 or 3% decrease in outside services due to a decrease in sales commissions paid to third party sales representatives. This decrease was partially offset by a $273,000 or 6% increase in compensation expenses due to salary reinstatement in the second half of 2010; a $133,000 or 19% increase in travel and entertainment expenses; and a $100,000 or 70% increase in other employee costs.

Gain on Sale of TowerJazz Shares. In the first quarter of fiscal year 2010, we sold 700,000 of the TowerJazz ordinary shares which resulted in a realized gain of $993,000.

Interest Expense and Interest Income and Other, Net The table below sets forth the changes in interest expense and interest income and other, net, for 2011 as compared to 2010: Fiscal Years 2011 2010 (in thousands) Interest expense $ (36 ) $ (67 ) Interest income and other, net (159 ) (46 ) $ (195 ) $ (113 ) The decrease in interest expense is due primarily to the reduction of our average debt obligation to $300,000 in 2011 from $1.5 million in 2010. The change in interest income and other, net was due primarily to the other tax expenses including U.S. sales and use tax and business taxes in foreign jurisdictions, and foreign exchange losses in 2011 as compared to 2010.

We conduct a portion of our research and development activities in Canada and India and we have sales and marketing activities in various countries outside of the United States. Most of these international expenses are incurred in local currency. Foreign currency transaction gains and losses are included in interest and other income (expense), net, as they occur. We do not use derivative financial instruments to hedge our exposure to fluctuations in foreign currency and, therefore, our results of operations are and will continue to be susceptible to fluctuations in foreign exchange gains or losses.

Provision for (Benefit from) Income Taxes. The table below sets forth the changes in provision for (benefit from) income taxes for 2011 as compared to 2010: Fiscal Years 2011 2010 (in thousands)Income tax provision (benefit) $ 50 $ (184 ) The income tax expense (benefit) for 2011 and 2010 are primarily for our foreign operations which are cost-plus entities. Included within the benefit from income taxes for 2010 was an out of period adjustment relating to an intraperiod tax allocation resulting from the unrealized gains on our investment in TowerJazz.

The adjustment in 2010 had the impact of increasing the benefit from income taxes by $209,000 for the year.

As of the end of 2011, our ability to utilize our U.S. deferred tax assets in future periods is uncertain and, accordingly, we have recorded a full valuation allowance against the related U.S. tax asset. We will continue to assess the realizability of deferred tax assets in future periods.

Stock-Based Compensation. For 2011 and 2010, stock-based compensation totaled $1.7 million and $2.4 million, respectively, and was included in the statement of operations as follows (in thousands): Fiscal Years 2011 2010 Cost of revenue $ 131 $ 169 Research and development 458 645 Selling, general and administrative 1,087 1,604 Total costs and expenses $ 1,676 $ 2,418 In 2010, we granted RSUs in lieu of cash compensation. Total stock-based compensation related to RSUs in lieu of cash was $414,000 in 2010. We issued net shares for the vested RSUs, withholding shares in settlement of employee tax withholding obligations.

The amount of stock-based compensation included in inventories at the end of 2011 and 2010 was not material and there was no tax effect on the financial statements for all periods presented.

30-------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources We have financed our operations and capital investments through sales of common stock, private equity investments, capital and operating leases, bank line of credit and cash flow from operations. As of December 30, 2012, our principal sources of liquidity consisted of our cash and cash equivalents of $22.6 million, available credit under our revolving line of credit with Silicon Valley Bank of $6.0 million, and our investment in TowerJazz with a market value of approximately $345,000. As of December 30, 2012 there is no material difference between the fair value and the carrying amount of capital leasing arrangements.

The borrowing under the Company's line of credit is subject to maintaining a tangible net worth of at least $15.0 million, unrestricted cash or cash equivalent balance of at least $8.0 million and a quick ratio of 2-to-1. We have extended the term of the revolving debt facility until June 2013. Upon each advance, the Company can elect a fixed interest rate, which is the prime rate plus the prime rate margin, or a fixed rate which is the LIBOR plus the LIBOR rate margin. We were in compliance with all loan covenants as of the end of the current reporting period. As of December 30, 2012, there were no borrowings against the line of credit.

Most of our cash and cash equivalents were invested in a U.S. Treasury money market fund rated AAAm/Aaa. Our interest-bearing debt consisted of $426,000 outstanding under capital leases (see Note 6 of the Consolidated Financial Statements). As of December 30, 2012, the 42,970 remaining shares of our investment in TowerJazz had a market value of approximately $345,000.

Cash balances held at our foreign subsidiaries were approximately $461,000 and $950,000 at December 30, 2012 and January 1, 2012, respectively. Earnings from our foreign subsidiaries are currently deemed to be indefinitely reinvested. We do not expect such reinvestment to affect our liquidity and capital resources, and we continuously evaluate our liquidity needs and ability to meet global cash requirements as a part of our overall capital deployment strategy. Factors which affect our global capital deployment strategy include anticipated cash flows, the ability to repatriate cash in a tax efficient manner, funding requirements for operations and investment activities, acquisitions and divestitures, and capital market conditions.

Net Cash from Operating Activities In 2012, net cash used for operating activities was $8.7 million and resulted from changes in working capital offset by a net loss of $12.3 million which included $3.6 million in non-cash charges. These non-cash charges included write-downs of inventories in the amount of $447,000 to reflect excess quantities, depreciation and amortization of our long-lived assets of $1.2 million, and stock-based compensation of $2.0 million. In addition, changes in working capital accounts provided cash of $6,000 as a result of a decrease in accounts receivable of $333,000, a decrease in inventory of $289,000, and a decrease in accounts payable of $654,000.

In 2011, net cash used for operating activities was $2.5 million and resulted from changes in working capital offset by a net loss of $8.0 million which included $3.7 million in non-cash charges. These non-cash charges included write-downs of inventories in the amount of $710,000 to reflect excess quantities, depreciation and amortization of our long-lived assets of $1.2 million, and stock-based compensation of $1.7 million. In addition, changes in working capital accounts used cash of $1.4 million as a result of an decrease in accounts receivable of $2.6 million, increase in inventory of $1.1 million, and increase in accounts payable of $312,000. These cash uses were partially offset by a decrease in deferred royalty revenue of $320,000.

In 2010, net cash used for operating activities was $147,000 and resulted from changes in working capital offset by a net income of $123,000 which included $2.6 million in non-cash charges. These non-cash charges included write-downs of inventories in the amount of $112,000 to reflect excess quantities, depreciation and amortization of our long-lived assets of $1.2 million, and stock-based compensation of $2.4 million. In addition, changes in working capital accounts used cash of $2.8 million as a result of an increase in accounts receivable of $1.7 million, increase in inventory of $1.3 million, increase in other assets of $105,000, and decrease in accounts payable of $352,000. These cash uses were partially offset by an increase in accrued liabilities and other long term liabilities of $631,000.

Net Cash from Investing Activities Net cash used by investing activities for 2012 was $1,241,000, resulting from capital expenditures made primarily to acquire manufacturing equipment.

In 2011 and 2010, net cash used for investing activities was $896,000 and $270,000, respectively, as a result of capital expenditures made primarily to acquire software used in the development and production of our products and solutions.

Net Cash from Financing Activities 31-------------------------------------------------------------------------------- Table of Contents In 2012, net cash provided by financing activities was $12.3 million, resulting from $12.7 million of proceeds related to the issuance of common shares under the confidentially marketed underwritten offering and to employees under our equity plans, partially offset by payments of $452,000 under the terms of our capital lease obligations.

In 2011, net cash provided by financing activities was $1.6 million, resulting from $2.0 million of proceeds related to the issuance of common shares to employees under our equity plans, partially offset by payments of $408,000 under the terms of our debt and capital lease obligations.

In 2010, net cash provided by financing activities was $3.6 million, resulting from $6.0 million in proceeds from the revolving line of credit and $6.0 million of proceeds related to warrants exercised by private stockholders and the issuance of common shares to employees under our equity plans, partially offset by payments of $8.4 million under the terms of our debt and capital lease obligations.

We require substantial cash to fund our business. However, we believe that our existing cash resources will be sufficient to fund operations and capital expenditures, and provide adequate working capital for at least the next twelve months. After the next twelve months, our cash requirements will depend on many factors, including our level of revenue and gross profit, the market acceptance of our existing and new products, the levels at which we maintain inventories and accounts receivable, costs of securing access to adequate manufacturing capacity, new product development efforts, capital expenditures and the level of our operating expenses.

Contractual Obligations and Commercial Commitments The following table summarizes our contractual obligations and commercial commitments as of the end of 2012 and the effect such obligations and commitments are expected to have on our liquidity and cash flows in future fiscal periods (in thousands): Payments Due by Period More than Total Less than 1 year 1-3 Years 3 Years Contractual cash obligations: Operating leases $ 2,137 $ 695 $ 1,442 $ - Wafer purchases(1) 621 621 - - Other purchase commitments 568 468 100 - Total contractual cash obligations 3,326 1,784 1,542 - Other commercial commitments(2): Capital lease obligations 426 160 266 - Total commercial commitments 426 160 266 - Total contractual obligations and commercial commitments(3) $ 3,752 $ 1,944 $ 1,808 $ - (1) Certain of our wafer manufacturers require us to forecast wafer starts several months in advance. We are committed to take delivery of and pay for a portion of forecasted wafer volume. Wafer purchase commitments of $621,000 include firm purchase commitments and a portion of our forecasted wafer starts as of the end of 2012.

(2) Other commercial commitments are included as liabilities on our balance sheets as of the end of 2012.

(3) Does not include unrecognized tax benefits of $79,000 as of the end of 2012. See Note 8 of our consolidated financial statements.

Concentration of Suppliers We depend on a limited number of contract manufacturers, subcontractors, and suppliers for wafer fabrication, assembly, programming and testing of our devices, and for the supply of programming equipment. These services are typically provided by one supplier for each of our devices. We generally purchase these single or limited source services through standard purchase orders. Because we rely on independent subcontractors to perform these services, we cannot directly control product delivery schedules, costs or quality levels.

Our future success also depends on the financial viability of our independent subcontractors. These subcontract manufacturers produce products for other companies and we must place orders in advance of 32-------------------------------------------------------------------------------- Table of Contents expected delivery. As a result, we have only a limited ability to react to fluctuations in demand for our products, which could cause us to have an excess or a shortage of inventories of a particular product, and our ability to respond to changes in demand is limited by these suppliers' ability to provide products with the quantity, quality, cost and timeliness that we require. The decision not to provide these services to us or the inability to supply these services to us, such as in the case of a natural or financial disaster, would have a significant impact on our business. Increased demand from other companies could result in these subcontract manufacturers allocating available capacity to customers that are larger or have long-term supply contracts in place and we may be unable to obtain adequate foundry and other capacity at acceptable prices, or we may experience delays or interruption in supply. Additionally, volatility of economic, market, social and political conditions in countries where these suppliers operate may be unpredictable and could result in a reduction in product revenue or increase our cost of revenue and could adversely affect our business, financial condition and results of operations.

Off-Balance Sheet Arrangements We do not maintain any off-balance sheet partnerships, arrangements or other relationships with unconsolidated entities or others, often referred to as structured finance or special purpose entities, which are established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

Recently Issued Accounting Pronouncements In December 2011, the Financial Accounting Standards Board ("FASB") issued ASU No. 2011-11, "Balance Sheet (Topic 210)-Disclosures about Offsetting Assets and Liabilities" ("ASU 2011-11"). The update requires entities to disclose information about offsetting and related arrangements of financial instruments and derivative instruments. ASU 2011-11 is effective for the Company in the first quarter of its fiscal year ending March 30, 2014. The Company currently believes there will be no significant impact on its financial statements.

In December 2011, the FASB issued ASU 2011-12, "Comprehensive Income (Topic 220) - Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income" in Accounting Standards Update No. 2011-05. ASU 2011-12 defers only those changes in Update No. 2011-05 that relate to the presentation of the reclassification adjustments. Under the amendments in Update No. 2011-05, entities are required to present reclassification adjustments and the effect of those reclassification adjustments on the face of the financial statements where net income presented, by component of net income, and on the face of the financial statements where other comprehensive income is presented, by component of other comprehensive income. In addition, the amendments in Update No. 2011-05 require that reclassification adjustments be presented in interim financial periods. This standard is effective for interim and annual reporting periods beginning after December 15, 2011.

In February 2013, the FASB issued authoritative guidance related to reclassifications out of accumulated OCI. Under the amendments in this update, an entity is required to report, in one place, information about reclassifications out of accumulated OCI and to report changes in its accumulated OCI balances. For significant items reclassified out of accumulated OCI to net income in their entirety in the same reporting period, reporting is required about the effect of the reclassifications on the respective line items in the statement where net income is presented. For items that are not reclassified to net income in their entirety in the same reporting period, a cross reference to other disclosures currently required under GAAP is required in the notes. This guidance is effective prospectively for reporting periods beginning after December 15, 2012. The Company will provide the required disclosures beginning in the first quarter of fiscal year 2013 and does not believe the adoption of this guidance will have a material impact on its Consolidated Financial Statements.

33-------------------------------------------------------------------------------- Table of Contents

[ Back To Technology News's Homepage ]