SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended October 31, 2005

OR

For the transition period from           to           

0-21488

(Commission File Number)

CATALYST SEMICONDUCTOR, INC.

(Exact name of Registrant as specified in its charter)

(408) 542-1000

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12(b)(2) of the Exchange Act). Yes ý No o

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12(b)(2) of the Exchange Act). Yes o No ý

The number of shares outstanding of the Registrant’s Common Stock as of December 1, 2005 was 16,740,104 exclusive of 5,889,444 shares of treasury stock.

CATALYST SEMICONDUCTOR, INC.

TABLE OF CONTENTS

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Part I. Financial Information

Item 1. Financial Statements

CATALYST SEMICONDUCTOR, INC.

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

See accompanying notes to the unaudited condensed consolidated financial statements.

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CATALYST SEMICONDUCTOR, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share data)

See accompanying notes to the unaudited condensed consolidated financial statements.

4

CATALYST SEMICONDUCTOR, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

See accompanying notes to the unaudited condensed consolidated financial statements.

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CATALYST SEMICONDUCTOR, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1—Basis of Presentation

Catalyst Semiconductor, Inc. (the “Company”), was founded in October 1985, and designs, develops and markets a broad line of reprogrammable non-volatile memory and analog/mixed-signal products.

In the opinion of the management of the Company, the unaudited condensed consolidated interim financial statements included herein have been prepared on the same basis as the Company’s April 30, 2005 audited consolidated financial statements and include all adjustments, consisting of only normal recurring adjustments, necessary to fairly state the information set forth herein.  For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended April 30, 2005.

The Company’s fiscal year is the 52 or 53-week period ending on the Sunday closest to April 30.  In a 52 week year, each fiscal quarter consists of 13 weeks.  Fiscal year 2005 was comprised of 52 weeks.  Fiscal year 2006 will be comprised of 52 weeks.  For ease of presentation, all periods are presented as if they ended on month end. All references to the quarter refer to the Company’s fiscal quarter.  The fiscal quarter covered by this report ended on October 30, 2005.

Principles of Consolidation

The consolidated financial statements include the accounts of Catalyst Semiconductor, Inc. and its wholly owned subsidiaries, Nippon Catalyst KK (“NCKK”), a sales organization in Yokohama, Japan and Catalyst Semiconductor Romania SRL (“CSR”), a product development center in Bucharest, Romania.  All significant intercompany accounts and transactions are eliminated in consolidation.

Uses of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles in the United States (“US GAAP”) requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes.  Estimates in these financial statements include inventory valuation, deferral of gross profit on shipments of inventory not sold by distributors at the end of the period, reserves for stock rotation on sales to distributors, the original equipment manufacturers (“OEMs”) sales return reserve, reserve for warranty costs, allowances for doubtful accounts receivable and income taxes.  Actual results could differ from those estimates.

Stock-Based Compensation

The Company has elected to measure employee stock-based compensation costs using the intrinsic value method prescribed by the Accounting Principles Board Opinion (“ABP”) No. 25, “Accounting for Stock Issued to Employees.”  Accordingly, no compensation expense has been recorded for stock options granted with exercise prices greater than or equal to the fair value of the underlying common stock at the option grant date.

Pro forma information regarding net income and earnings is required by Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation.” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure.”  SFAS No. 123 requires the disclosure of pro forma net income and earnings per share as if the Company had adopted the fair value method.  Stock-based compensation to employees under SFAS No. 123 is based on the fair value of the option, estimated using the Black-Scholes Option Pricing Model on the date of grant.  The related stock-based compensation expense is recognized over the vesting period.

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Stock-based compensation to employees under SFAS No. 123 is based on the fair value of the option, estimated using the Black-Scholes option pricing model on the date of grant.  The related stock-based compensation expense is recognized over the vesting period.  The following table summarizes the weighted-average assumptions used in the SFAS No. 123 calculation:

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

Note 2—Significant Accounting Policies

Cash and Cash Equivalents

All highly liquid investments purchased with an original maturity of three months or less are considered cash equivalents.

Short-term Investments

All of the Company’s short-term investments are classified as available-for-sale.  Investments in available-for-sale securities are reported at fair value with unrealized gains and losses, being recorded net of related tax, as a component of accumulated other comprehensive income (loss).  Refer to Note 4 for details related to available-for-sale securities.

Accounts Receivable

The Company’s accounts receivable are reported net of allowance for doubtful accounts. The Company estimates the collectibility of its accounts receivable at the end of each reporting period.  The Company analyzes the aging of accounts receivable and bad debt history, payment history, customer concentration, customer credit worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts.  The Company maintains an allowance for doubtful accounts, which is created by recording a provision to selling, general and administrative expenses in the statement of income.

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Fair Value of Financial Instruments

The Company measures its financial assets and liabilities in accordance with generally accepted accounting principles.  For financial instruments, including cash and cash equivalents, short-term investments, accounts receivable, accounts payable and accrued expenses, the carrying amounts approximate fair value due to their short maturities.

Foreign Currency Translation

The Company uses the U.S. dollar as its functional currency.  All of the Company’s sales and a substantial majority of its costs are transacted in U.S. dollars.  The Company purchases wafers from, and has test and assembly activities in, Asia and supports sales and marketing activities in various countries outside of the United States.  Most of these costs are paid for with U.S. dollars.  Research and development personnel costs in Romania are tracked against the euro while all other activities are paid in Romanian leu.  Foreign currency transaction gains and losses, resulting from remeasuring local currency to the U.S. dollar, are included in determining net income for the period.  The foreign exchange gains and losses were not material for the periods presented.

Recognition of Revenues

The Company generally recognizes revenues as products are shipped if evidence of an arrangement exists, the customer has taken title to the products, services, if any, have been rendered, the sales price is fixed or determinable, collection of the resulting receivable is reasonably assured and product returns are reasonably estimable.

The Company markets and sells products directly through its sales force and sales representatives to original equipment manufacturers (“OEM”) and indirectly through distributors and resellers.  Revenues are recognized upon delivery to OEMs and resellers who have no product return rights and no price protection rights.  Reserves for estimated returns and allowances are provided against net revenues at the time of recognition of revenues.  The Company also sells products to certain distributors under agreements which allow certain rights to return the product and provides for price protection rights.  These agreements generally permit the distributor to return up to 10%, by value, of the total products they purchased from the Company every six months.  As a result of the above, the Company defers recognition of revenues until the time the distributor sells the product to an end-customer.  Upon shipment to a distributor, the Company records an account receivable from the distributor, relieves inventory for the cost of the product shipped, and records the gross profit, which equals revenues less the cost of revenues, on the consolidated balance sheet as “deferred gross profit on shipments to distributors” until such time as the inventory is resold by the distributor to their end-customers.

Inventories

Inventory is stated at the lower of standard cost or net realizable value.  Standard cost approximates actual cost on a first-in, first-out basis.  The Company periodically reviews its inventory for slow moving or obsolete items and writes down the related products to estimated net realizable value.  Once established, inventory reserves are not reversed until the related inventory has been sold or physically scrapped.

Shipping and Handling Costs

The Company charges inbound freight shipments within the supply chain and associated handling costs to the “cost of revenues” on its consolidated statements of income.  The Company charges outbound freight shipments and associated handling costs to “selling, general and administrative” on its consolidated statements of income.  Such outbound freight costs aggregated to $258,000 and $159,000 for the three months ended October 31, 2005 and 2004, respectively and to $287,000 and $313,000 for the six months ended October 31, 2005 and 2004, respectively.

Property and Equipment

Property and equipment are stated at cost less accumulated depreciation and amortization.  Depreciation is calculated on a straight-line basis over the estimated useful lives of the assets.  Furniture, office equipment and engineering/test equipment are depreciated over five years with the exception of mask sets which are depreciated over two years.  Computer hardware and software is depreciated over three years.  Buildings are generally depreciated over 30 years.  Amortization of leasehold improvements is computed on a straight-line basis and amortized over the shorter of the remaining lease term or the estimated useful lives of the assets.

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Concentration of Credit Risk

Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of cash and cash equivalents, short-term investments and accounts receivable.  Cash and cash equivalents and short-term investments are maintained with high quality financial institutions.  The Company’s accounts receivable are denominated in U.S. dollars and are derived from sales to customers located principally in North America, Europe and Asia.  The Company performs ongoing credit evaluations of its customers and generally does not require collateral.

As of October 31, 2005, two customers accounted for 10% or more of the Company’s gross accounts receivable.  These two customers each accounted for 11% and 12% of gross accounts receivable, respectively. As of April 30, 2005, one customer accounted for 12% of gross accounts receivable.

Concentration of Other Risks

The semiconductor industry is characterized by rapid technological change, competitive pricing pressures and cyclical market patterns.  The Company’s financial results are affected by a wide variety of factors, including general economic conditions worldwide, economic conditions specific to the semiconductor industry, the timely implementation of new manufacturing process technologies and the ability to safeguard patents and intellectual property in a rapidly evolving market.  In addition, the semiconductor market has historically been cyclical and subject to significant economic downturns at various times.  As a result, the Company may experience significant period-to-period fluctuations in operating results due to the factors mentioned above or other factors.

Advertising Costs

Costs related to advertising and promotional expenditures are charged to “selling, general and administrative” on the Company’s consolidated statements of income.  Such advertising and promotional expenditures were less than $25,000 in each of the three months ended October 31, 2005 and 2004 and less than $50,000 in each of the six months ended October 31, 2005 and 2004.

Accumulated Other Comprehensive Income (Loss)

Accumulated other comprehensive income (loss) includes all changes in stockholders’ equity during a period from non-owner sources.  Accumulated other comprehensive income (loss) for the Company is comprised of unrealized gains (losses) on securities available-for-sale, net of tax.

Segment Reporting

The Company reports in accordance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information” (“SFAS No. 131”).  SFAS No. 131 requires the management approach in identifying reportable segments.  The management approach designates the internal organization that is used by management for making operating decisions and assessing performance as the source of the company’s reportable segments.  Based on its operating structure and management reporting, the Company has concluded it has one reporting segment: the semiconductor segment.

Reclassifications

Certain prior year balances have been reclassified to conform to current year presentation.  These reclassifications had no impact on total assets, income from operations or net income.

New Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) SFAS No. 123 (revised 2004), “Share-Based Payment,” or SFAS No. 123(R).  SFAS No. 123(R) eliminates the alternative of applying the intrinsic value measurement provisions of Accounting Principals Board (“APB”) Opinion No. 25, or APB 25, to stock compensation awards issued to employees.  Rather, the new standard requires enterprises to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide services in exchange for the award, usually the vesting period.

The pro forma effects on net income and earnings per share as if the Company had applied the fair value recognition

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provisions of original SFAS No. 123 on stock compensation awards (rather than applying the intrinsic value measurement provisions of APB 25) are in the Notes to Consolidated Financial Statements (see Note 1).  Although the pro forma effects of applying original SFAS No. 123 may be indicative of the effects of adopting SFAS No. 123(R), the provisions of these two statements differ in some important respects.  The actual effects of adopting SFAS No. 123(R) will be dependent on numerous factors including, but not limited to, the valuation model chosen by the Company to value stock-based awards; the assumed award forfeiture rate; the accounting policies adopted concerning the method of recognizing the fair value of awards over the requisite service period; and the transition method chosen for adopting SFAS No. 123(R).  Adoption of this accounting standard will have a material adverse impact on its consolidated financial statements.  SFAS No. 123(R) will be effective for the Company’s fiscal quarter ending July 31, 2006.

On December 21, 2004, the FASB issued Staff Position No. FAS 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004.”  The American Jobs Creation Act introduces a special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision), provided certain criteria are met. FSP FAS 109-2 provides accounting and disclosure guidance for the repatriation provision.  The Company may elect to apply this provision to qualifying earnings repatriations in fiscal 2006.  The Company plans to evaluate the effects of the repatriation provision and in particular of the limitation of the deduction to certain qualifying expenses incurred in the United States.  The Company does not expect to be able to complete this evaluation until late in fiscal 2006 when its qualifying expenses for 2006 will be known. The Company is currently assessing the impact of adopting FSP FAS 109-2.

On March 29, 2005, the Securities and Exchange Commission, or SEC, issued Staff Accounting Bulletin (“SAB”) No. 107, which provides guidance on the interaction between SFAS No. 123(R) and certain SEC rules and regulations.  SAB No. 107 provides guidance that may simplify some of SFAS No. 123(R)’s implementation challenges and enhance the information that investors receive.

On May 30, 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections,” a replacement of APB Opinion No. 20 and FASB Statement No. 3, which changes the requirements for the accounting and reporting of a change in accounting principle effective for fiscal years beginning after December 15, 2005.  SFAS No. 154 applies to all voluntary changes in accounting principle as well as to changes required by an accounting pronouncement that does not include specific transition provisions.  SFAS No. 154 eliminates the requirement in APB Opinion No. 20, “Accounting Changes,” to include the cumulative effect of changes in accounting principle in the income statement in the period of change.  Instead, to enhance the comparability of prior period financial statements, SFAS No. 154 requires that changes in accounting principle be retrospectively applied.  Under retrospective application, the new accounting principle is applied as of the beginning of the first period presented as if that principle had always been used.  Under SFAS No. 154, a change in reporting entity is also retrospectively applied as of the beginning of the first period presented.  A change in accounting estimate continues to be accounted for in the period of change and future periods if necessary.  The Company is currently assessing the impact of adopting SFAS No. 154 and believes the new standard will not have any material impact on its financial statements.

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Note 3—Net Income Per Share

Basic net income per share is computed by dividing net income available to common stockholders (numerator) by the weighted average number of common shares outstanding (denominator) during the period.  Diluted net income per share is computed using the weighted number of common and potentially dilutive common shares outstanding during the period under the treasury stock method.  In computing diluted net income per share, the average stock price for the period is used in determining the number of shares assumed to be purchased from the exercise of stock options.  A reconciliation of the basic and diluted per share computations for the three months ended October 31, 2005 and October 31, 2004 is as follows (in thousands, except per share data):

Options to purchase 2,305,000 shares of common stock at a weighted average exercise price of $6.37 per share outstanding during the three months ended October 31, 2005 and options to purchase 2,013,000 shares of common stock at a weighted average exercise price of $6.79 per share outstanding during the three months ended October 31, 2004 were not included in the computation of diluted income per share because their option price was greater than the average fair market value for the period.

A reconciliation of the basic and diluted per share computations for the six months ended October 31, 2005 and October 31, 2004 is as follows (in thousands, except per share data):

Options to purchase 2,308,000 shares of common stock at a weighted average exercise price of $6.39 per share outstanding during the six months ended October 31, 2005 and options to purchase 1,488,000 shares of common stock at a weighted average exercise price of $6.96 per share outstanding during the six months ended October 31, 2004 were not included in the computation of diluted income per share because their option price was greater than the average fair market value for the period.

Note 4 — Balance Sheet Components

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The net unrealized gains (losses) as of October 31, 2005 and April 30, 2005 are recorded in accumulated other comprehensive loss, net of related tax of $3,000 and $34,000, respectively.

The financial instruments in short-term investments are highly liquid and can be converted to cash and cash equivalents without restriction and, accordingly, are classified as current assets in the accompanying consolidated balance sheets (in thousands).

The Company did not have any bad debts written off to the allowance for doubtful accounts in the three months or six months ended October 31, 2005 and 2004, respectively.

Note 5—Income Taxes

The provision for income taxes was $449,000, or 32.6% of income before taxes, for the three months ended October 31, 2005.  The provision for income taxes was $216,000, or 17.7% of income before taxes, for the three months ended October 31, 2004. 

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The income tax rate provision for the three months ended October 31, 2004 is lower than the income tax rate provision for the three months ended October 31, 2005 primarily due to expected tax benefits associated with the extension of the federal research credits during the second quarter of fiscal 2005.

The provision for income taxes was $696,000, or 32.9% of income before taxes, for the six months ended October 31, 2005.  The provision for income taxes was $1.5 million, or 32.0% of income before taxes, for the six months ended October 31, 2004.  The income tax rate provision for the six months ended October 31, 2005 is higher than the income tax rate provision for the six months ended October 31, 2004 primarily due to reduced tax benefits associated with federal research credits.  The federal tax law authorizing such credits is set to expire in December 2005.

Note 6—Stockholders’ Equity

Common and Preferred Stock

The Company completed a secondary public offering of its common stock in July 2004.  The Company sold 1,450,000 common shares at $6.00 per share.  Proceeds to the Company, net of underwriting discounts and commissions and related offering expenses of $714,000 were approximately $8.0 million.  In connection with this transaction, Elex N.V., a related party, and other selling stockholders sold 2,850,000 and 300,000 common shares, respectively, at $6.00 per share.  In aggregate, 4,600,000 common shares were sold.

Note 7—Segment Reporting

The Company operates in one business segment, the semiconductor segment.  Sales transactions are denominated in U.S. dollars.

Net revenues by product group were as follows (in thousands):

Net revenues by geography were as follows (in thousands):

For the three months ended October 31, 2005, one customer, Avnet, an international distributor, represented 10% or more of the Company’s net revenues.  For the three months ended October 31, 2004, Memec Electronics, an international distributor, represented 10% or more of the Company’s net revenues.  In July 2005, Avnet acquired Memec Electronics.

For the six months ended October 31, 2005, Avnet, an international distributor, represented 10% or more of the Company’s net revenues.  For the six months ended October 31, 2004, no customer represented 10% or more of the Company’s net revenues.

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Property and equipment, net, geographical breakdown was as follows (in thousands):

Note 8—Commitments and Contingencies

Purchase Commitments

Purchase commitments for open purchase orders at October 31, 2005 for which goods and services had not been received were approximately $3.7 million as compared to approximately $3.9 million at April 30, 2005.

Contingencies

In the normal course of business, the Company periodically receives notification of threats of legal action in relation to claims of patent infringement by the Company.  Currently there are no such active actions.  Although no assurances can be given as to the results of such claims, management does not believe that any such results will have a material adverse impact on the Company’s financial condition, results of operations, or cash flows.

In November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (FIN 45).  The Company applies the disclosure provisions of FIN 45 to its agreements that contain guarantee or indemnification clauses.  FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee.  In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities.  These disclosure provisions expand those required by SFAS No. 5, “Accounting for Contingencies,” by requiring that guarantors disclose certain types of guarantees, even if the likelihood of requiring the guarantor’s performance is remote.  The following is a description of significant arrangements through which the Company is a guarantor:

Indemnification Obligations

The Company is a party to a variety of agreements pursuant to which it may be obligated to indemnify the other party with respect to certain matters.  Typically, these obligations arise in the context of contracts entered into by the Company, under which the Company customarily agrees to hold the other party harmless against losses arising from a breach of representations and covenants related to such matters as title to assets sold and certain intellectual property rights.  Generally, payment by the Company is conditioned on the other party making a claim pursuant to the procedures specified in the particular contract, which procedures typically allow the Company to challenge the other party’s claims.  Further, the Company’s obligations under these agreements may be limited in terms of time and/or amount, and in some instances, the Company may have recourse against third parties for certain payments made by it under these agreements.

It is not possible to predict the maximum potential amount of future payments under these or similar agreements due to the conditional nature of the Company’s obligations and the unique facts and circumstances involved in each particular agreement.  Historically, payments made by the Company under these agreements have not had a material effect on its business, financial condition, cash flows or results of operations.  The Company believes that if it were to incur a loss in any of these matters, such loss should not have a material effect on its business, financial condition, cash flows or results of operations.

Product Warranties

The Company estimates its product warranty costs based on historical warranty claim experience and applies this estimate to the revenue stream for products under warranty.  Included in the Company’s sales returns reserves are estimated return exposures associated with product warranties.  Estimated future costs for warranties applicable to revenues recognized in the current period are charged to the Company’s cost of revenues.  The warranty accrual is reviewed

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quarterly to verify that it properly reflects the remaining obligations based on the anticipated expenditures over the balance of the obligation period.  Adjustments are made when actual claim experience differs from estimates.  Warranty costs were less than $25,000 for the three months ended October 31, 2005 and 2004 and less than $50,000 for the six months ended October 31, 2005 and 2004.

Note 9—Related Party Transactions

Elex N.V.

During the fourth quarter of fiscal 2000, the Company began taking delivery of wafers fabricated at X-FAB Texas, Inc. (“X-FAB”) a wholly owned subsidiary of Elex N.V. (“Elex”), a Belgian holding company.  Roland Duchâtelet, the Chairman and Chief Executive Officer of Elex, serves as a member of the Company’s Board of Directors.  Elex initially became a related party in 1998 through the purchase of 5.5 million restricted shares of the Company’s common stock.  The wafers provided by X-FAB include most of the Company’s analog/mixed-signal products and supplement some of the same EEPROM designs fabricated at various other foundries the Company utilizes.  Other than purchase orders currently open with X-FAB, there is no purchasing agreement in place with X-FAB.

During the six months ended October 31, 2005 and 2004, the Company purchased $1.0 million and $870,000 of wafers, respectively, from X-FAB.  As of October 31, 2005 and April 30, 2005, the total amount owed X-FAB by the Company was $37,000 and $314,000, respectively.  In the first quarter of fiscal 2005, Elex reduced its holdings from 3,578,700 shares, or 21.8% of the outstanding shares of the Company as of April 30, 2004, to 728,700 shares, or 4.4% of the outstanding shares of the Company as of October 31, 2005.

Note 10—Other Comprehensive Income

The components of other comprehensive income, net of tax, are presented in the following table (in thousands):

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

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 which involve risks and uncertainties.  Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors that include, but are not limited to, the risks discussed in “Factors Affecting Future Results.”  These forward-looking statements include, but are not limited to: the statements relating to downward pricing trends; the statements relating to the increasing portion of our net revenues from analog/mixed-signal products; the statements relating to the sufficiency of our cash resources and cash flows to fund our operating and capital requirements and the risks associated with seeking additional financing; and the statements relating to our efforts to increase our die supply and decrease our unit costs, and the statements regarding our future sales outside the United States, among others.  These forward-looking statements are based on current expectations and entail various risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Such risks and uncertainties are set forth below under “Factors Affecting Future Operating Results.”

Overview

We design, develop and market a broad line of reprogrammable non-volatile memory products and analog/mixed-signal products.  Our products are used by manufacturers of electronic products in a wide range of consumer, computing, communications, industrial and automotive applications.  We generally target high volume markets for our cost effective, high quality products.  We have been a committed long-term supplier of memory products including through periods of tight manufacturing capacity and cyclical market downturns.

The market for our non-volatile memory is highly competitive and market participants have relatively weak pricing power.  Average selling prices of our non-volatile memory products have declined over time and prices are sensitive to conditions in our OEM customers’ target markets. For example, in fiscal 2005 and continuing into fiscal 2006, we experienced a downward trend in average selling prices for our non-volatile memory products due to market competition, product availability and manufacturing capacity.  In response to that trend, we are working with our major foundry to migrate the majority of our memory products from 0.8 micron geometries to 0.35 micron geometries in order to increase our die supply and decrease our per unit costs.

We are leveraging our extensive experience in high volume, reprogrammable memory products to develop complementary analog/mixed-signal products that offer our customers a more complete system solution.  In fiscal 2003, we strengthened and expanded the expertise of our research and development team by establishing our own development center in Bucharest, Romania and by hiring additional engineers in Bucharest, Romania.  In fiscal 2005, we purchased a new building in Bucharest for our Romanian product development team.  We continue to make substantial investments in research and development to advance our non-volatile memory products, as well as develop broader solutions with our line of analog/mixed-signal products.

Sales of our analog/mixed-signal products continue to trend upwards, reaching 7.3% of net revenues in the six months ended October 31, 2005 as compared to 4.1% of net revenues in the similar period in the prior year.  We expect net revenues from analog/mixed-signal products to increase in the future.

Our business is less capital intensive than traditional semiconductor companies since we outsource to third parties the manufacturing, assembling and most of the testing of our products.  We strive to maintain long-term relationships with our suppliers to ensure stability in our supply of products at a competitive cost.  Additionally, in an effort to alleviate any potential wafer capacity constraints, we maintain a supply of wafers in a die bank for selected products.

We market and sell our products directly through our sales force and sales representatives to OEMs and indirectly through distributors and resellers who sell to their end customers.  Indirect sales were a majority of our total sales in fiscal 2005 though the second quarter of fiscal 2006.  Our total customer base, including OEMs and end-customers of our distributors and resellers, is relatively diverse and during fiscal 2005 consisted of more than 4,000 customers.  We have approximately 39 active distributors and resellers.

In the six months ended October 31, 2005, one customer accounted for more than ten percent of our net revenues.

Our sales are initiated by purchase orders received from our customers and are typically shipped within a few weeks of receiving the order.  Since industry practice allows customers to reschedule or cancel orders on relatively short notice, we

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do not use backlog to forecast our future net revenues.  Cancellations of customer orders, distributor price protection and distributor stock rotation rights, all industry standards, could result in the loss of future net revenues without allowing us sufficient time to reduce our inventory and operating expenses.

Sales to customers outside the United States comprised the vast majority of our net revenues in recent periods.  This increasing non-United States growth in net revenues was consistent with the trend towards outsourcing of the manufacturing process, particularly to companies who manufacture in Asia.  Substantially all sales of our products are denominated in U.S. dollars, minimizing the effects of currency fluctuations.

Description of Operating Accounts

Net Revenues.  Net revenues consist of product sales, net of returns and allowances.

Gross Profit.  Gross profit is net revenues less cost of revenues and is affected by a number of factors, including competitive pricing, product mix, foundry pricing, the cost of test and assembly services and manufacturing yields.  Cost of revenues consists primarily of costs of manufacturing, assembly and testing of our products as well as compensation and associated costs related to manufacturing support, inbound freight shipments and quality assurance personnel.  It also can include, on occasion, adjustments to inventory valuations based on demand and average selling prices expected in future periods.

Research and Development.  Research and development expense consists primarily of compensation and associated costs for engineering, technical and support personnel, contract engineering services, depreciation of equipment and cost of wafers and mask sets used to evaluate new products and new versions of current products.

Selling, General and Administrative.  Selling, general and administrative expense consists primarily of compensation and associated costs for sales, marketing and administrative personnel, commissions, promotional activities, outbound freight shipments, professional fees and director and officer insurance.

Critical Accounting Estimates

The preparation of our condensed consolidated financial statements and related disclosures in conformity with generally accepted accounting principles in the United States requires us to make estimates and judgments that affect the amounts reported in our financial statements and accompanying notes.  We evaluate our estimates and judgments based on historical experience and apply them on a consistent basis.  We believe that such consistent application results in financial statements and accompanying notes that fairly represent our financial condition, operating results and cash flows for all periods presented.  However, any factual errors or errors in these estimates and judgments may have a material impact on our financial conditions, operating results and cash flows.

Recognition of Revenues

We generally recognize revenues as products are shipped if all of the following criteria are met:

•                       we have evidence that a sales arrangement exists;

•                       our customer has taken title to the products;

•                       we have performed the services, if any;

•                       the sales price is fixed or determinable;

•                       we believe that collection of the resulting receivable is reasonably assured; and

•                       we can reasonably estimate product returns.

We sell our products directly through our sales force and sales representatives to OEMs and indirectly through distributors and resellers who sell to their end customers.  We recognize revenues upon delivery to OEM customers and resellers who have no product return rights and no price protection rights.  We deem that delivery occurs when legal title and the risk of loss transfers to the customer.  Delivery is generally defined by the customers’ shipping terms, as stated in the related purchase order.  If the customers’ purchase orders do not define the shipping terms, the shipping terms will be

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Ex-Works as defined in our invoice.  We record an estimated allowance for returns from OEM customers and resellers, based on a percentage of our revenues.  This estimate is based on historical averages.

We sell to some of our distributors under agreements which provide for product return and price protection rights.  These agreements generally permit the distributor to return up to 10% by value of the total products that the distributor has purchased from us in specified six-month periods.  We defer recognition of revenues until such time as the distributor resells the product to their end customer, at which time the sales price becomes fixed.  On a monthly basis, we receive point of sales and ending inventory information from each distributor.  Using this information, we determine the amount of revenues to recognize.  For distributors who have product return rights, we also record an inventory reserve to address the cost of products we anticipate that we will not be able to resell after their return by the distributors.  For distributors who have price protection rights, distributors may take the associated credits immediately and in general, we process the credits one or two months after the credit is taken by the distributor.  We record a reserve to cover the estimated liability of those unprocessed credits.  We re-evaluate our revenue recognition policies periodically and no less often than annually.

We defer the recognition of revenue for certain resellers who have no product return rights and no price protection rights.  In accordance with our policy, we will generally defer the recognition of revenue for certain resellers based on their high dollar volume of purchases.

Inventory Valuation

We value our inventory 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 the value and quantities of our inventory in light of the current market conditions and market trends and we record reserves for quantities in excess of demand, cost in excess of market value and product age.  Our analysis may take into consideration historical usage, expected demand, anticipated sales price, new product development schedules, the effect new products might have on the sales of existing products, product age, customer design activity, customer concentration and other factors.  Our forecasts for our inventory may differ from actual inventory use and the time we have held finished goods in inventory.  The lives of our products are usually long and obsolescence has not been a significant factor historically in the valuation of our inventories.

We reduce the value of our inventory by analyzing on-hand quantities and open purchase orders which are in excess of demand equal to the cost of inventory that exceeds expected demand for approximately the next 12 to 15 months.  We make judgments in establishing these reserves and do not establish reserves if we believe we can sell the excess inventory.  If market conditions are less favorable than those we estimate, we may be required to write down inventory.  If we overestimate the future selling prices, we will incur additional losses when the inventory is sold for a lower price or when we establish additional write downs to cover the even lower estimated sales price.  Once written down, we establish a new cost basis and accordingly we do not reverse inventory provisions until the associated inventory has been sold or physically scrapped.

Allowance for Doubtful Accounts

We estimate the collectibility of our accounts receivable at the end of each reporting period.  We analyze the aging of accounts receivable and bad debt history, payment history, customer concentration, customer credit worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts.  We maintain an allowance for doubtful accounts, which is created by charges to selling, general and administrative expense.  Our accounts receivable balance was $12.3 million, net of allowance for doubtful accounts of $138,000, as of October 31, 2005.

Income Taxes

As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate.  This process involves estimating our current tax exposure and assessing temporary differences resulting from differing treatment of items, such as deferred revenues, for tax and accounting purposes.  These differences result in deferred tax assets and liabilities, which are included on our balance sheet on a net basis.  We then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we establish a valuation allowance or increase this allowance in a period, we will include an additional tax provision in the statement of income.

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We reassess and may adjust the estimated tax rate quarterly.  We apply the current tax rate to our year-to-date income and our tax provision and related accrual is adjusted accordingly.  Our effective income tax rate was 32.9% and 32.0% for the six months ended October 31, 2005 and 2004, respectively.

We make significant judgments in determining our provision for income taxes, our deferred tax assets and any valuation allowance recorded against our net deferred tax asset.  As of October 31, 2005, our gross deferred tax assets, consisting primarily of net operating loss carryforwards, tax credit carryforwards and nondeductible reserves and accruals, were valued at $8.3 million and our valuation allowance was zero.

We have concluded that all of our deferred tax assets will be realizable, based on available objective evidence and our history of income before taxes.

Results of Operations

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

Comparison of the three months ended October 31, 2005 and October 31, 2004

The following table sets forth net revenues (in thousands) and percentage of net revenues by product group:

Net Revenues.  Our net revenues increased approximately $1.3 million, or 8.5%, to $16.9 million for the three months ended October 31, 2005 from $15.6 million for three months ended October 31, 2004.  The increase in net revenues was primarily due to improved market demand resulting in an increase in unit volume sold to end customers in both the EEPROM and analog/mixed-signal product groups.

Sales to customers outside the United States represented approximately 88.5% of net revenues for the three months ended October 31, 2005 as compared to 87.1% of net revenues for the three months ended October 31, 2004.

Gross Profit.  Gross profit increased $78,000, or 1.2%, to $6.4 million for the three months ended October 31, 2005 from $6.4 million for three months ended October 31, 2004.  The increase in gross profit was primarily due to improved market demand resulting in increase in overall unit volume of 24.3% and improved factory throughput, market demand and overall unit volume resulting in increased absorption of operational expenses for the three months ended October 31, 2005.  This increase was offset by declining overall average selling prices due to increasing market competition and product mix.  The benefit from sales of previously reserved inventory was $73,000 for the three months ended October 31, 2005 and $333,000 for the three months ended October 31, 2004.  The provision for excess and obsolete inventory was $239,000 the three months ended October 31, 2005 and $366,000 for the three months ended October 31, 2004.  The net impact of these

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inventory provisions was a decrease in gross profit of $166,000 for the three months ended October 31, 2005 and a decrease in gross profit of $33,000 for the three months ended October 31, 2004.

Research and Development.  Research and development expense increased $44,000, or 2.3%, to $2.0 million for the three months ended October 31, 2005 from $1.9 million for the three months ended October 31, 2004.  The increase in research and development expense was primarily attributable to a $32,000 increase in personnel-related expenses.

Selling, General and Administrative.  Selling, general and administrative expense decreased $40,000, or 1.2%, to $3.4 million for the three months ended October 31, 2005 from $3.4 million for the three months ended October 31, 2004.  The decrease was primarily attributable to a $140,000 decrease in employee incentive compensation and $85,000 decrease in fees paid primarily to consultants and accountants related to compliance with Section 404 of the Sarbanes-Oxley Act of 2002.  These decreases were offset by a $103,000 increase in freight costs to end customers, a $69,000 increase in commission expense as a result of higher net revenue and a $34,000 increase in depreciation expense associated with the implementation of our enterprise resource planning, or ERP, system in late fiscal 2005.

Net Interest Income and Other.  We earned net interest income of $266,000 for the three months ended October 31, 2005 compared to net interest income of $184,000 for the three months ended October 31, 2004.  Our rate of return on our average balance of cash, cash equivalents and short-term investments was approximately 3.2% for the three months ended October 31, 2005 and approximately 1.6% for the three months ended October 31, 2004. The increase in net interest income was primarily attributable to the higher rates of return.

Income Tax Provision.  The provision for income taxes was $449,000, or 32.6% of income before taxes, for the three months ended October 31, 2005.  The provision for income taxes was $216,000, or 17.7% of income before taxes, for the three months ended October 31, 2004.  The income tax rate provision for the three months ended October 31, 2004 is lower than the income tax rate provision for the three months ended October 31, 2005 primarily due to tax benefits associated with the extension of the federal research credits during the second quarter of fiscal 2005.

Comparison of the six months ended October 31, 2005 and October 31, 2004

The following table sets forth net revenues (in thousands) and percentage of net revenues by product group: