Pixelworks - 10-Q quarterly report FY

 

 

(Exact name of registrant as specified in its charter)

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

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

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

Number of shares of Common Stock outstanding as of October 31, 2005: 47,087,600

 

See accompanying notes to condensed consolidated financial statements.

See accompanying notes to condensed consolidated financial statements.

See accompanying notes to condensed consolidated financial statements.

Pixelworks, Inc. (“Pixelworks” or the “Company”) is a leading designer, developer and marketer of semiconductors and software for use in electronic display devices and equipment for encoding and decoding streaming digital video. Our system-on-chip semiconductors provide the ‘intelligence’ for these types of applications by processing and optimizing video and computer graphic signals to produce high quality images.

These condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) have been condensed or omitted pursuant to such regulations, although we believe that the disclosures provided are adequate to prevent the information presented from being misleading.

The financial information included herein for the three and nine months ended September 30, 2005 and 2004 is unaudited; however, such information reflects all adjustments, consisting only of normal recurring adjustments, that are, in the opinion of management, necessary for a fair presentation of the consolidated financial position, consolidated results of operations and consolidated cash flows of the Company for these interim periods. The financial information as of December 31, 2004 is derived from our audited consolidated financial statements and notes thereto for the fiscal year ended December 31, 2004, included in Item 8 of our Annual Report on Form 10-K, and should be read in conjunction with such consolidated financial statements.

The results of operations for the three and nine months ended September 30, 2005 are not necessarily indicative of the results expected for the entire fiscal year ending December 31, 2005.

The preparation of consolidated financial statements in conformity with GAAP requires us to make estimates and judgments that affect the amounts reported in the financial statements and accompanying notes. Our significant estimates and judgments include those related to product returns, warranty obligations, bad debts, inventory valuation, property and equipment, intangible assets and income taxes. The actual results experienced by the Company could differ materially from our estimates.

Certain reclassifications have been made to the 2004 condensed consolidated financial statements to conform to the 2005 presentation, including the reclassification of investments in auction rate securities from cash and cash equivalents to available-for-sale short-term marketable securities and the reclassification of tooling depreciation from research and development expense to cost of revenue. Additionally, facilities and information technology expenses have been allocated between selling, general and administrative expense, research and development expense and cost of revenue based on employee headcount.

We have a 1997 Stock Incentive Plan and a 2001 Nonqualified Stock Option Plan under which employees, officers and directors may be granted stock options to purchase shares of the Company’s common stock. We also have a 2000 Employee Stock Purchase Plan under which eligible employees may purchase shares of Pixelworks’ common stock at 85% of fair market value at specific, pre-determined dates.

As permitted by Statement of Financial Accounting Standards No. (“SFAS”) 123, Accounting for Stock-Based Compensation (“SFAS 123”), and SFAS 148, Accounting for Stock-Based Compensation – Transition and Disclosure, an Amendment of FASB Statement No. 123, we continue to apply the intrinsic value based method of accounting for stock compensation described in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“Opinion 25”). As such, stock-based compensation cost is measured as the excess, if any, of the quoted market price of Pixelworks’ stock on the grant, or other measurement date, over the amount that an option holder must pay to acquire the stock.

Entities electing to continue to apply Opinion 25 must make prominent pro-forma disclosure of net income and earnings per share as if the fair value based method prescribed by SFAS 123 had been applied. Had we accounted for our stock-based compensation plans in accordance with SFAS 123, our net income (loss) would have approximated the pro-forma amounts below:

The fair value of stock-based compensation costs reflected in the above pro-forma amounts were determined using the Black-Scholes option pricing model and the following weighted average assumptions:

The effects of applying SFAS 123 in this pro-forma disclosure are not indicative of future amounts and additional awards are anticipated in future periods.

At December 31, 2004, we classified all marketable securities as held-to-maturity in accordance with SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, with the exception of auction rate securities and our investment in Semiconductor Manufacturing International Corporation (“SMIC”), which we classified as available-for-sale.

On March 31, 2005, we determined that we no longer had the intent to hold any of our securities to maturity based on the potential for future acquisitions, and we reclassified all of our held-to-maturity securities to available-for-sale. The amortized cost of the securities transferred from held-to-maturity to available-for-sale was $159,632 on the March 31, 2005 transfer date.

Short-term marketable securities were classified as follows:

Long-term marketable securities were classified as follows:

Unrealized holding losses on short-term available-for-sale marketable securities, net of tax, were $72 at September 30, 2005. Unrealized holding losses on long-term available-for-sale marketable securities, net of tax, were $885 at September 30, 2005. These unrealized holding losses are recorded in accumulated other comprehensive income, a component of shareholders’ equity, at September 30, 2005.

There were no unrealized holding gains or losses on available-for-sale auction rate securities at December 31, 2004, and the unrealized holding gain on our investment in SMIC at December 31, 2004, net of tax, was $531. This unrealized holding gain was recorded in accumulated other comprehensive income at December 31, 2004.

Gross unrealized holding losses on short-term held-to-maturity marketable securities were $48 at December 31, 2004, and gross unrealized losses on long-term held-to-maturity marketable securities were $68 at December 31, 2004.

Accounts receivable are recorded at invoiced amount and do not bear interest when recorded or accrue interest when past due. We do not have any off balance sheet exposure risk related to customers. Accounts receivable are stated net of an allowance for doubtful accounts, which is maintained for estimated losses that may result from the inability of our customers to make required payments. Accounts receivable, net consists of the following:

Inventories consist of finished goods and work-in-process, and are stated at the lower of standard cost (which approximates actual cost on a first-in, first-out basis) or market (net realizable value), net of a reserve for slow moving and obsolete items. Inventories, net consists of the following:

The following is a summary of the change in our reserve for slow moving and obsolete items:

While we do not currently expect to be able to sell or otherwise use the reserved inventory we have on hand at September 30, 2005 based upon our forecast and backlog, it is possible that a customer will decide in the future to purchase a portion of the reserved inventory. It is not currently possible to predict if or when this will happen, or how much we may sell.

Property and equipment, net consists of the following:

Acquired intangible assets, net consists of the following:

Accrued liabilities and current portion of long-term liabilities consists of the following:

The following is a summary of the change in our reserve for sales returns and allowances:

The following is a summary of the change in our reserve for warranty returns:

On May 18, 2004, we issued $125,000 of convertible subordinated debentures (the “debentures”) due 2024 in a private offering pursuant to Rule 144A under the Securities Act of 1933 and outside of the United States in accordance with Regulation S under the Securities Act. On June 4, 2004, we issued an additional $25,000 of debentures pursuant to the exercise of an option granted to the initial purchasers.

The debentures bear interest at a rate of 1.75% per annum and interest is payable on May 15 and November 15 of each year, beginning November 15, 2004. The debentures are convertible, under certain circumstances, into our common stock at a conversion rate of 41.0627 shares of common stock per $1,000 principal amount of debentures for a total of 6,159 shares. This is equivalent to a conversion price of approximately $24.35 per share. The debentures are convertible if (a) during any calendar quarter, the market price of our common stock exceeds 130% of the conversion price per share for at least 20 trading days during the period of 30 consecutive trading days ending on the last trading day of the previous calendar quarter, (b) the trading price of the debentures declines to less than 98% of the product of the closing sale price of our common stock and the number of shares issuable upon conversion of $1,000 principal amount of the debentures for five consecutive trading days, (c) a call for redemption occurs, or (d) in the event of certain other corporate transactions. We may redeem some or all of the debentures for cash on or after May 15, 2011 at a price equal to 100% of the principal amount of the debentures plus accrued and unpaid interest. The holders of the debentures have the right to require us to purchase all or a portion of their debentures on May 15, 2011, May 15, 2014 and May 15, 2019, at a price equal to 100% of the principal amount plus accrued and unpaid interest.

We have filed a shelf registration statement with the Securities and Exchange Commission covering resales of the debentures and the common stock issuable upon conversion of the debentures. The registration statement was declared effective August 24, 2004. The debentures are unsecured obligations and are subordinated in right of payment to all our existing and future senior debt.

Total comprehensive income (loss) was as follows:

We calculate earnings per share in accordance with SFAS 128, Earnings per Share. Basic earnings per share amounts are computed based on the weighted average number of common shares outstanding, and includes exchangeable shares. These exchangeable shares, which were issued on September 6, 2002 by Jaldi, our Canadian subsidiary, to its shareholders in connection with the Jaldi asset acquisition, have characteristics essentially equivalent to Pixelworks’ common stock.

Diluted weighted average shares outstanding includes the increased number of common shares that would be outstanding assuming the exercise of certain stock options and the vesting of certain restricted stock, when such exercise or vesting would have the effect of reducing earnings per share. In the fourth quarter of 2004, we adopted Emerging Issues Task Force Issue No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share. As a result, diluted weighted average shares outstanding also includes the increased number of common shares that would be outstanding assuming the conversion of our convertible debentures, using the if-converted method, when such conversion would have the effect of reducing earnings per share.

The following schedule reconciles basic and diluted weighted average shares outstanding for the periods presented:

The following schedule reconciles net income (loss) used in the calculation of basic net income (loss) per share to net income (loss) used in the calculation of diluted net income (loss) per share for the periods presented:

Because of our net loss position for the three and nine months ended September 30, 2005, incremental shares related to stock options of 1,156 and 907, respectively, are excluded from diluted weighted average shares outstanding.

For the three and nine months ended September 30, 2005, weighted average shares related to stock options of 6,858 and 5,811, respectively, were excluded from the calculation of diluted weighted average shares outstanding because the exercise prices of these options were equal to or greater than the average market price of Pixelworks’ common stock during the respective periods, and as a result, their inclusion would have been anti-dilutive. For the three and nine months ended September 30, 2004, weighted average shares related to stock options of 3,941 and 2,039, respectively, were excluded for this reason.

In accordance with SFAS 131, Disclosures about Segments of an Enterprise and Related Information, we have identified a single operating segment: the design and development of integrated circuits for use in electronic display devices and equipment for encoding and decoding streaming digital video. Substantially all of our assets are located in the United States.

Revenue by geographic region, attributed to countries based on the domicile of the bill-to customer, was as follows:

Sales to distributors represented 38% and 70% of total revenue for the three months ended September 30, 2005 and 2004, respectively, and 48% and 71% of total revenue for the nine months ended September 30, 2005 and 2004, respectively. The following distributors accounted for 10% or more of total revenue:

Effective February 4, 2005, we terminated our distributor relationship with Neoview, located in Taiwan. We now sell our products directly to Taiwanese customers previously served by Neoview, as well as through our other Taiwanese distributors.

End customers include customers who purchase directly from us, as well as customers who purchase our products indirectly through distributors and contract manufacturers. Sales to our top five end customers represented 34% and 42% of total revenue for the three months ended September 30, 2005 and 2004, respectively, and 34% of total revenue for the nine months ended September 30, 2005 and 2004.

One end customer represented 12% and 11% of total revenue for the three months ended September 30, 2005 and 2004, respectively. A second end customer represented 6% and 15% of total revenue for the three months ended September 30, 2005 and 2004, respectively. No end customer accounted for more than 10% of total revenue for the nine months ended September 30, 2005 and 2004.

The following accounts represented 10% or more of gross accounts receivable:

We do not own or operate a semiconductor fabrication facility and do not have the resources to manufacture our products internally. We rely on four third-party foundries to produce all of our products and we do not have any long-term agreements with any of these suppliers. In light of these dependencies, it is reasonably possible that failure to perform by one of these suppliers could have a severe impact on our results of operations.

The markets in which we compete or seek to compete are subject to rapid technological change, frequent new product introductions, changing customer requirements for new products and features and evolving industry standards. The introduction of new technologies and the emergence of new industry standards could render our products less desirable or obsolete, which could harm our business.

Financial instruments that potentially subject us to concentrations of credit risk consist of cash equivalents, short and long-term marketable securities and accounts receivable. We limit our exposure to credit risk associated with cash equivalent and marketable security balances by placing our funds in various high quality securities and limiting concentrations of issuers and maturity dates. We limit our exposure to credit risk associated with accounts receivable by carefully evaluating creditworthiness before offering terms to customers.

Certain of our agreements include limited indemnification provisions for claims from third parties relating to our intellectual property. Such indemnification provisions are accounted for in accordance with SFAS 5, Accounting for Contingencies. The indemnification is limited to the amount paid by the customer. As of September 30, 2005, we have not incurred any material liabilities arising from these indemnification obligations, however in the future, such obligations could immediately impact our results of operations but would not materially affect our business.

On June 14, 2005, the Company acquired 100% of the outstanding shares of Equator Technologies, Inc. (“Equator”). Equator is at the forefront of delivering programmable advanced video compression technology with system-on-chip integrated circuits and software solutions that unlock broadband networks for video entertainment and communications. This acquisition will provide programmable technologies to Pixelworks customers in order to create a new generation of digital televisions, including those that might integrate Internet Protocol television decoding technology to allow viewing of digital video directly over the Internet. The results of Equator’s operations have been included in our consolidated statement of operations beginning on the date of acquisition.

The aggregate purchase price for Equator was $118,091, which consisted of cash of $107,854, the value of 1,263 options exchanged of $8,336, plus acquisition costs of $1,901. The estimated fair value of the options exchanged was calculated using the Black-Scholes option pricing model with the average closing price of Pixelworks’ common stock for two days prior to the announcement of the Agreement and Plan of Merger, the day of the announcement, and two days following the announcement ($7.62 per share) and following weighted average assumptions: risk-free interest rate of 2.55%, an expected dividend yield of 0%, an expected life of 1.2 years, and volatility of 59%.

     The purchase price was allocated to the assets and liabilities based on fair values as follows:

In connection with this acquisition, we performed a valuation of acquired intangible assets. We assigned $36,800 of the purchase price to acquired developed technology with a five year estimated life, $3,400 to customer relationships with a three year estimated life, and $800 to backlog and trademark with estimated lives of one year or less. In-process research and development was considered in our analysis of the Equator intangible assets; however, it was determined to have no value since the technologies were determined to be too early in the research and development stages.

We also recorded gross deferred tax assets of approximately $63,687, subject to a valuation allowance of $43,372, and deferred tax liabilities of $17,000 to recognize book basis and tax basis differences of various balance sheet assets and liabilities and corporate tax attributes acquired. If the valuation allowance is subsequently changed, the amount of the adjustment may affect net income or goodwill depending on the nature of the adjustment in the period such change is made.

The goodwill resulting from this transaction was assigned to Pixelworks, Inc., our sole reporting unit.

In addition to the $107,854 cash consideration included in the purchase price we paid $2,518 in cash, which was classified as contingent consideration on the acquisition date. The Equator shareholders will receive disbursement of the contingent consideration if certain revenue targets are achieved by March 31, 2006. If the target is not fully achieved by March 31, 2006, we will receive a refund of a portion of the contingent consideration. During the quarter ended September 30, 2005, $558 of the contingent consideration was earned by the shareholders. At September 30, 2005, the remaining $1,960 of contingent consideration is included in prepaid expenses and other current assets in the condensed consolidated balance sheet.

The purchase price allocation is substantially complete. Certain elements, such as the filing of pre-acquisition tax returns, may impact the final purchase price allocation. During the quarter ended September 30, 2005, we reclassified $18,862 from net deferred tax assets to goodwill due to the completion of an analysis of recoverability of acquired deferred tax assets and related limitations. Although we do not anticipate significant revisions to the purchase price allocation, material adjustments could occur.

The following table reflects the unaudited combined results of Pixelworks and Equator as if the merger had taken place as of January 1, 2004. For the three and nine months ended September 30, 2004, weighted average shares related to convertible subordinated debentures of 6,159 and 2,971, respectively, were excluded from the calculation of diluted weighted average shares outstanding because their inclusion would have been anti-dilutive.

The adjustment to mark-up inventory to fair value of $5,190 is not included in cost of revenue in the pro forma results of operations for the nine months ended September 30, 2004 as it is not reflective of the ongoing operations of the combined entities. The pro-forma information does not necessarily reflect the actual results that would have occurred, nor is it necessarily indicative of future results of operations of the combined companies.

During October 2005, we initiated a restructuring of our workforce which resulted in the elimination of 36 positions. We expect to incur approximately $1,000 in severance expenses in the fourth quarter of 2005 as a result of this restructuring. In the future, we expect to incur costs to move employees from two separate facilities in California into one facility. This restructuring is intended to improve the efficiency and effectiveness of our product development efforts.

This Management’s Discussion and Analysis of Financial Condition and Results of Operations and other sections of this Report contain “forward-looking statements” within the meaning of the Securities Litigation Reform Act of 1995 that are based on current expectations, estimates, beliefs, assumptions and projections about our business. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks and uncertainties that are difficult to predict. Actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements due to numerous factors. Such factors include, but are not limited to, increased competition, adverse business conditions, failure to design, develop and manufacture new products, lack of success in technological advancements, lack of acceptance of new products, the timing of orders for our products, unexpected changes in the demand for our products and services, the inability to successfully manage inventory pricing pressures, failure to reduce costs or improve operating efficiencies, changes to and compliance with international laws and regulations, currency fluctuations and our ability to attract, hire and retain key and qualified employees. These forward-looking statements speak only as of the date on which they are made, and we do not undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date of this Quarterly Report on Form 10-Q. If we do update or correct one or more forward-looking statements, you should not conclude that we will make additional updates or corrections with respect thereto or with respect to other forward-looking statements.

(Dollars in thousands)

We are a leading designer, developer and marketer of semiconductors and software for use in electronic display devices and equipment for encoding and decoding streaming digital video. Our system-on-chip semiconductors provide the ‘intelligence’ for these types of applications by processing and optimizing video and computer graphic signals to produce high-quality images. Many of the world’s leading manufacturers of consumer electronics and computer display products utilize our technology to enhance image quality and ease of use of their products. Our goal is to provide all of the electronics necessary to process the entire signal path in order to provide a turn-key solution for our customers.

On June 14, 2005, we acquired 100% of the outstanding shares of Equator Technologies, Inc. (“Equator”). Equator is at the forefront of delivering programmable advanced video compression technology with system-on-chip integrated circuits and software solutions that unlock broadband networks for video entertainment and communications. This acquisition will provide programmable technologies to Pixelworks customers in order to create a new generation of digital televisions, including those that might integrate Internet Protocol television decoding technology to allow viewing of digital video directly over the Internet. The results of operations of Equator are included in our financial statements beginning on June 14, 2005.

We sell our products worldwide through a direct sales force and indirectly through distributors and manufacturers’ representatives. Manufacturers’ representatives support some of our European and Asian sales. We sell to distributors in Japan, Taiwan, China and Europe. Sales to distributors represented 48% and 71% of total revenue for the nine months ended September 30, 2005 and 2004, respectively, and 38% and 70% of total revenue for the three months ended September 30, 2005 and 2004, respectively. Effective February 4, 2005, we terminated our distributor relationship with Neoview, one of our Taiwanese distributors. We now sell our products directly to Taiwanese customers previously served by Neoview, as well as through our other Taiwanese distributors. The termination of this relationship led to the decrease in sales to distributors during the three and nine months ended September 30, 2005, compared to the three and nine months ended September 30, 2004.

Historically, significant portions of our revenue have been generated by sales to a relatively small number of end customers and distributors. Sales to our top five end customers represented 34% and 42% of total revenue for the three months ended September 30, 2005 and 2004, respectively, and 34% of revenue for the nine months ended September 30, 2005 and 2004. During the three months ended September 30, 2005, there was one end customer that accounted for more than 10% of total revenue. There were no end customers that accounted for 10% or more of total revenue during the nine months ended September 30, 2005. There were two end customers that represented more than 10% of total revenue during the three months ended September 30, 2004 and no end customer represented more than 10% of total revenue during the nine months ended September 30, 2004. End customers include customers who purchase directly from us, as well as customers who purchase our products indirectly through distributors and contract manufacturers.

Significant portions of our products are sold overseas. Sales outside the U.S. accounted for approximately 91% and 96% of total revenue for the three and nine months ended September 30, 2005, respectively, and 99% of total revenue for the three and nine months ended September 30, 2004. Our integrators, branded manufacturers and branded suppliers incorporate our products into systems that are sold worldwide. All revenue to date has been denominated in U.S. dollars.

Our discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The preparation of financial statements in conformity with GAAP requires us to make estimates and judgments that affect the amounts reported in the financial statements and accompanying notes. On an ongoing basis, we evaluate our estimates, including those related to product returns, warranty obligations, inventories, property and equipment, intangible assets and income taxes. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect the more significant judgments and estimates we use in preparing our consolidated financial statements:

Revenue Recognition. We recognize revenue in accordance with Staff Accounting Bulletin No. 104,Revenue Recognition. Accordingly, revenue is recognized when an authorized purchase order has been received, the sales price is fixed and determinable, title and risk of loss have transferred, collection of the resulting receivable is probable and product returns are reasonably estimable. This generally occurs upon shipment of the underlying merchandise.

Sales Returns and Allowances. Our customers do not have a stated right to return product other than under our warranty policy discussed below. As such, customer returns are accepted on a case-by-case basis as customer accommodations only. However, certain of our distributors have stock rotation provisions in their distributor agreements, which allow them to return 5-10% of the products purchased in the prior six months in exchange for products of equal value. Certain distributors also have price protection provisions in their agreements with us.

We record estimated reductions to gross profit for these sales returns and allowances in our reserve for sales returns and allowances. We update the balance in this reserve at each reporting period based on historical experience. If actual returns and allowances increase, we may be required to recognize additional reductions to gross profit.

Product Warranties. We warrant that our products will be free from defects in materials and workmanship for a period of twelve months from delivery. Warranty repairs are guaranteed for the remainder of the original warranty period. Our warranty is limited to repairing or replacing products, or refunding the purchase price.

We provide for the estimated cost of product warranties in our warranty reserve. We update the balance in this reserve based on historical experience at each reporting period. While we engage in extensive product quality programs and processes, which include actively monitoring and evaluating the quality of our suppliers, should actual product failure rates or product replacement costs differ from our estimates, revisions to the estimated warranty liability may be required.

Allowance for Doubtful Accounts. We offer credit to customers after careful examination of their creditworthiness. We maintain an allowance for doubtful accounts for estimated losses that may result from the inability of our customers to make required payments. We evaluate the balance in the allowance based on historical experience and the age of outstanding receivables at each reporting period. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Inventory Valuation. We record a reserve against our inventory for estimated obsolete, unmarketable, and otherwise impaired products by calculating the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. We review our inventory at the end of each reporting period for valuation issues. If actual market conditions are less favorable than those we projected at the time the reserve was recorded, additional inventory reserves may be required.

Useful Lives and Recoverability of Equipment and Other Long-Lived Assets. In accordance with Statement of Financial Accounting Standards No. (“SFAS”) 144, Accounting for the Impairment or Disposal of Long-Lived Assets, we evaluate the remaining useful life and recoverability of equipment and other assets, including identifiable intangible assets with definite lives, whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. If there is an indicator of impairment, we prepare an estimate of future, undiscounted cash flows expected to result from the use of each asset and its eventual disposition. If these cash flows are less than the carrying value of the asset, we adjust the carrying amount of the asset to its estimated fair value.

Goodwill. Goodwill represents the excess cost over the fair value of net assets acquired in business combinations. Goodwill is not amortized, instead we test goodwill annually for impairment, and more frequently if events and circumstances indicate that it might be impaired. The impairment tests are performed in accordance with SFAS 142, Goodwill and Other Intangible Assets. Accordingly, an impairment loss is recognized to the extent that the carrying amount of goodwill exceeds its implied fair value. This determination is made at the reporting unit level. We have assigned all goodwill to a single, enterprise-level reporting unit. The impairment test consists of two steps. First, we determine the fair value of the reporting unit. The fair value is then compared to its carrying amount. Second, if the carrying amount of the reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation in accordance with SFAS 141, Business Combinations. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. We perform our annual impairment test in the first quarter of each year. We have not recorded any impairment losses against goodwill as a result of impairment tests performed.

Income Taxes. Deferred income taxes are provided for temporary differences between the amount of assets and liabilities for financial and tax reporting purposes. We establish a valuation allowance in accordance with SFAS 109, Accounting for Income Taxes, to reduce our deferred tax assets to the amount that is more likely than not to be realized. Should we determine that we will not be able to realize all or part of our net deferred tax asset in the future, an adjustment to the deferred tax asset will be charged to income in the period such determination is made.

Tax contingencies are recorded to address potential exposures involving tax positions we have taken that could be challenged by taxing authorities. These potential exposures result from the varying applications of statutes, rules, regulations and interpretations. Our tax contingencies contain assumptions based on past experiences and judgments about potential actions by taxing jurisdictions. The ultimate resolution of these matters may be greater or less than the amount that we have accrued.

The following table sets forth certain unaudited financial data for the periods indicated:

Revenue, net increased $2,824, or 6%, to $46,794 for the three months ended September 30, 2005 from $43,970 for the three months ended September 30, 2004. Revenue decreased $9,379, or 7%, to $128,370 for the nine months ended September 30, 2005 from $137,749 for the nine months ended September 30, 2004.

Revenue by market as a percentage of total revenue was as follows:

Advanced television revenue increased $1,317, or 7%, to $19,767 for the three months ended September 30, 2005 from $18,450 for the three months ended September 30, 2004. This increase is due to an increase in units sold of 22%, offset by a decrease in average selling prices of 12%. Advanced television revenue increased $10,302, or 19%, to $65,743 for the nine months ended September 30, 2005, from $55,441 for the nine months ended September 30, 2004. This increase is due to an increase in units sold of 27%, offset by a decrease in average selling prices of 7%.

The advanced television market includes products sold into the flat panel television sector, which is comprised of liquid crystal display (“LCD”) televisions and plasma televisions, and products sold into the digital cathode ray tube (“CRT”) and digital rear projection television sectors. Revenue from products sold into the flat panel television sector comprised approximately 94% of our advanced television revenue during the three and nine months ended September 30, 2005. During the three and nine months ended September 30, 2004, revenue from products sold into the flat panel television sector comprised approximately 74% and 68%, respectively, of our total advanced television revenue. The increases in revenue to the flat panel television sector were attributable to overall growth in the market. These increases were partially offset by decreases in revenue to the CRT sector during the three and nine months ended September 30, 2005 compared to the three and nine months ended September 30, 2004.

Our advanced television revenue is generated on sales to customers primarily located in China, Taiwan, Europe, Korea and Japan.

In the fourth quarter of 2005, we expect our advanced television revenue to increase approximately 10% to 15% from the third quarter of 2005. This increase will be driven largely by the continued ramp of our new products.

Multimedia projector revenue decreased $6,792, or 32%, to $14,488 for the three months ended September 30, 2005 from $21,280 for the three months ended September 30, 2004. This decrease is due to a decrease in units sold of 21%, combined with a decrease in average selling prices of 14%. Multimedia projector revenue decreased $23,776, or 37%, to $40,604 for the nine months ended September 30, 2005, from $64,380 for the nine months ended September 30, 2004. This decrease is due to a decrease in units sold of 21%, combined with a decrease in average selling prices of 20%.

The decreases in revenue in the multimedia projector market are primarily attributable to market share lost to Texas Instruments in projectors using their Digital Light Processing (“DLP”) display device.

The majority of our multimedia projector revenue is generated on sales to customers located in Japan. Japanese customers accounted for 82% and 76% of total multimedia projector revenue for the three months ended September 30, 2005 and 2004, respectively, and 85% and 69% of total multimedia projector revenue for the nine months ended September 30, 2005 and 2004, respectively.

In the fourth quarter of 2005, we believe multimedia projector revenue will decrease approximately 5% from the third quarter of 2005. This decrease will be driven by softness in demand in the overall market as we move into the second half of the fourth quarter.

Advanced media processor revenue was $8,804 and $9,053 for the three and nine months ended September 30, 2005, respectively. Sales into this market are a result of our acquisition of Equator Technologies, Inc. in June of 2005. Accordingly, we had no revenue in this market for the comparable periods of 2004.

The advanced media processor market consists of products sold into video conferencing and set-top-box applications, as well as products sold into other miscellaneous applications which include broadcast encoding and imaging. The majority of our advanced media processor revenue is derived from customers located in United States and Canada.

In the fourth quarter of 2005, we believe advanced media processor revenue will decrease approximately 15% to 35% from the third quarter of 2005. This decrease will be due to softness in set-top-box demand as we expect that new orders to support continued rollout from our major customers will push out beyond the fourth quarter.

LCD monitor revenue decreased $179, or 6%, to $2,943 for the three months ended September 30, 2005 from $3,122 for the three months ended September 30, 2004. This decrease is due to a decrease in units sold of 9%, offset by an increase in average selling prices of 4%. LCD monitor revenue decreased $5,757, or 39%, to $9,119 for the nine months ended September 30, 2005 from $14,876 for the nine months ended September 30, 2004. This decrease is due to a decrease in units sold of 59%, offset by an increase in average selling prices of 51%.

The overall decrease in LCD monitor revenue is primarily attributable to our strategy to stop developing mainstream products for this market, and to focus on higher end products. The increase in average selling prices resulted from an increase in the percentage of chips sold into Ultra Extended Graphics Array (“UXGA”) monitors, the highest resolution monitors, which carry higher average selling prices than chips sold into Super Extended Graphics Array (“SXGA”), which are high resolution monitors, or Extended Graphics Array (“XGA”) monitors, which are the lowest resolution monitors.

The majority of our LCD monitor revenue is generated on sales to customers located in Taiwan.

In the fourth quarter of 2005, we expect that LCD monitor revenue will decrease approximately 15% to 20% from third quarter of 2005.

Other revenue includes revenue generated from the sales of evaluation kits and from sales into small, niche markets that are unrelated to the four primary markets for our products, as well as the impact of any change in our reserve for sales returns and allowances.

Cost of revenue includes purchased materials, assembly, test, labor and overhead, warranty expense, royalties, amortization of purchased developed technology, provisions for slow moving and obsolete inventory and information technology and facilities allocations.

Gross profit decreased to 31.3% and 37.2% for the three and nine months ended September 30, 2005, respectively, from 49.4% and 49.5% for the comparable periods in 2004. The decrease is primarily driven by an increase in amortization of acquired inventory mark-up, acquired intangible assets and stock-based compensation of $5,701 and $6,123 for the three and nine months ended September 30, 2005, respectively, and changes in the mix of products sold. The decrease in sales to multimedia projector manufacturers as a percentage of total revenue contributed significantly to the overall decrease in gross profit, as our multimedia projector sales generally have the highest gross profit margins.

We expect our gross profit margin to be approximately 34% to 36% for the fourth quarter of 2005. This increase will primarily be driven by less non-cash acquisition related expenses in the fourth quarter of 2005 compared to the third quarter. We expect non-cash acquisition related expenses to be approximately $3,800 in the fourth quarter compared to $5,797 for the third quarter.

Research and development includes compensation and related costs for personnel, depreciation and amortization, fees for outside services and expensed equipment and software.

Research and development expense, inclusive of stock-based compensation expense, increased $7,473, or 88%, to $15,997 for the three months ended September 30, 2005 from $8,524 for the three months ended September 30, 2004 due to the following factors:

Research and development expense, inclusive of stock-based compensation expense, increased $12,836, or 53%, to $37,170 for the nine months ended September 30, 2005 from $24,334 for the nine months ended September 30, 2004 due to the following offsetting factors:

We expect our research and development expenses to continue to increase in future periods as a result of our ongoing investment in new product development programs.

Selling, general and administrative expense includes compensation and related costs for personnel, travel, outside services, sales commissions and other overhead incurred in our sales, marketing, customer support, management, legal and other professional and administrative support functions.

Selling, general and administrative expense, inclusive of stock-based compensation expense, increased $2,487, or 42%, to $8,368 for the three months ended September 30, 2005 from $5,881 for the three months ended September 30, 2004 due to the following offsetting factors:

Selling, general and administrative expense, inclusive of stock-based compensation expense, increased $4,887, or 28%, to $22,400 for the nine months ended September 30, 2005 from $17,513 for the nine months ended September 30, 2004 due to the following offsetting factors:

We expect our selling, general and administrative expenses to increase in future periods. The increases will result from higher sales-related and overhead costs.

Stock-based compensation and amortization of purchased intangible assets is comprised of the following:

Stock-based compensation and amortization of purchased intangible assets increased $834, or 401%, and $858, or 122%, for the three and nine months ended September 30, 2005 from the comparable periods in 2004, respectively. These increases are due to our acquisition of Equator, which closed June 14, 2005, offset by the diminishing amortization of purchased intangible assets from a previous asset purchase. As a result of the acquisition of Equator, we recorded, among other identifiable intangible assets, acquired customer relationships of $3,400, deferred stock-based compensation of $2,219, and acquired trademark of $200.

Interest income, net includes interest income earned on cash equivalents and short and long-term marketable securities, interest expense related to our 1.75% convertible subordinated debentures, realized loss on the sale of marketable securities and amortization of our debt issuance costs and is comprised of the following for the periods presented:

Interest income decreased $443, or 30%, to $1,031 for the three months ended September 30, 2005 from $1,474 for the three months ended September 30, 2004, due to the acquisition of Equator in June 2005 which lowered our combined cash and cash equivalents and short-term and long-term marketable securities balances. Interest income increased $2,201, or 98%, to $4,439 for the nine months ended September 30, 2005 from $2,238 for the nine months ended September 30, 2004, due to the investment of the proceeds from the issuance of the debentures which were issued in May and June of 2004.

Interest expense increased $1,022, or 107%, for the nine months ended September 30, 2005 compared to the comparable period of 2004. Our 1.75% convertible debentures were issued in May and June of 2004 and were therefore not outstanding for the entire nine month period ended September 30, 2004.

During the second quarter of 2005, we realized a loss on the sale of marketable securities of $779 as a result of the sale of marketable securities to fund the acquisition of Equator.

Debt issuance costs related to the convertible debentures have been capitalized and are being amortized over seven years.

We have recorded a recovery of income taxes of $4,716 and $4,703 for the three and nine months ended September 30, 2005, respectively. The provision for income taxes was $2,373 and $9,149 for the three and nine months ended September 30, 2004, respectively. The decrease in the provision was primarily attributable to our decreased income before taxes and the generation of various credits offset by the recognition of valuation allowance and other permanent items. The effective tax rate differs from the federal statutory rate primarily due to the following: the utilization of federal, state and foreign tax credits, non-cash and other permanent expense items treated differently for book and tax purposes, the accrual of contingent amounts related to potential permanent establishment exposure and the establishment of valuation allowance against credits generated in state and foreign jurisdictions.

As of September 30, 2005 we had cash and cash equivalents of $54,054, short and long-term marketable securities of $93,322 and working capital of $166,012. Cash used in operating activities during the nine months ended September 30, 2005 was $5,057 compared to cash provided by operating activities of $17,092 during the nine months ended September 30, 2004. The decrease in cash provided by operating activities is primarily attributable to the net loss of $6,696 for the nine months ended September 30, 2005 compared to the net income of $17,761 for the nine months ended September 30, 2004.

Cash provided by investing activities during the nine months ended September 30, 2005 was $24,574. This compares to $140,197 used in investing activities during the nine months ended September 30, 2004. Cash provided by investing activities during the nine months ended September 30, 2005 was primarily generated from sales and maturities of marketable securities offset by the acquisition of Equator, purchases of marketable securities, purchases of property and equipment and other assets, and payments on accrued balances related to asset acquisitions. Cash used in investing activities during the nine months ended September 30, 2004 was primarily attributable to purchases of marketable securities, purchases of property and equipment and other assets, and payments on accrued balances related to asset acquisitions offset by proceeds from sales and maturities of marketable securities.

Cash provided by financing activities was $1,952 for the nine months ended September 30, 2005. This compares to $150,161 provided by financing activities during the nine months ended September 30, 2004. Cash provided by financing activities for the nine months ended September 30, 2005 was primarily generated by proceeds from the issuance of common stock, while cash provided by financing activities for the nine months ended September 30, 2004 was primarily generated from the issuance of the convertible subordinated debentures and issuances of common stock.

We anticipate that our existing cash and investment balances, along with cash expected to be generated from operations will be adequate to fund our operating and investing needs for the next twelve months and the foreseeable future. From time to time, we may evaluate acquisitions of businesses, products or technologies that complement our business. Any such transactions, if consummated, may consume a material portion of our working capital or require the issuance of equity securities that may result in dilution to existing shareholders.

Accounts receivable, net increased to $27,420 at September 30, 2005 from $14,605 at December 31, 2004. The increase is attributable to the acquisition of Equator which contributed $6,458 to consolidated accounts receivable as of September 30, 2005. The increase is also attributable to higher sales during the last month of the quarter ended September 30, 2005 compared to the quarter ended December 31, 2004. Average days sales outstanding was 53 at September 30, 2005 compared to 34 days at December 31, 2004.

Inventories, net increased to $27,809 at September 30, 2005 from $18,575 at December 31, 2004. The increase is primarily attributable to the acquisition of Equator. Equator’s inventory balance was $7,000 as of September 30, 2005. Inventory turnover on an annualized basis was approximately four at September 30, 2005, which represents approximately 13 weeks of inventory.

A summary of our contractual payment obligations as of September 30, 2005 was as follows:

The lease payments above are net of sublease rentals of $95 and $40 for the years ending December 31, 2005 and 2006, respectively.

We do not have any off-balance sheet arrangements that have or are reasonably likely to have a material current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

In May 2005, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. (“SFAS”) 154, Accounting Changes and Error Corrections — a replacement of APB Opinion No. 20 and FASB Statement No. 3. SFAS 154 replaces Accounting Principles Board (“APB”) Opinion No. 20, Accounting Changes, and SFAS 3, Reporting Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for, and reporting of, a change in accounting principle. This statement carries forward without change the guidance contained in Opinion 20 for reporting the correction of an error in previously issued financial statements and a change in accounting estimate. SFAS 154 is effective for accounting changes and corrections of errors in fiscal years beginning after December 31, 2005. Early adoption is permitted for accounting changes and corrections of errors made in fiscal years beginning after the date SFAS 154 is issued. We do not expect that the adoption of SFAS 154 will have a material impact on our consolidated financial statements.

In April 2005, the Securities and Exchange Commission issued release number 33-8568, Amendment to Rule 4-01(a) of Regulation S-X Regarding the Compliance Date for Statement of Financial Accounting Standards No. 123 (Revised 2004), Share Based Payment. This release delays the date for compliance with SFAS 123 (Revised 2004), Share Based Payment from the first interim or annual reporting period beginning after June 15, 2005 to the registrant’s first fiscal year beginning on or after June 15, 2005. SFAS 123R requires public entities 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, and no longer allows companies to apply the intrinsic value based method of accounting for stock compensation described in APB Opinion No. 25, Accounting for Stock Issued to Employees. While we are still in the process of determining how we will adopt Statement 123R and what the impact will be on our financial statements, we do expect it to have an adverse effect on our consolidated statements of operations and earnings per share.

In June 2005, we completed the acquisition of Equator Technologies, Inc. (“Equator”), a privately held company, for an aggregate purchase price of $118,091. The acquisition of Equator required a substantial expenditure and involves substantial risks on our part. Equator’s current product offerings and technological developments relate to internet protocol television (“IPTV”) set top boxes, digital media appliances, videoconferencing devices and security devices. These are emerging technologies and the markets they serve are as yet developing and largely untested, and we do not have direct experience developing and selling products into these markets. In addition, in making the acquisition of Equator we have made certain assumptions and projections with respect to the following: Equator’s revenue for future quarters; our expectations regarding the growth of the markets Equator serves; the ability of Equator to introduce new products and software and the risk that customers will not accept those new products and software; and the synergies we believe we can realize from the acquisition. We cannot be sure that such assumptions are correct. For these reasons we cannot provide assurance that the acquisition of Equator will produce the revenues, earnings or business synergies that we anticipate, or that it will perform as expected.

We may not be able to successfully integrate businesses, products, technologies or personnel of Equator or of any other entity that we might acquire in the future and any failure to do so could disrupt our business and seriously harm our financial condition. In addition, if we acquire companies with weak internal controls, it will take time to get the acquired company up to the same level of operating effectiveness as Pixelworks and to implement adequate internal control, management, financial and operating reporting systems. Our inability to address these risks could negatively affect our operating results.

To date, we have acquired Panstera, Inc. in January 2001, nDSP in January 2002, Jaldi Semiconductor in September 2002 and Equator Technologies, Inc. in June 2005. In March 2003, we announced the execution of a definitive merger agreement with Genesis Microchip, Inc.; however, the merger was terminated in August of 2003, and we incurred $8,949 of expenses related to the transaction. In the third quarter of 2003, we made an investment of $10,000 in Semiconductor Manufacturing International Corporation (SMIC). We intend to continue to consider investments in or acquisitions of complementary businesses, products or technologies.

The acquisitions of Panstera, nDSP and Jaldi contained a very high level of risk primarily because the investments were made based on in-process technological development that may not have been completed, or if completed, may not have become commercially viable.

These and any future acquisitions and investments could result in:

Our operation of any acquired business will also involve numerous risks, including, but not limited to: