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FORM 10-Q

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

(Mark One) x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE           SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended	March 31, 2003

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
          SECURITIES EXCHANGE ACT OF 1934

     For the transition period from                                     to                                          

     Commission file number           000-23084          

Integrated Silicon Solution, Inc.

     Registrant’s telephone number, including area code (408) 588-0800           

     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 past 90 days.

Yes x   Noo

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes o   No x

     The number of outstanding shares of the registrant’s Common Stock as of May 2, 2003 was 27,774,313

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Item 1. Financial Statements

Integrated Silicon Solution, Inc.
Condensed Consolidated Statements of Operations
(Unaudited)
(In thousands, except per share data)

See accompanying notes to condensed consolidated financial statements.

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Integrated Silicon Solution, Inc.
Condensed Consolidated Balance Sheets
(In thousands)

(1) Derived from audited financial statements.
See accompanying notes to condensed consolidated financial statements.

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Integrated Silicon Solution, Inc.
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(In thousands)

See accompanying notes to condensed consolidated financial statements.

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INTEGRATED SILICON SOLUTION, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1. Basis of Presentation

     The accompanying condensed financial statements include the accounts of Integrated Silicon Solution, Inc. (the “Company”) and its consolidated majority owned subsidiaries, after elimination of all significant intercompany accounts and transactions and have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments considered necessary for fair presentation have been included.

     Operating results for the three and six months ended March 31, 2003 are not necessarily indicative of the results that may be expected for the year ending September 30, 2003 or for any other period. The financial statements included herein should be read in conjunction with the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2002.

2. Concentrations

     Sales to ATM Electronic Corporation accounted for approximately 14% and 12% of total net sales for the three months and six months ended March 31, 2003, respectively. Sales to LG Electronics Inc. accounted for approximately 11% of total net sales for the three months ended March 31, 2003. Sales to Samsung Electronics Inc. accounted for approximately 12% of total net sales for the three months ended March 31, 2003. In the three and six month periods ended March 31, 2002, no single customer accounted for over 10% of net sales.

3. Cash, Cash Equivalents and Short-term Investments

     Cash, cash equivalents and short-term investments consisted of the following:

4. Inventories

     The following is a summary of inventories by major category:

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INTEGRATED SILICON SOLUTION, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

     In the six months ended March 31, 2003 and in fiscal 2002, the Company recorded inventory write-downs of $4.1 million and $28.6 million, respectively. The inventory write-downs were predominately for lower of cost or market and excess and obsolescence issues on certain of the Company’s products.

5. Other Assets

     Other assets consisted of the following:

     The market value of the Company’s investment in the common stock and convertible debentures of ICSI at March 31, 2003 was approximately $20,223,000 and $2,615,000, respectively, based on quoted market prices. The Company’s total carrying value for ICSI common stock as of March 31, 2003 was approximately $19,199,000 of which approximately $5,433,000 is included in other comprehensive loss as accumulated foreign currency translation adjustment in the equity portion of our balance sheet.

6. Comprehensive Loss

     Comprehensive loss includes net loss as well as other comprehensive income (loss). The Company’s other comprehensive income (loss) consists of changes in cumulative translation adjustment and unrealized gains and losses on investments.

     Comprehensive loss, net of taxes, was as follows (in thousands):

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INTEGRATED SILICON SOLUTION, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

     The accumulated comprehensive loss component within the stockholders’ equity section of the Balance Sheet is comprised of foreign currency translation adjustments and the unrealized loss on an investment.

     The components of accumulated other comprehensive loss, net of tax, were as follows:

7. Income Taxes

     The Company recorded no provision for income taxes for the three and six month periods ended March 31, 2003 due to its net operating loss position. The benefit for income taxes for the three and six month periods ended March 31, 2002 reflects a benefit for alternative minimum taxes provided for the fiscal year ended September 30, 2001 which can be recovered based on changes in the tax laws.

8. Net Loss Per Share

     The following table sets forth the computation of basic and diluted net loss per share (in thousands, except per share amounts):

     The above diluted calculation for the three months ended March 31, 2003 and March 31, 2002 does not include approximately 6,126,000 and 4,739,000 shares attributable to options as of March 31, 2003 and 2002, respectively, as their impact would be anti-dilutive. The above diluted calculation for the six months ended March 31, 2003 and 2002, does not include approximately 6,053,000 and 4,740,000 shares attributable to options as of March 31, 2003 and 2002, respectively, as their impact would be anti-dilutive.

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INTEGRATED SILICON SOLUTION, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

9. Stock Options

     The Company applies the intrinsic-value method prescribed in APB Opinion No. 25,“Accounting for Stock issued to Employees,” in accounting for employee stock options. Accordingly compensation expense is generally recognized only when options are granted with a discounted exercise price. Any resulting compensation expense is recognized ratably over the associated service period, which is generally the option vesting term.

     The Company has determined pro forma loss and loss per share information as if the fair value method described in SFAS No. 123, “Accounting for Stock Based Compensation,” had been applied to its employee stock-based compensation. The proforma effect on net loss and net loss per share is as follows for the three month and six month periods ending March 31, 2003 and 2002:

10. Use of Estimates

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates, and such difference, may be material to the financial statements.

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INTEGRATED SILICON SOLUTION, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

11. Impact of Recently Issued Accounting Standards

     In July 2002, the Financial Accounting Standards Board issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities”. SFAS No. 146 addresses the financial accounting and reporting for obligations associated with an exit activity, including restructuring, or with a disposal of long-lived assets. Exit activities include, but are not limited to, eliminating or reducing product lines, terminating employees and contracts and relocating plant facilities or personnel. SFAS No. 146 specifies that a company will record a liability for a cost associated with an exit or disposal activity only when that liability is incurred and can be measured at fair value. Therefore, commitment to an exit plan or a plan of disposal expresses only management’s intended future actions and, therefore, does not meet the requirement for recognizing a liability and the related expense. SFAS No. 146 is effective prospectively for exit or disposal activities initiated after December 31, 2002, with earlier adoption encouraged. The adoption of SFAS No. 146 did not have a material effect on the Company’s financial position or results of operations.

     In November 2002, the Financial Accounting Standards Board issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” (FIN 45). FIN 45 requires that upon issuance of a guarantee, a guarantor must recognize a liability for the fair value of an obligation assumed under a guarantee. FIN 45 also requires additional disclosures by a guarantor in its interim and annual financial statements about the obligations associated with guarantees issued. The recognition provisions of FIN 45 are effective for any guarantees issued or modified after December 31, 2002. The disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. The Company adopted the disclosure requirements in the first quarter of fiscal 2003. The adoption of FIN 45 did not have a material effect on the Company’s financial position, results of operations, or cash flows.

     In December 2002, the Financial Accounting Standards Board issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure”. SFAS No. 148 amends SFAS No. 123 to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The transition guidance and annual disclosure requirements are effective for interim and annual periods beginning after December 15, 2002. The Company adopted the interim disclosure requirements in the quarter ended March 31, 2003 as disclosed in Note 9. The Company will continue to account for stock-based compensation under the provisions of APB Opinion No. 25 using the “intrinsic value” method.

12. Commitments and Contingencies

       Commitments to Wafer Fabrication Facilities

     At March 31, 2003, the Company had a remaining non-cancelable purchase commitment to a wafer foundry for which it was obligated to purchase approximately $351,000 of wafers by June 30, 2003. The Company purchased approximately $861,000 under this commitment in the six months ended March 31, 2003.

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INTEGRATED SILICON SOLUTION, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

13. Geographic and Segment Information

     The Company has one operating segment, which is to design, develop, and market high-performance SRAM, DRAM, and other memory products. The following table summarizes the Company’s operations in different geographic areas:

14. Related Party Transactions

     For the six months ended March 31, 2003 and March 31, 2002, the Company sold approximately $157,000 and $819,000, respectively, of memory products to ICSI. The Company currently has approximately a 29% ownership interest in ICSI. The Company’s Chairman and Chief Executive Officer (“CEO”), Jimmy S.M. Lee, is a director of ICSI. The Company also provides services and licenses certain products to ICSI. At March 31, 2003 and September 30, 2002, the Company had an accounts receivable balance from ICSI of approximately $376,000 and $560,000, respectively.

     The Company purchases goods and contract manufacturing services from ICSI. For the three months ended March 31, 2003 and March 31, 2002, purchases of goods and services were approximately $21,000 and $1,614,000, respectively. The Company also pays ICSI for certain product development costs, license fees and royalties. For the six months ended March 31, 2003 and March 31, 2002, these charges totaled approximately $256,000 and $2,391,000, respectively. At March 31, 2003 and September 30, 2002, the Company had an accounts payable balance to ICSI of approximately $210,000 and $777,000, respectively.

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INTEGRATED SILICON SOLUTION, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

     The Company purchases services from NexFlash. The Company currently has approximately a 14% ownership interest in NexFlash. The Company’s Chairman and CEO, Jimmy S.M. Lee, is a director of NexFlash. For the six months ended March 31, 2003, purchases of services were approximately $18,000. At March 31, 2003 and September 30, 2002, the Company had an accounts payable balance to NexFlash of approximately $7,000 and $4,000, respectively.

     The Company provides services to GetSilicon in which the Company currently has approximately a 17% ownership interest. The Company’s Chairman and CEO, Jimmy S.M. Lee, was the Chairman of GetSilicon until May 14, 2002 and continues to serve as a director. For the six months ended March 31, 2003 and March 31, 2002, the Company provided services of approximately $36,000 and $78,000, respectively, to GetSilicon. At March 31, 2003 and September 30, 2002, the Company had an accounts receivable balance from GetSilicon of approximately $109,000 and $73,000, respectively.

     The Company engages GetSilicon for business-to-business data exchange and professional services. For the six months ended March 31, 2003 and March 31, 2002, the purchase of services was approximately $12,000 and $229,000, respectively. At March 31, 2003 and September 30, 2002, the Company had an accounts payable balance to GetSilicon of approximately $194,000 and $317,000, respectively.

     For the six months ended March 31, 2003 and March 31, 2002, the Company sold approximately $17,000 and $214,000, respectively, of memory products to E-CMOS in which the Company currently has approximately a 26% ownership interest. The Company’s Chairman and CEO, Jimmy S.M. Lee, is the Chairman of E-CMOS. At March 31, 2003 and September 30, 2002, the Company had an accounts receivable balance from E-CMOS of approximately $4,000 and $12,000, respectively.

     The Company receives administrative support services and reimburses E-CMOS for expenses incurred on its behalf. At March 31, 2003 and September 30, 2002, the Company had an accounts payable balance to E-CMOS of approximately $96,000 and $434,000, respectively.

     For the six months ended March 31, 2003 and March 31, 2002, the Company sold approximately $327,000 and $254,000, respectively, of memory products to Marubun USA Corporation (“Marubun”). Hide L. Tanigami, a director of the Company, is the president and chief executive officer of Marubun. At March 31, 2003 and September 30, 2002, the Company had an accounts receivable balance from Marubun of approximately $171,000 and $301,000, respectively.

     The Company purchases goods from SMIC in which the Company has less than a 4% ownership interest. The Company’s Chairman and CEO, Jimmy S.M. Lee, is a director of SMIC. For the six months ended March 31, 2003 and March 31, 2002, purchases of goods from SMIC were approximately $15,140,000 and $6,000, respectively. At March 31, 2003 and September 30, 2002, the Company had an accounts payable balance to SMIC of approximately $4,358,000 and $2,373,000, respectively.

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INTEGRATED SILICON SOLUTION, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

15. Investment in Integrated Circuit Solution Inc. (“ICSI”)

     The following summarizes financial information for ICSI, an equity investee. (In thousands)

     In the June 2002 quarter, the Company invested approximately $3.2 million in convertible debentures issued by ICSI. The Company classifies this investment as available-for-sale. ICSI raised approximately $17 million with the proceeds to be used for general working capital purposes. Key terms of the issuance included: 5 year term, 0% coupon rate, convertible into ICSI common stock after 90 days, four specified conversion dates per year, conversion price at 101% over a calculated average closing price, an anti-dilution clause, a put option at 4% interest after 3 years and 4.5% after 4 years, and callable after 2 years if the market price of ICSI common stock meets certain conditions.

     As a result of a decline in ICSI’s convertible debenture price, the Company recorded an unrealized loss of approximately $69,000 related to the ICSI convertible debentures in the six months ended March 31, 2003. The unrealized loss is included in accumulated other comprehensive loss. In addition, in the three and six month periods ended March 31, 2003, the Company recorded charges of approximately $87,000 and $365,000, respectively, related to the decline in the fair value of an embedded derivative associated with the ICSI convertible debenture. The charge associated with the embedded derivative is included in other income (expense). The market value of the Company’s convertible debentures at December 31, 2002 was approximately $2.6 million.

     The Company accounts for investments in 50 percent or less owned companies over which it has the ability to exercise significant influence using the equity method of accounting. At March 31, 2003 and September 30, 2002, approximately, $2.6 million and $4.6 million, respectively, of undistributed earnings of 50% or less owned companies accounted for using the equity method are included in consolidated retained earnings. The Company periodically reviews these investments for other-than-temporary declines in market value and writes these investments to their fair value when an other-than-temporary decline has occurred.

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

     We have made forward-looking statements in this report on Form 10-Q that are subject to risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of our operations. Also, when we use such words as “believe,” “expect,” “anticipate,” or similar expressions, we are making forward-looking statements. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth below and elsewhere in this report on Form 10-Q.

Background

     Integrated Silicon Solution, Inc. was founded in October 1988. We design, develop and market memory products used in networking, Internet infrastructure, telecommunications, wireless products, handheld devices, computer peripherals and automotive electronics. Our high speed and low power SRAMs, our low to medium density DRAMs, and our family of EEPROMs enable customers to design products that meet the demanding connectivity, portability and bandwidth requirements of today’s electronic products. Our objective is to capitalize on major trends in electronic products and position ISSI as a key supplier to leading companies in such markets. Our goal is to be a focused supplier of high performance memories targeting the mobile communications, networking/broadband, digital consumer and automotive electronics markets.

     We believe our close relationship with leading silicon wafer foundries gives us access to the advanced wafer process technology required to design and manufacture high performance memories. We entered into our first development program with Taiwan Semiconductor Manufacturing Corporation (“TSMC”) in 1990 and with Chartered Semiconductor in 1994 and have also worked closely with United Microelectronics Corporation (“UMC”) since 1995. We are also an equity investor and have a seat on the board of directors of Semiconductor Manufacturing International Corporation (“SMIC”), the first eight-inch wafer foundry in China. Through this collaborative strategy, we have been at the forefront in utilizing the most advanced process technology for memories and in securing access to wafer capacity. We believe that ISSI is a technology leader and that our ability to design and develop high performance, cost-effective products, and our collaborative development with our manufacturing partners utilizing state-of-the-art process technology, gives us a competitive advantage.

Results of Operations

     Our financial results for fiscal 2003 and fiscal 2002 reflect accounting for ICSI on the equity basis and include our percentage share of the results of ICSI’s operations. Our financial results for fiscal 2003 and fiscal 2002 reflect accounting for E-CMOS on the equity basis and include our share of E-CMOS’s results of operations on a one quarter lag. Our financial results for fiscal 2003 and fiscal 2002 reflect accounting for GetSilicon, NexFlash and SMIC on the cost basis. At March 31, 2003, we owned approximately 29% of ICSI, approximately 26% of E-CMOS, approximately 17% of GetSilicon, approximately 14% of NexFlash and less than 4% of SMIC.

Critical Accounting Policies

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make difficult and subjective estimates, judgments and assumptions. These estimates, judgments and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenue and expenses during the reporting period. The estimates and judgments that we use in applying our accounting policies have a significant impact on the results we report in our financial statements. We base our estimates and judgments on our historical experience combined with knowledge of current conditions and our beliefs of what could occur in the future considering the information available at the time. Actual results could differ from those estimates and such differences may be material to our financial statements. We reevaluate our estimates and judgments on an ongoing basis.

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     Our critical accounting policies which are impacted by estimates are: (i) the valuation of our inventory, which impacts cost of goods sold and gross profit; (ii) the valuation of our allowance for sales returns and allowances, which impacts net sales (iii) the valuation of our allowance for doubtful accounts, which impacts general and administrative expense; and (iv) the valuation of our non-marketable equity securities, which impacts gains and losses on equity securities when we record impairments. Each of these policies is described in more detail below. We also have other key accounting policies that may not require us to make estimates and judgments that are as subjective or difficult, for instance, our policies with regard to revenue recognition, including the deferral of revenues on sales to distributors. These policies are described in the notes to our financial statements contained in this Annual Report on Form 10-K for the year ended September 30, 2002.

Valuation of inventory

     Our inventories are stated at the lower of cost or market value. Determining market value requires us to project unit prices and volumes for future periods in which we expect to sell inventory on hand as of the balance sheet date. As a result of these estimates, we may record a charge to cost of goods sold, which decreases our gross profit, in advance of when the inventory is actually sold to reflect market values that are below our manufacturing and sales commission costs. Conversely, if we sell inventory that has previously been written down to the lower of cost or market at more favorable prices than we had forecasted at the time of the write-down, our gross profit may be higher. In addition to lower of cost or market write-downs, we also analyze inventory to determine whether any of it is excess or obsolete. We write down to zero dollars (which is a charge to cost of goods sold) the carrying value of inventory on hand in excess of six months’ estimated sales volumes to cover estimated excess and obsolete exposures, unless adjustments are made to the forecast based on our judgments for newer products, end of life products or planned inventory increases. In making such judgments to write down inventory, we take into account the product life cycles which can range from 6 to 30 months, the stage in the life cycle of the product, the impact of competitors’ announcements and product introductions on our products.

Valuation of allowance for sales returns and allowances

     Net sales consist principally of total product sales less estimated sales returns. To estimate sales returns and allowances, we analyze potential customer specific product application issues, potential quality and reliability issues and historical returns. We evaluate quarterly the adequacy of the reserve for sales returns and allowances. This reserve is reflected as a reduction to accounts receivable in our consolidated balance sheets. Increases to the reserve are recorded as a reduction to net sales. Because the reserve for sales returns and allowances is based on our judgments and estimates, particularly as to product application, quality and reliability issues, our reserves may not be adequate to cover actual sales returns and other allowances. If our reserves are not adequate, our net sales could be adversely affected.

Valuation of allowance for doubtful accounts

     We maintain an allowance for doubtful accounts for losses that we estimate will arise from our customers’ inability to make required payments for goods and services purchased from us. We make our estimates of the uncollectibility of our accounts receivable by analyzing historical bad debts, specific customer creditworthiness and current economic trends. Once an account is deemed unlikely to be fully collected, we write down the carrying value of the receivable to the estimated recoverable value, which results in a charge to general and administrative expense, which decreases our profitability.

Valuation of non-marketable securities

     Our ability to recover our investments in equity securities that are non-marketable and to earn a return on these investments is largely dependent on financial market conditions and the occurrence of liquidity events, such as initial public offerings, mergers or acquisitions and private party transactions. All of these events are difficult to predict, particularly in the current economic environment. In addition, under our accounting policy, we are required to periodically review all of our investments for impairment. In the case of non-marketable

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equity securities, this requires significant judgment on our part, including an assessment of the investees’ financial condition, the existence of subsequent rounds of financing and the impact of any relevant equity preferences, as well as the investees’ historical results of operations, and projected results and cash flows. If the actual outcomes for the investees’ are significantly different from their forecasts, the carrying value of our non-marketable equity securities may be overstated, and we may incur additional charges in future periods, which will decrease our profitability. At March 31, 2003, our strategic investments in non-marketable securities totaled $46.6 million of which $40.0 million was invested in SMIC.

Three Months Ended March 31, 2003 Compared to Three Months Ended March 31, 2002

     Net Sales. Net sales consist principally of total product sales less estimated sales returns. Net sales increased by 34% to $22.3 million in the three months ended March 31, 2003 from $16.6 million in the three months ended March 31, 2002. The increase in sales was principally due to an increase in unit shipments of our DRAM products partially offset by declines in the average selling prices for such products in the three months ended March 31, 2003 compared to the three months ended March 31, 2002. While SRAM units shipped increased in the three months ended March 31, 2003 compared to the three months ended March 31, 2002, the impact of the reduction in average selling prices for such products resulted in an overall reduction in SRAM revenue. We anticipate that the average selling prices of our existing products will generally decline over time, although the rate of decline may fluctuate for certain products. In this regard, we experienced a decline in the average selling prices for certain of our SRAM and DRAM products in the three months ended March 31, 2003 as compared to the three months ended December 31, 2002. We anticipate further price declines for certain of our SRAM and DRAM products in the June 2003 quarter. There can be no assurance that such declines will be offset by higher volumes or by higher prices on newer products.

     Sales to ATM Electronic Corporation accounted for approximately 14% of our total net sales for the three months ended March 31, 2003. Sales to LG Electronics Inc. accounted for approximately 11% of our total net sales for the three months ended March 31, 2003. Sales to Samsung Electronics Inc. accounted for approximately 12% of our total net sales for the three months ended March 31, 2003. In the three months ended March 31, 2002, no single customer accounted for over 10% of our net sales. As sales to these customers are executed pursuant to purchase orders and no purchasing contract exists, these customers can cease doing business with us at any time.

     Gross Profit. Cost of sales includes die cost from the wafers acquired from foundries, subcontracted package costs, assembly costs and test costs, costs associated with in-house product testing, quality assurance and import duties. Gross profit increased 11% to $3.3 million in the three months ended March 31, 2003 from $3.0 million in the three months ended March 31, 2002. As a percentage of net sales, gross profit decreased to 15.0% in the three months ended March 31, 2003 from 18.1% in the three months ended March 31, 2002. Our gross margin for the three months ended March 31, 2002 benefited from the reversal of approximately $5.2 million in antidumping duties previously charged to cost of sales, as a result of the favorable termination of an antidumping case. In addition, in the three months ended March 31, 2002, we recorded an inventory write-down of approximately $4.4 million predominately for lower of cost or market accounting on certain of our DRAM and SRAM products. The increase in gross profit dollars was principally due to an increase in unit shipments of our DRAM products, and to a lesser extent our SRAM products, in the three months ended March 31, 2003 compared to the three months ended March 31, 2002. In addition, reductions in the cost of our SRAM products more than offset declines in the average selling prices in the three months ended March 31, 2003 compared to the three months ended March 31, 2002, resulting in an increase in gross profit dollars. We believe that the average selling price of our products will generally decline over time and, unless we are able to reduce our cost per unit to the extent necessary to offset such declines, the decline in average selling prices will result in a material decline in our gross margin. In this regard, we experienced a decline in the average selling prices for certain of our SRAM and DRAM products in the three months ended March 31, 2003 compared to the three months ended December 31, 2002. We anticipate a further decline in the average selling prices for certain of our SRAM and DRAM products in the June 2003 quarter. In addition, product unit costs could increase if our suppliers raise prices, which could result in a material decline in our gross margin. Although we have product cost reduction programs in place for certain products that involve efforts to reduce internal costs and supplier costs, there can be no assurance that product costs will be reduced or that such reductions will be sufficient to

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offset the expected declines in average selling prices. We do not believe that such cost reduction efforts are likely to have a material adverse impact on the quality of our products or the level of service provided by us.

     Research and Development. Research and development expenses decreased by 14% to $6.1 million in the three months ended March 31, 2003 from $7.2 million in the three months ended March 31, 2002. As a percentage of net sales, research and development expenses decreased to 27.5% in the three months ended March 31, 2003 from 43.0% in the three months ended March 31, 2002. The decrease in absolute dollars was primarily the result of a reduction in expenses associated with new product development as we limited the focus of our development efforts. In addition, we have reduced research and development expenses through salary reductions, headcount reductions and the transfer of some design and engineering efforts to Asia. The increased costs associated with the development of new products could offset these reductions, which could result in our research and development expenses increasing in absolute dollars in future periods.

     Selling, General and Administrative. Selling, general and administrative expenses decreased by 21% to $3.4 million in the three months ended March 31, 2003 from $4.3 million in the three months ended March 31, 2002. As a percentage of net sales, selling, general and administrative expenses decreased to 15.2% in the three months ended March 31, 2002 from 25.9% in the three months ended March 31, 2002. The decrease in absolute dollars was primarily the result of controlling expenses through salary reductions, headcount reductions and limiting discretionary spending. We expect our selling, general and administrative expenses may increase in future quarters although such expenses may fluctuate as a percentage of net sales.

     In-process Technology. On February 13, 2002, we acquired Purple Ray, Inc. The assets of Purple Ray consisted primarily of intellectual property. The transaction was accounted for using the purchase method of accounting. The total estimated purchase price of $7.1 million consisted of the fair market value of ISSI’s common stock issued of $5.2 million, the fair value of options to purchase Purple Ray common stock assumed by ISSI of $1.7 million and estimated transaction costs of $0.2 million. The transaction resulted in an in-process technology charge of $4.7 million in our March 31, 2002 quarter.

     Other income (expense), net. Other income (expense), net decreased by $0.6 million to approximately $0.2 million in the three months ended March 31, 2003 from $0.8 million in the three months ended March 31, 2002. The decrease was primarily the result of decreased interest income as the result of lower cash balances. In addition, in the three months ended March 31, 2003, we recorded a charge of approximately $87,000 related to the decline in the fair value of an embedded derivative associated with the ICSI convertible debenture.

     Benefit for income taxes. We recorded no provision for income taxes for the three month period ended March 31, 2003 due to our net operating loss position. The benefit for income taxes for the three month period ended March 31, 2002 reflects a benefit for alternative minimum taxes provided for the fiscal year ended September 30, 2001 which can be recovered based on changes in the tax laws in 2002.

     Minority interest in net loss of consolidated subsidiary. In October 2001, we invested $3.0 million for a 95% interest in D2Code Co. Inc. (“D2Code”), a subsidiary that we established in Korea to focus on semiconductor design activities. The results of their operations are included in our consolidated financial statements. The minority interest in net loss of consolidated subsidiary, represents the minority shareholders’ proportionate share of the net loss of D2Code. The minority interest in net loss of consolidated subsidiary decreased to $0 in the three months ended March 31, 2003 from $15,000 in the three months ended March 31, 2002.

     Equity in net loss of affiliated companies. Equity in net loss of affiliated companies decreased by $0.6 million to $0.9 million in the three months ended March 31, 2003 from $1.5 million in the three months ended March 31, 2002. This primarily reflects a decrease in the loss from our percentage share of ICSI’s financial results in the three months ended March 31, 2003 compared to the three months ended March 31, 2002.

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Six Months Ended March 31, 2003 Compared to Six Months Ended March 31, 2002

     Net Sales. Net sales increased by 37% to $43.4 million in the six months ended March 31, 2003, from $31.7 million in the six months ended March 31, 2002. The increase in sales was principally due to an increase in unit shipments of our DRAM products, specifically our 64, 4 and 16 megabit DRAM products partially offset by declines in the average selling prices for such products in the six months ended March 31, 2003 compared to the six months ended March 31, 2002. While SRAM units shipped increased in the six months ended March 31, 2003 compared to the six months ended March 31, 2002, the impact of the reduction in average selling prices for such products resulted in an overall reduction in SRAM revenue. We anticipate that the average selling prices of our existing products will generally decline over time, although the rate of decline may fluctuate for certain products. In this regard, we experienced a decline in the average selling prices for certain of our SRAM and DRAM products in the three months ended March 31, 2003 compared to the three months ended December 31, 2002. We anticipate further price declines for certain of our SRAM and DRAM products in the June 2003 quarter. There can be no assurance that such declines will be offset by higher volumes or by higher prices on newer products.

     Sales to ATM Electronic Corporation accounted for approximately 12% of our total net sales for the six months ended March 31, 2003. In the six months ended March 31, 2002, no single customer accounted for over 10% of our net sales. As sales to this customer are executed pursuant to purchase orders and no purchasing contract exists, this customer can cease doing business with us at any time.

     Gross Profit. Gross profit decreased 63% to $2.1 million in the six months ended March 31, 2003, from $5.7 million in the six months ended March 31, 2002. As a percentage of net sales, gross profit decreased to 4.9% in the six months ended March 31, 2003 from 17.9% in the six months ended March 31, 2002. In the six months ended March 31, 2003, we recorded inventory write-downs of $4.1 million predominately for lower of cost or market accounting. Our gross margin for the six months ended March 31, 2002 benefited from the reversal of approximately $5.2 million in antidumping duties previously charged to cost of sales, as a result of the favorable termination of an antidumping case. In addition, in the six months ended March 31, 2002 we recorded inventory write-downs of approximately $4.4 million predominately for lower of cost or market accounting. Excluding the inventory write-downs and the benefit of the reversal of antidumping duties, gross profit dollars would have increased principally due to an increase in unit shipments of our DRAM products, and to a lesser extent our SRAM products, in the six months ended March 31, 2003 compared to the six months ended March 31, 2002. The increase in gross profit dollars associated with increased unit shipments was partially offset by price decreases as declines in the average selling prices of our SRAM and DRAM products more than offset declines in the cost of our SRAM and DRAM products in the six months ended March 31, 2003 compared to the six months ended March 31, 2002. We believe that the average selling prices of our products will generally decline over time and, unless we are able to reduce our cost per unit to the extent necessary to offset such declines, the decline in average selling prices will result in a material decline in our gross margin. In this regard, we experienced a decline in the average selling prices for certain of our SRAM and DRAM products in the three months ended March 31, 2003 compared to the three months ended December 31, 2002. We anticipate a further decline in the average selling prices for certain of our SRAM and DRAM products in the June 2003 quarter. In addition, product unit costs could increase if our suppliers raise prices, which could result in a material decline in our gross margin. Although we have product cost reduction programs in place for certain products that involve efforts to reduce internal costs and supplier costs, there can be no assurance that product costs will be reduced or that such reductions will be sufficient to offset the expected declines in average selling prices. We do not believe that such cost reduction efforts are likely to have a material adverse impact on the quality of our products or the level of service provided by us.

     Research and Development. Research and development expenses decreased by 6% to $12.9 million in the six months ended March 31, 2003 from $13.8 million in the six months ended March 31, 2002. As a percentage of net sales, research and development expenses decreased to 29.8% in the six months ended March 31, 2003, from 43.5% in the six months ended March 31, 2002. The decrease in absolute dollars was primarily the result of a reduction in expenses associated with new product development as we limited the focus of our

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development efforts. In addition, we have reduced research and development expenses through salary reductions, headcount reductions and the transfer of some design and engineering efforts to Asia.

     Selling, General and Administrative. Selling, general and administrative expenses decreased by 11% to $7.1 million in the six months ended March 31, 2003 from $8.0 million in the six months ended March 31, 2002. As a percentage of net sales, selling, general and administrative expenses decreased to 16.3% in the six months ended March 31, 2003, from 25.1% in the six months ended March 31, 2002. The decrease in absolute dollars was primarily the result of controlling expenses through salary reductions, headcount reductions and limiting discretionary spending.

     In-process Technology. On February 13, 2002, we acquired Purple Ray, Inc. The assets of Purple Ray consisted primarily of intellectual property. The transaction was accounted for using the purchase method of accounting. The total estimated purchase price of $7.1 million consisted of the fair market value of ISSI’s common stock issued of $5.2 million, the fair value of options to purchase Purple Ray common stock assumed by ISSI of $1.7 million and estimated transaction costs of $0.2 million. The transaction resulted in an in-process technology charge of $4.7 million in our March 31, 2002 quarter.

     Gain on sale of investments. The gain on the sale of investments decreased to $0 in the six months ended March 31, 2003 from $35,000 in the six months ended March 31, 2002. In the six months ended March 31, 2002, we sold shares of ICSI for approximately $64,000 resulting in a pre-tax gain of $35,000.

     Other income (expense), net. Other income (expense), net decreased by $1.1 million to $0.2 million in the six months ended March 31, 2003 from $1.3 million in the six months ended March 31, 2002. The decrease was primarily the result of decreased interest income as the result of lower cash balances. In addition, in the six months ended March 31, 2003, we recorded a charge of approximately $365,000 related to the decline in the fair value of an embedded derivative associated with the ICSI convertible debenture.

     Benefit for Income Taxes. We recorded no provision for income taxes for the six month period ended March 31, 2003 due to our net operating loss position. The benefit for income taxes for the six month period ended March 31, 2002 reflects a benefit for alternative minimum taxes provided for the fiscal year ended September 30, 2001 which can be recovered based on changes in the tax law in 2002.

     Equity in net loss of affiliated companies. Equity in net loss of affiliated companies decreased by $2.4 million to $2.0 million in the six months ended March 31, 2003 from $4.4 million in the six months ended March 31, 2002. This primarily reflects a decrease in the loss from our percentage share of ICSI’s financial results in the six months ended March 31, 2003 compared to the six months ended March 31, 2002.

     Minority interest in net loss of consolidated subsidiary. In October 2001, we invested $3.0 million for a 95% interest in D2Code Co. Inc. (“D2Code”), a subsidiary that we established in Korea to focus on semiconductor design activities. The results of their operations are included in our consolidated financial statements. The minority interest in net loss of consolidated subsidiary, represents the minority shareholders’ proportionate share of the net loss of D2Code. The minority interest in net loss of consolidated subsidiary decreased to $17,000 in the six months ended March 31, 2003 from $24,000 in the six months ended March 31, 2002.

Liquidity and Capital Resources

     As of March 31, 2003, our principal sources of liquidity included cash, cash equivalents and short-term investments of approximately $66.7 million. During the six months ended March 31, 2003, operating activities used cash of approximately $11.8 million compared to $3.1 million provided in the six months ended March 31, 2002. Cash used by operations was primarily due to net loss of $19.7 million adjusted for non-cash charges including depreciation of $2.4 million, equity in net loss of affiliated companies of $2.0 million and other non-cash items of $0.5 million, as well as decreases in accounts payable of $4.1 million and increases in accounts receivables of $1.2 million. This was partially offset by decreases in inventories of $6.6 million primarily

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driven by inventory write-downs, increases in accrued expenses of $1.3 million and decreases in other current assets of $0.4 million.

     In the six months ended March 31, 2003, we generated $13.2 million from investing activities compared to $3.5 million used in the three months ended March 31, 2002. The cash generated by investing activities in the six months ended March 31, 2003 primarily resulted from net sales of available-for-sale securities of $14.0 million. The cash used for investing activities during the six months ended March 31, 2002 was primarily the $11.4 million additional investment in SMIC. In addition, we had net sales of available-for-sale securities of $11.8 million.

     In the six months ended March 31, 2003, we made capital expenditures of approximately $0.8 million for engineering tools and computer software. We expect to spend approximately $1.0 million to $2.0 million to purchase capital equipment during the next twelve months, principally for the purchase of design and engineering tools, additional test equipment and computer software and hardware.

     We generated $0.6 million from financing activities during the six months ended March 31, 2003 compared to $1.3 million in the six months ended March 31, 2002. Cash generated from financing activities for the six months ended March 31, 2003 and March 31, 2002 was primarily the result of proceeds from the issuance of common stock from option exercises and sales under our employee stock purchase plan.

     In August 2000, we made a commitment for an equity investment in SMIC. In fiscal 2002, we made investments totaling $21.2 million in SMIC, bringing our total investment in this foundry as of March 31, 2003, to $40.0 million. We have no further commitments to SMIC for additional equity investments at this time. We have received certain capacity commitments from SMIC. In addition, we have remaining non-cancelable purchase commitments to another wafer foundry for which we are obligated to purchase approximately $0.4 million of wafers over the next 3 months.

     In July 2002, we made a commitment for an equity investment in Signia Technologies, Inc. (“Signia”), a development stage company focusing on BlueTooth™ design. At December 31, 2002, our investment in Signia was $1.5 million. We were committed to invest an additional $1.5 million in Signia, if Signia achieved certain milestones with respect to its BlueTooth™ product by January 19, 2003. As Signia did not achieve the milestones by January 19, 2003, we are no longer contractually obligated to this commitment. However, we anticipate investing approximately $0.8 million in Signia in the June 2003 quarter.

     We lease our facilities including our headquarters in Santa Clara, California, our field sales offices in the U.S. and Europe and sales and engineering offices in Asia. Our leases expire at various dates through 2007. Our outstanding commitments under these leases are approximately $6.5 million.

     Our contractual cash obligations at March 31, 2003 are outlined in the table below:

     We believe our existing funds will satisfy our anticipated working capital and other cash requirements through at least the next 12 months. We may from time to time take actions to further increase our cash position through bank borrowings, sales of additional shares of ICSI, the disposition of certain assets, equity financing or debt financing. From time to time, we also evaluate potential acquisitions and equity investments complementary to our memory expertise and market strategy, including investments in wafer fabrication

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foundries. To the extent we pursue such transactions, any such transaction could require us to seek additional equity or debt financing to fund such activities. There can be no assurance that any such additional financing could be obtained on terms acceptable to us, if at all.

Certain Factors Which May Affect Our Business or Future Operating Results

Our operating results are expected to continue to fluctuate and may not meet published analyst forecasts. This may cause the price of our common stock to decline.

     Our future quarterly and annual operating results are subject to fluctuations due to a wide variety of factors, including:

	•		the cyclicality of the semiconductor industry;
	•		decreases in the demand for our products;
	•		excess inventory levels at our customers;
	•		declines in average selling prices of our products;
	•		cancellation of existing orders or the failure to secure new orders;
	•		oversupply of memory products in the market;
	•		our failure to introduce new products and to implement technologies on a timely basis;
	•		market acceptance of ours and our customers’ products;
	•		economic slowness and low end-user demand;
	•		our failure to anticipate changing customer product requirements;
	•		fluctuations in manufacturing yields;
	•		our failure to deliver products to customers on a timely basis;
	•		disruption in the supply of wafers or assembly services;
	•		changes in product mix;
	•		the timing of significant orders;
	•		increased expenses associated with new product introductions, masks, or process changes;
	•		the ability of customers to make payments to us; and
	•		the commencement of, or developments with respect to, any future antidumping proceedings.

We have incurred significant losses in certain recent periods, and there can be no assurance that we will be able to achieve or sustain profitability in the future.

     We have incurred losses in the eight consecutive quarters ended March 31, 2003 totaling $115.6 million. We expect to incur a loss in the June 2003 quarter and may incur losses in subsequent quarters. We were profitable for fiscal 2001 and fiscal 2000. Our ability to achieve or maintain profitability on a quarterly basis in

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the future will depend on a variety of factors, including our ability to increase our net sales, introduce new products on a timely basis, secure sufficient wafer fabrication capacity and control our operating expenses. Adverse developments with respect to these or other factors could result in quarterly or annual operating losses in the future.

Any continued downturn in the markets we serve would harm our business.

     Substantially all of our products are incorporated into products such as internet access devices, networking equipment, digital consumer products, telecom/mobile communications devices, and automotive electronics. Historically, these markets have from time to time experienced cyclical, depressed business conditions, often in connection with, or in anticipation of, a decline in general economic conditions. Such industry downturns have resulted in reduced product demand and declining average selling prices. These markets are currently experiencing severely depressed business conditions which are adversely affecting our business. We are unable to predict how long this current downturn will continue or whether current conditions will worsen.

Our sales depend on SRAM and DRAM products, and a decline in average selling prices or reduced demand for these products could harm our business.

     A substantial majority of our net sales are derived from the sale of DRAM and SRAM products, which are subject to unit volume fluctuations and declines in average selling prices that could harm our business. In fiscal 2001, we experienced sequential declines in revenue in the March 2001, June 2001, and September 2001 quarters. These declines were a result of a decline in the average selling prices for our products as well as a decrease in unit shipments of our products as a result of lower demand for electronic products. While the average selling prices for certain of our SRAM and DRAM products declined in the three months ended March 31, 2003 compared to the three months ended December 31, 2002, unit shipments of certain SRAM and DRAM products increased which resulted in an overall increase in our SRAM and DRAM revenue. We anticipate further price declines for certain of our SRAM and DRAM products in the June 2003 quarter. There can be no assurance that such declines will be offset by higher volumes or by higher prices on newer products.

We may not be able to compensate for price decreases in our products.

     Competitive pricing pressures due to an industry-wide oversupply of wafer capacity as well as product inventory resulted in significant price decreases for our products during fiscal 1996 through fiscal 1999. While we experienced increases in average selling prices in fiscal 2000, historically, average selling prices for semiconductor memory products have declined, and we expect that average selling prices will decline in the future. In this regard, we experienced a decline in the average selling prices for most of our products during fiscal 2002, and for certain products in the most recent quarter ended March 31, 2003. We anticipate a further decline in the average selling prices for certain of our SRAM and DRAM products in the June 2003 quarter. Our ability to maintain or increase revenues will depend upon our ability to increase unit sales volume of existing products and introduce and sell new products that compensate for the anticipated declines in the average selling prices of our existing products.

     Declining average selling prices will also adversely affect our gross margins and profits unless we are able to introduce new products with higher margins or reduce our cost per unit. We may not be able to increase unit sales volumes, introduce and sell new products or reduce our cost per unit.

Shifts in industry-wide capacity may cause our results to fluctuate. In the past, such shifts have resulted in significant inventory write-downs.

     Shifts in industry-wide capacity from shortages to oversupply or from oversupply to shortages may result in significant fluctuations in our quarterly or annual operating results. The semiconductor industry is highly cyclical and is subject to significant downturns resulting from excess capacity, overproduction, reduced demand or technological obsolescence. These factors can result in a decline in average selling prices and the stated value of inventory. In the three months ended December 31, 2002, in fiscal 2002 and in fiscal 2001, we recorded inventory write-downs of $4.1 million, $28.6 million and $38.3 million, respectively. The inventory write-downs

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were predominately for lower of cost or market accounting on our products, and to a lesser extent, excess inventory.

     We write down to zero carrying value inventory on hand in excess of six months’ estimated sales volumes to cover estimated excess and obsolete exposures, unless adjustments are made to the forecast based on management’s judgments for newer products, end of life products or planned inventory increases. In making such judgments to write down inventory, management takes into account the product life cycles which can range from 6 to 30 months, the stage in the life cycle of the product, the impact of competitors’ announcements and product introductions on our products.

     We believe that six months is an appropriate period because it is difficult to accurately forecast for a specific product beyond this time frame due to the potential introduction of products by competitors, technology obsolescence or fluctuations in demand. Our policy regarding excess inventory resulted in inventory write-downs for excess inventory of approximately $10.4 million for fiscal 2002 and $5.7 million for fiscal year 2001. Future additional inventory write-downs may occur due to lower of cost or market accounting, excess inventory or inventory obsolescence.

If we are unable to obtain an adequate supply of wafers, our business will be harmed.

     If we are unable to obtain an adequate supply of wafers from our current or any alternative sources in a timely manner, our business will be harmed. To date, our principal manufacturing relationship has been with TSMC, from which we have obtained a majority of our wafers. We also receive wafers from Chartered Semiconductor, SMIC, and UMC. Each of our wafer foundries also supplies wafers to other integrated circuit companies, including certain of our competitors. Although we have written commitments specifying wafer capacities from some suppliers, if any suppliers experience manufacturing failures or yield shortfalls, choose to prioritize capacity for other uses, or reduce or eliminate deliveries to us, we may not be able to enforce fulfillment of any delivery commitments. Additionally, we may not be able to qualify additional manufacturing sources for existing or new products in a timely manner and we cannot be certain that other manufacturing sources would agree to deliver an adequate supply of wafers to us.

Foundry capacity can be limited and we may be required to enter into costly long-term supply arrangements to secure foundry capacity.

     If we are not able to obtain additional foundry capacity as required, our relationships with our customers would be harmed and our future sales would be adversely impacted. In order to secure additional foundry capacity, we have entered into and may enter into various arrangements with suppliers, which could include:

	•		contracts that commit us to purchase specified quantities of silicon wafers over extended periods;
	•		investments in foundries;
	•		joint ventures;
	•		other partnership relationships with foundries;
	•		option payments or other prepayments to foundries; or
	•		nonrefundable deposits with or loans to foundries in exchange for capacity commitments.

     We may not be able to make any such arrangements in a timely fashion or at all, and such arrangements, if any, may not be on terms favorable to us. Moreover, if we are able to secure foundry capacity, we may be obligated to utilize all of that capacity or incur penalties. Such penalties may be expensive and could harm our financial results.

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We depend on a small number of customers for a high percentage of our sales, and the loss of a significant customer could adversely effect our operating results.

     In the six months ended March 31, 2003, sales to ATM Electronic Corporation accounted for approximately 12% of our total net sales. In fiscal 2002, no single customer accounted for over 10% of our net sales. However, in fiscal 2001, sales to Flextronics International accounted for approximately 15% of our net sales. Substantially all of our sales to Flextronics were for products to be delivered to Cisco. Shipments for Cisco directly, or indirectly through subcontractors, accounted for approximately 18% of our net sales for fiscal 2001. Shipments for 3Com directly, or indirectly through subcontractors, accounted for approximately 11% of our net sales for fiscal 2001. As sales to our customers are executed pursuant to purchase orders and no purchasing contract exists, our customers can cease doing business with us at any time. In this regard, we experienced order cancellations from these customers in the March 2001 quarter that adversely impacted our operating results in subsequent quarters. We expect a significant portion of our future sales to remain concentrated within a limited number of strategic customers. We may not be able to retain our strategic customers, such customers may cancel or reschedule orders, or in the event of canceled orders, such orders may not be replaced by other sales. In addition, sales to any particular customer may fluctuate significantly from quarter to quarter, and such fluctuating sales could harm our business.

Our products are complex and could contain defects, which could reduce sales of those products or result in claims against us.

     We develop complex and evolving products. Despite testing by us and our customers, errors may be found in existing or new products. This could result in a delay in recognition or loss of revenues, loss of market share or failure to achieve market acceptance. These defects also may cause us to incur significant warranty, support and repair costs, may divert the attention of our engineering personnel from our product development efforts and could harm our relationships with our customers. The occurrence of these problems could result in the delay or loss of market acceptance of our products and would likely harm our business. Defects, integration issues or other performance problems in our products could result in financial or other damages to our customers or could lessen market acceptance of our products. Our customers could also seek and obtain damages from us for their losses. Although we specifically limit our liability to replacement of defective items or return of amounts paid, a product liability claim brought against us, even if unsuccessful, would likely be time consuming and costly to defend.

Strong competition in the semiconductor memory market may harm our business.

     The semiconductor memory market is intensely competitive and has been characterized by an oversupply of product, price erosion, rapid technological change, short product life cycles, cyclical market patterns and heightened foreign and domestic competition. Certain of our competitors offer broader product lines and have greater financial, technical, marketing, distribution and other resources than us. We may not be able to compete successfully against any of these competitors. Our ability to compete successfully in the high performance memory market depends on factors both within and outside of our control, including:

	•		real or perceived imbalances in supply and demand;
	•		product pricing;
	•		the rate at which OEM customers incorporate our products into their systems;
	•		the success of our customers’ products and end-user demand;
	•		access to advanced process technologies at competitive prices;
	•		product functionality, performance and reliability;

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	•		successful and timely product development;
	•		the supply and cost of wafers;
	•		achievement of acceptable yields of functional die;
	•		the gain or loss of significant customers; and
	•		the nature of our competitors and general economic conditions.

     In addition, we are vulnerable to technology advances utilized by competitors to manufacture higher performance or lower cost products. We may not be able to compete successfully in the future as to any of these factors. Our failure to compete successfully in these or other areas could harm our business.

Potential intellectual property claims and litigation could subject us to significant liability for damages and could invalidate our proprietary rights.

     In the semiconductor industry, it is not unusual for companies to receive notices alleging infringement of patents or other intellectual property rights of others. We have been, and from time-to-time expect to be, notified of claims that we may be infringing patents, maskwork rights or copyrights owned by third parties. If it appears necessary or desirable, we may seek licenses under patents that we are alleged to be infringing. Although patent holders commonly offer such licenses, licenses may not be offered and the terms of any offered licenses may not be acceptable to us.

     The failure to obtain a license under a key patent or intellectual property right from a third party for technology used by us could cause us to incur substantial liabilities and to suspend the manufacture of the products utilizing the invention or to attempt to develop non-infringing products, any of which could materially and adversely affect our business and operating results. Furthermore, we may become involved in protracted litigation regarding the alleged infringement by us of third party intellectual property rights or litigation to assert and protect our patents or other intellectual property rights. Any litigation relating to patent infringement or other intellectual property matters could result in substantial cost and diversion of our resources which could harm our business.

We have significant international sales and risks related to our international operations could harm our operating results.

     In the six months ended March 31, 2003, approximately 17% of our net sales was attributable to customers located in the United States, 12% was attributable to customers located in Europe and 71% was attributable to customers located in Asia. In fiscal 2002, approximately 30% of our net sales was attributable to customers located in the United States, 15% was attributable to customers located in Europe and 55% was attributable to customers located in Asia. In fiscal 2001, approximately 52% of our net sales was attributable to customers located in the United States, 25% was attributable to customers located in Europe and 23% was attributable to customers located in Asia. Accordingly, our future operating results will depend on general economic conditions in Asia, Europe, and the United States. In addition, the markets for our products, which are highly cyclical, may not continue to grow. We anticipate that sales to international customers will continue to represent a significant percentage of net sales.

     We are subject to the risks of conducting business internationally, including:

	•		economic conditions in Europe and Asia, particularly in Taiwan and the People’s Republic of China;
	•		travel or other restrictions related to the SARS outbreak;
	•		changes in trade policy and regulatory requirements;

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	•		duties, tariffs and other trade barriers and restrictions;
	•		the burdens of complying with foreign laws;
	•		foreign currency fluctuations;
	•		difficulties in collecting foreign accounts receivable; and
	•		political instability.

We have made strategic equity investments in other companies with no assurance that they will increase in value.

     Over the last few years, we have made several strategic equity investments in other technology companies. At March 31, 2003, we had investments in equity securities of privately held companies of approximately $46.6 million, $40 million of which is in SMIC. There can be no assurance that these investments will increase in value and there is the possibility that they could decrease in value over time, even to the point of becoming completely worthless. These investments are tested for impairment on a recurring basis and any reductions in the carrying value would lower our profitability. In this regard, we recorded approximately $397,000 in impairment losses during fiscal 2002.

We may encounter difficulties in effectively integrating acquired businesses.

     From time to time, we may acquire other companies that would be complementary to our business. Acquisitions may result in potentially dilutive issuances of equity securities, incurrence of debt and contingent liabilities, amortization expenses related to intangible assets and the possible impairment of goodwill, which could harm our profitability. In addition, acquisitions involve numerous risks, including, among other things: higher than estimated acquisition expenses; difficulties in successfully assimilating the operations, technologies and personnel of the acquired company; diversion of management’s attention from other business concerns; risks of entering markets in which we have no or limited direct prior experience; and the potential loss of key employees and customers as a result of the acquisition. In this regard, in February 2002, we acquired Purple Ray, Inc., a privately held research and development stage company developing network search engine and content addressable memory integrated circuits. There can be no assurance as to the effect of the Purple Ray acquisition or future acquisitions on our business or operating results.

We depend on our ability to attract and retain our key technical and management personnel.

     Our success depends upon the continued service of our key technical and management personnel, including Jimmy S.M. Lee, our Chairman and Chief Executive Officer, and Gary L. Fischer, our President, Chief Operating Officer, and Chief Financial Officer, as well as on our ability to continue to attract, retain and motivate qualified personnel, particularly experienced circuit designers and process engineers. The competition for such employees is intense. We have no employment contracts or key person life insurance policies with or for any of our executive officers. The loss of the service of one or more of our key personnel could materially and adversely affect our business and operating results.

Terrorist attacks, threats of further attacks, threats of war, and acts of war may negatively impact all aspects of our operations, revenues, costs and stock price.

     The September 2001 terrorist attacks in the United States, as well as future events occurring in response or connection to them, including, future terrorist attacks against United States targets, rumors or threats of war, actual conflicts involving the United States or its allies (such as the recent war in Iraq), or trade disruptions impacting our domestic or foreign suppliers or our customers, may impact our operations and may, among other things, cause delays or losses in the delivery of wafers or other products to us and decreased sales of our products. More generally, these events have affected, and are expected to continue to affect, the general

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economy and customer demand for products sold by our customers. Any of these occurrences could have a significant impact on our operating results, revenues, and costs, which in turn may result in increased volatility in our common stock price and a decline in the price of our common stock.

Our stock price is expected to be volatile.

     The trading price of our common stock has been and is expected to be subject to wide fluctuations in response to:

	•		quarter-to-quarter variations in our operating results;
	•		new or revised earnings estimates;
	•		comments or recommendations issued by analysts who follow us, our competitors or the semiconductor industry and other events or factors;
	•		aggregate valuations and movement of stocks in the broader semiconductor industry;
	•		announcements of new products, strategic relationships or acquisitions by us or our competitors;
	•		increases or decreases in wafer capacity;
	•		general conditions or cyclicality in the semiconductor industry or the end markets that we serve;
	•		governmental regulations, trade laws and import duties;
	•		announcements related to future or existing litigation involving us or any of our competitors;
	•		announcements of technological innovations by us or our competitors;
	•		additions or departures of senior management; and
	•		other events or factors many of which are beyond our control.

     In addition, stock markets have experienced extreme price and trading volume volatility in recent years. This volatility has had a substantial effect on the market prices of securities of many high technology companies for reasons frequently unrelated to the operating performance of the specific companies. These broad market fluctuations may adversely affect the market price of our common stock.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

     Our financial market risk includes risks associated with international operations and related foreign currencies. We anticipate that international sales will continue to account for a significant portion of our consolidated revenue. Our international sales are largely denominated in U.S. dollars and therefore are not subject to material foreign currency exchange risk. We have operations in China, Europe, Taiwan, Hong Kong, and Korea. Expenses of our international operations are denominated in each country’s local currency and therefore are subject to foreign currency exchange risk; however, through March 31, 2003 we have not experienced any significant negative impact on our operations as a result of fluctuations in foreign currency exchange rates. We do not currently engage in any hedging activities, and our derivative financial instruments were immaterial at March 31, 2003.

     We had short-term investments of $53.2 million at March 31, 2003. The primary objective of our investment activities is to preserve principal while at the same time maximizing yields without increasing risk. We invest primarily in high-quality, short-term debt instruments such as municipal auction rate certificates and instruments issued by high quality financial institutions and companies, including money market instruments. A

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hypothetical one percentage point decrease in interest rates would result in approximately a $0.7 million decrease in our interest income.

     We own approximately 29% of ICSI, a public company listed on the Taiwan Stock Exchange. We account for this investment on the equity basis and our total carrying value of this investment as of March 31, 2003 was approximately $19.2 million of which $13.8 million is included in other assets and $5.4 million is included in other comprehensive loss in the equity portion of our balance sheet. The market value of our investment in the common stock of ICSI at March 31, 2003 was approximately $20.2 million, based on quoted market prices. The share price of ICSI is subject to fluctuations. A significant decline in the stock price of ICSI may require us to record a loss related to this investment. In addition, we own approximately $2.6 million of ICSI convertible debentures. As a result of a decline in ICSI’s convertible debenture price, we recorded an unrealized loss of approximately $69,000 related to the ICSI convertible debentures in the six months ended March 31, 2003. This loss was included in other comprehensive loss in the equity portion of our balance sheet. In addition, in the three and six month periods ended March 31, 2003, we recorded charges of approximately $87,000 and $365,000, respectively, related to the decline in the fair value of an embedded derivative associated with the ICSI convertible debenture. The charge associated with the embedded derivative is included in other income (expense). Further deterioration in ICSI’s debenture price would result in additional losses.

     We have investments in equity securities of privately held companies for the promotion of business and strategic objectives of approximately $42.9 million at March 31, 2003, of which $40.0 million is invested in SMIC. These investments are generally in companies in the semiconductor industry. These investments are included in other assets and are accounted for using the cost method. In addition, we have an investment of $3.7 million that is accounted for on the equity method. For investments in which no public market exists, our policy is to review the operating performance, recent financing transactions and cash flow forecasts for such companies in assessing the net realizable values of the securities of these companies. Impairment losses on equity investments are recorded when events and circumstances indicate that such assets are impaired and the decline in value is other than temporary. We recorded $397,000 in impairment losses during fiscal 2002.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

     Our chief executive officer and our chief financial officer, after evaluating the effectiveness of our “disclosure controls and procedures” (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934) as of a date within 90 days of our filing of this quarterly report on Form 10-Q (referred to as the “Evaluation Date”), have concluded that, as of the Evaluation Date, our disclosure controls and procedures were adequate and effective to ensure the timely collection, evaluation and disclosure of information relating to us and our consolidated subsidiaries, if any, that would potentially be subject to disclosure under the Securities Exchange Act of 1934, as amended, and the rules and regulations promulgated thereunder.

Changes in Internal Controls

     There were no significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the Evaluation Date. No significant deficiencies or material weaknesses were identified in the evaluation of our internal controls and therefore no corrective actions have been taken.

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Part II. OTHER INFORMATION

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

The Company’s Annual Meeting of Stockholders was held on Friday, February 7, 2003 at 3:00 p.m., local time, in San Jose, California.

     (a)  The following nominees for Directors were elected. Each person elected as a Director will serve until the next annual meeting of stockholders or until such person’s successor is elected and qualified: