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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the Quarterly Period Ended September 30, 2009

OR

For the Transition Period From                      To                 

COMMISSION FILE NUMBER: 000-52014

Techwell, Inc.

(Exact name of registrant as specified in its charter)

408 E. Plumeria Drive

San Jose, CA  94134

(Address of principal executive offices, including Zip Code)

(408) 435-3888

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities 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 requirements for the past 90 days. Yes x  No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 229.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

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

As of October 31, 2009, 21,659,281 shares of the registrant’s common stock were outstanding.

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TECHWELL, INC.

FORM 10-Q

September 30, 2009

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PART I. Financial Information

Item 1. Financial Statements

TECHWELL, INC.

CONDENSED UNAUDITED CONSOLIDATED BALANCE SHEETS

(in thousands, except par value amount)

See accompanying notes to condensed unaudited consolidated financial statements.

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TECHWELL, INC.

CONDENSED UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

See accompanying notes to condensed unaudited consolidated financial statements.

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TECHWELL, INC.

CONDENSED UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

See accompanying notes to condensed unaudited consolidated financial statements.

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TECHWELL, INC.

NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Note 1—The Company and Basis of Presentation

The Company

Techwell, Inc. (“Techwell” or the “Company”) was incorporated in California in 1997 and reincorporated in Delaware in 2006. The Company is a fabless semiconductor company that designs, markets and sells mixed signal integrated circuits for two primary markets: security surveillance and automotive infotainment.

The Company’s headquarters is located in San Jose, California.  The Company’s international offices include branch offices in South Korea and Taiwan and subsidiaries in China and Japan. These offices provide marketing support to customers. The China and Japan offices are also involved in product development.

The Company has evaluated subsequent events through the date and time the financial statements were issued on November 6, 2009.

Basis of Presentation

The accompanying condensed unaudited consolidated financial statements of the Company have been prepared without audit in accordance with the rules and regulations of the Securities and Exchange Commission. The consolidated balance sheet at December 31, 2008 has been derived from the audited consolidated financial statements as of and for the year then ended. Certain information and disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted in accordance with these rules and regulations. The information in this report should be read in conjunction with the Company’s consolidated financial statements and notes thereto included in its Annual Report on Form 10-K for the year ended December 31, 2008.

In the opinion of management, the accompanying condensed unaudited consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary to summarize fairly the Company’s financial position, results of operations and cash flows for the interim periods presented. The operating results for the three and nine months ended September 30, 2009 are not necessarily indicative of the results that may be expected for the year ended December 31, 2009 or for any other future period.

Principles of Consolidation

The condensed unaudited consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation. The Company reports its financial results on a calendar fiscal year.

Use of Estimates

The preparation of condensed unaudited consolidated financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the condensed unaudited consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

Certain Significant Risks and Uncertainties

The Company operates in a dynamic high technology industry and changes in any of the following areas could have a material adverse effect on the Company’s financial position and results of operations: unpredictable volume and timing of customer orders, which are not fixed by contract; loss of one or more of its customers; decrease in the overall average selling prices of its products; changes in the relative sales mix of its products; changes in its cost of finished goods; the quality and timely service of third-party vendors that manufacture, assemble and test the Company’s products; the Company’s customers’ sales outlook, purchasing patterns and inventory adjustments based on demand and general economic conditions; product obsolescence and the Company’s ability to manage product transitions; the Company’s ability to successfully develop, introduce and sell new or enhanced products in a timely manner; and the timing of new product announcements or introductions by the Company or by its competitors.

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TECHWELL, INC.

NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Accumulated Other Comprehensive Income (Loss)

Accumulated other comprehensive income (loss) consists of net unrealized gains (losses) on available-for-sale investments. The change in unrealized gains on investments for the three and nine months ended September, 2009 was an increase of $0.1 million and $0.2 million, respectively. The change in unrealized losses for the three and nine months ended September 30, 2008 was an increase of $0.4 million and $0.8 million, respectively. Total comprehensive income for the three and nine months ended September 30, 2009 was $1.1 million and $0.1 million, respectively. Total comprehensive income for the three and nine months ended September 30, 2008 was $2.1 million and $5.4 million, respectively.

Note 2—Stock-Based Compensation

The Company has equity incentive plans under which it may grant stock options, restricted stock awards, stock units and stock appreciation rights to employees, consultants and directors. Currently, the Company is granting stock options, restricted stock awards, stock units and stock appreciation rights under its 2006 stock incentive plan (“Plan”) which was adopted by the Board of Directors in November 2005. At September 30, 2009, the total number of shares available for issuance under the Plan was 2.4 million.  Stock options and awards granted under the Plans have a contractual term of up to ten years, generally vest over four years at the rate of 25 percent on the one-year anniversary of the vesting commencement date and ratably each month thereafter and are exercisable under conditions determined by the Board of Directors or committee thereof as permissible under the terms of the Plan. At September 30, 2009, 834 shares exercised prior to vesting are subject to repurchase by the Company.

For the three and nine months ended September 30, 2009 and 2008, stock-based compensation expense includes compensation cost related to estimated fair values of stock options and awards granted after January 1, 2006 and stock-based compensation costs based on intrinsic value related to unvested stock options at January 1, 2006.

The following table summarizes the distribution of stock-based compensation expense (in thousands):

Total compensation cost attributable to activities capitalized into inventory was not significant in any period presented.

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TECHWELL, INC.

NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 3—Net Income (Loss) Per Share

Basic net income (loss) per common share is calculated by dividing net income (loss) by the weighted-average number of common shares outstanding during the reporting period excluding shares subject to repurchase. Diluted net income (loss) per common share reflects the effects of potentially dilutive securities, which consist of common stock options (calculated using the treasury stock method) and restricted awards and shares subject to repurchase. A reconciliation of shares used in the calculation of basic and diluted net income (loss) per share is as follows (in thousands):

For the three months ended September 30, 2009 and 2008, 1.7 million and 1.5 million shares, respectively, associated with stock options and restricted awards outstanding and unvested shares subject to repurchase have been excluded from the weighted-average number of common shares outstanding for the diluted net income per share computation as they are anti-dilutive. For the nine months ended September 30, 2009 and 2008, 3.0 million and 1.2 million shares, respectively, associated with stock options and restricted awards outstanding and unvested shares subject to repurchase have been excluded from the weighted-average number of common shares outstanding for the diluted net income (loss) per share computation as they are anti-dilutive.

Note 4—Income Taxes

In accounting for income taxes, the Company is required to estimate its current tax expense together with assessing temporary differences resulting from differing treatments of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. Significant management judgment is required to assess the likelihood that its deferred tax assets will be recovered from future taxable income. As of September 30, 2009, the Company’s total deferred tax assets were principally comprised of research and other credit carryforwards, stock-based compensation and expense accruals.

The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction, various states and foreign jurisdictions.  The Company is currently under examination by the Internal Revenue Service for the tax years 2007 and 2008. The outcome of the examination is not known, and therefore, the Company is unable to estimate the effect of the audit to the Company’s financial position, results of operations or cash flows.

The Company’s effective tax rate is based on the estimated annual effective tax rate. The effective tax rate was 52% and 39% for the three months ended September 30, 2009 and 2008, respectively. The effective tax rate was 112% and 39% for the nine months ended September 30, 2009 and 2008, respectively. For the nine months ended September 2009, the Company had a significant discrete tax expense related to stock-based compensation of approximately $0.5 million that impacted the Company’s effective tax rate. In the three and nine months ended September 30, 2009 and 2008 the effective tax rate differed from the statutory federal income tax rate primarily due to stock-based compensation, research and development credits and state income taxes.

Note 5—Financial Instruments

The Company’s investments consist of corporate bonds, US government agency securities, commercial paper and auction rate securities (“ARS”). Investments, with the exception of ARS which are currently classified as trading, are considered available-for-sale. With the exception of ARS, they are all carried at fair market value based on market quotes. The Company’s investment in ARS was intended to provide liquidity via an auction process that resets the applicable interest rate at predetermined calendar intervals, allowing investors to either roll over their holdings or gain immediate liquidity by selling such interests at par. During 2008, uncertainties in the credit markets affected all of the Company’s holdings in ARS investments and auctions for the Company’s investments in these securities failed to settle on their respective settlement dates. Consequently, the investments are not currently liquid and the Company will not be able to access these funds until a future auction of these investments is successful or a buyer is found outside of the auction process. All of the ARS investments were investment grade quality and were in compliance with the Company’s investment policy at the time of acquisition.

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TECHWELL, INC.

NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

During the fourth quarter of 2008, the Company entered into an agreement with one of its investment providers, which currently holds its ARS and from whom it had purchased the ARS, to sell, at the Company’s discretion, at par value all of the ARS the Company currently holds back to the investment provider at anytime starting in June 2010. The rights granted under the agreement represent a firm agreement, which is as an agreement with an unrelated party, binding on both parties and legally enforceable, with the following characteristics: a) the agreement specifies all significant terms, including the quantity to be exchanged, the fixed price and the time of transaction and b) the agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable. The enforceability of the agreement results in a put option and should be recognized as a free standing asset separate from the ARS. The put option does not meet the definition of a derivative instrument. Therefore, the Company has elected to measure the put option at fair value, based on authoritative guidance which permits an entity to elect the fair value option for recognized financial assets. As a result, realized gains and losses will be included in earnings in the period in which they arise.

In connection with the acceptance of the offer, the Company recorded $1.0 million as the fair value of the put option asset with a corresponding gain to interest income. Additionally, the Company transferred its ARS from investments classified as available-for-sale to trading. The transfer to trading reflects the Company’s intent to exercise the put option, whereas, prior to the agreement, the Company’s intent was to hold the ARS until the market recovered. Upon transfer to trading, the Company recognized a loss of $1.0 million, included in interest income, for the amount of unrealized loss not previously recognized in earnings. As a result of this transfer unrealized gains or losses will be included in earnings in future periods, and the Company anticipates future changes in fair value of the put option will approximate the fair value movement of the related ARS. The net impact of the change in fair value of the ARS and related put option to the Company’s operating results was nil for the three and nine months ended September 30, 2009.

As of September 30, 2009, the entire ARS investment balance of $6.3 million is classified as short-term investments on the condensed unaudited consolidated balance sheet because the sale of the ARS back to the investment provider is expected to occur in June 2010.

Typically the fair value of ARS investments approximates par value due to the frequent resets through the auction process. While the Company continues to earn interest on its ARS investments at the maximum contractual rate, these investments are not currently trading and therefore do not currently have a readily determinable market value. Accordingly, the estimated fair value of ARS no longer approximates par value.

The Company has used a discounted cash flow model to determine the estimated fair value of its investment in ARS as of September 30, 2009. The assumptions used in preparing the discounted cash flow model include estimates for interest rates, estimates for discount rates using yields of comparable traded instruments adjusted for illiquidity and other risk factors, amount of cash flows and expected holding periods of the ARS. These inputs reflect the Company’s own assumptions about the assumptions market participants would use in pricing the ARS, including assumptions about risk, developed based on the best information available in the circumstances.

The put option is a free standing asset separate from the ARS, and represents the Company’s contractual right to require its investment provider to purchase the ARS at par at anytime starting in June 2010. The Company values the put option based on amount of cash flows and expected holding periods of the related ARS, time value of money and the Company’s assessment of the credit worthiness of its investment provider.

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TECHWELL, INC.

NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The following is a summary of the Company’s available-for-sale securities as of September 30, 2009 (in thousands):

The following is a summary of the Company’s available-for-sale securities as of December 31, 2008 (in thousands):

As of September 30, 2009, the unrealized losses on our available-for-sale securities were insignificant in relation to our total available-for-sale securities. Substantially all of our unrealized losses on our available-for-sale investments can be attributed to fair value fluctuations in an unstable credit environment. The Company considers the declines in market value of its available-for-sale securities to be temporary in nature. When evaluating the investments for other-than-temporary impairment, the Company reviews factors such as the length of time and extent to which fair value has been below cost basis, the financial condition of the issuer and any changes thereto, and the Company’s intent to sell, or whether it is more likely than not it will be required to sell, the investment before recovery of the investment’s amortized cost basis. The Company believes that the unrealized losses are temporary and do not require an other-than-temporary impairment. During the three and nine months ended September 30, 2009 and 2008, the Company did not recognize any other-than-temporary impairment charges on outstanding available-for-sale securities.

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TECHWELL, INC.

NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Effective January 1, 2008, the Company adopted the authoritative guidance for fair value measurements and the fair value option for financial assets and financial liabilities. The table below represents the fair value hierarchy of the Company’s financial instruments measured at fair value as of September 30, 2009 (in thousands):

The following table provides a reconciliation of the beginning and ending balances for the assets measured at fair value using significant unobservable inputs (Level 3) (in thousands):

Note 6—Details of Certain Balance Sheet Components

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TECHWELL, INC.

NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 7—Segment Information

The Company currently operates in one reportable segment, the designing, marketing and selling of mixed signal integrated circuits for multiple video applications primarily for the security surveillance and automotive infotainment markets. The Company’s chief operating decision maker is the Chief Executive Officer.

The percentage of total revenues by geographic location is as follows:

Revenues by product line are as follows (in thousands):

(1) Consists of contract development projects, early generation mixed signal semiconductors for digital video applications and PCI video decoder products.

The revenues and accounts receivable from customers representing 10% or more of total revenues and accounts receivable are as follows:

* less than 10%

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TECHWELL, INC.

NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The following is a summary of long-lived assets by geographic region (in thousands):

Note 8—Related Party Transactions

One of the Company’s Board members is a partner in a law firm that provides services to the Company. The Company incurred fees of nil and $8,000 from this law firm for legal services in the three months ended September 30, 2009 and 2008, respectively. The Company incurred fees of $7,000 and $21,000 from this law firm for legal services in the nine months ended September 30, 2009 and 2008, respectively. The amount payable to this law firm was nil and $8,000 at September 30, 2009 and December 31, 2008, respectively.

Note 9—Contingencies

Indemnification Obligations

Subject to certain limitations, the Company is obligated to indemnify its current and former directors, officers and employees in connection with government inquiries and litigation.  These obligations arise under the terms of the Company’s certificate of incorporation, its bylaws, applicable contracts, and Delaware and California law.  The obligation to indemnify generally means that the Company is required to pay or reimburse the individuals’ reasonable legal expenses and possibly damages and other liabilities incurred in connection with these matters.  Additionally, the Company has certain indemnification obligations to customers under its contract development projects with respect to any infringement of third-party patents and intellectual property rights by its products.

Other Legal Matters

The Company is currently not a party to any material legal proceedings. The Company may be named from time to time as a party to lawsuits in the normal course of its business. Litigation in general and intellectual property and securities litigation in particular, can be expensive and disruptive to normal business operations.  Moreover, the results of legal proceedings are difficult to predict.

Note 10—Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (“FASB”) issued authoritative guidance for fair value measurements, which defines fair value, establishes a framework for measuring fair value and expands disclosures about assets and liabilities measured at fair value in the financial statements. In February 2008, the FASB issued authoritative guidance, which allows for the delay of the effective date of the authoritative guidance for fair value measurements for one year for all non-financial assets and liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis. The Company adopted the provisions of the guidance for financial assets and liabilities effective January 1, 2008 and the provisions of the guidance for non-financial assets and non-financial liabilities effective January 1, 2009. The application of the guidance to non-financial assets and non-financial liabilities did not have an impact on the condensed unaudited consolidated financial position, results of operations or cash flows.

In December 2007, the FASB revised the authoritative guidance for business combinations, which establishes principles and requirements for how an acquirer recognizes and measures in its consolidated financial statements the identifiable assets acquired, the liabilities assumed, contractual contingencies and contingent consideration at their fair value on the acquisition date, any controlling interest in the acquiree and the goodwill acquired. The guidance also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. The guidance is effective for fiscal years beginning after December 15, 2008. The Company will apply the provisions of the guidance to any acquisitions occurring subsequent to January 1, 2009.

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TECHWELL, INC.

NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

In April 2009, the FASB issued authoritative guidance on accounting for assets acquired and liabilities assumed in a business combination that arise from contingencies, which amends the guidance for the initial recognition and measurement, subsequent measurement and accounting, and disclosures for assets and liabilities arising from contingencies in business combinations. The guidance eliminates the distinction between contractual and non-contractual contingencies, including the initial recognition and measurement criteria. The guidance is effective for contingent assets and contingent liabilities acquired in business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The Company will assess the impact of this guidance at the time of any such acquisition.

In April 2009, the FASB issued three related authoritative guidance for determining fair value when the volume and level of activity for an asset or liability have significantly decreased and identifying transactions that are not orderly, recognition and presentation of other-than-temporary impairments and interim disclosures about fair value of financial instruments, which are effective for interim and annual periods ending after June 15, 2009. These authoritative guidance provides guidance on how to determine the fair value of assets and liabilities in the current economic environment and reemphasizes that the objective of a fair value measurement remains an exit price, modifies the requirements for recognizing other-than-temporarily impaired debt securities and revises the existing impairment model for such securities, by modifying the current intent and ability indicator in determining whether an investment in debt security is other-than-temporarily impaired, and enhances the disclosure of instruments for both interim and annual periods. Effective April 1, 2009, the Company adopted the provisions of the guidance. The adoption of the three guidance did not have an impact on the condensed unaudited consolidated financial position, results of operations or cash flows.

Note 11—Subsequent Events

On October 9, 2009, the Company acquired substantially all of the assets of a development stage company based in China. The purchase price for the acquisition was $4.2 million, less assumed liabilities of approximately $0.8 million.. The Company paid the purchase price in cash and agreed to make restricted stock awards, which will vest over four years, to employees in connection with their new employment with the Company. The acquired company is focused on developing video solutions for the security surveillance market. As part of the purchase agreement, the Company extended employment offers to approximately 40 employees.

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

The following discussion of our financial condition and results of operations should be read in conjunction with the condensed unaudited consolidated financial statements and notes to those statements included elsewhere in this Quarterly Report on Form 10-Q for the three and nine months ended September 30, 2009 and our audited consolidated financial statements for the year ended December 31, 2008 included in our Annual Report on Form 10-K.

This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. These statements relate to future periods, future events or our future operating or financial plans or performance. These statements can often be identified by the use of forward-looking terminology such as “expects,” “believes,” “intends,” “anticipates,” “estimates,” “plans,” “may,” or “will,” or the negative of these terms, and other similar expressions. These forward-looking statements include statements as to the source of our revenues, our ability to generate revenues, our ability to sustain our growth rate and return to profitability, expected growth in our target markets and application-specific products, our expectation regarding the increase in certain expenses, our cash needs, our capital requirements, our market risk sensitivity, our business and product strategies, our anticipated tax rate, industry trends and our anticipation that developments in our technologies and new products will increase our target market share.

These forward-looking statements reflect our current views with respect to future events, are based on assumptions and are subject to risks and uncertainties. These risks and uncertainties could cause actual results to differ materially from those projected and include, but are not limited to, fluctuations in our revenue and operating results, our ability to return to profitability, the demand for our products in our target markets, our ability to compete, our dependence on key and highly skilled personnel, the ability to develop new products and to enhance our existing products, the continued seasonality of our business due to our target markets and location of our customers, our ability to integrate businesses that we may acquire, our ability to estimate and predict customer demand, economic volatility in either domestic or foreign markets, the impact of any change in United States federal income tax laws and the loss of any beneficial tax treatment that we currently enjoy, our reliance on independent foundries and subcontractors for the manufacture, assembly and testing of our products, the length of our sales cycle and reliance on distributors, our ability to protect our intellectual property, the cyclical nature of the semiconductor industry, our ability to raise capital, the potential volatility of our stock, the outcome of future litigation and the other risks set forth under PART II — OTHER INFORMATION,  Item 1A. “Risk Factors.” Given these risks and uncertainties, you should not place undue reliance on these forward-looking statements. Except as required by federal securities laws, we undertake no obligation to update any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.

In this report all references to “Techwell,” “we,” “us” or “our” mean Techwell, Inc.

Techwell is our registered trademark. We also refer to trademarks of other corporations and organizations in this Form 10-Q.

Overview

We are a fabless semiconductor company that designs, markets and sells mixed signal integrated circuits for two primary markets: security surveillance and automotive infotainment. We design application-specific products for our two primary markets that enable the conversion of analog video signals to digital form and perform advanced digital video processing to facilitate the display, storage and transport of video content. We believe this application specific product strategy allows us to better address varying customer requirements, fully leverage our technology capabilities and achieve greater share within our two core markets. To a lesser extent, we market and sell video decoders to the consumer market. Our semiconductors are based on our proprietary architecture and mixed signal technologies that we believe provide high video quality under a wide range of signal conditions, enable high levels of integration and are cost-effective.

Our business has experienced significant growth primarily as a result of our ability to develop new products, obtain design wins and convert these design wins into revenues. We generated revenues from the sale of over 25 different products in the quarter ended September 30, 2009.

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We have three principal semiconductor product lines: security surveillance products, automotive infotainment products and consumer products. Our security surveillance products integrate important functions required to display, store and transport analog video signals from security surveillance cameras. For example, we integrate multiple video decoders into a single semiconductor. As a result, this semiconductor is able to receive and decode analog video signals from multiple cameras into a standard digital format. In addition, we integrate a multiplexor, a key technology required to combine multiple video signals into a single video signal, and a display processor, a key technology required to display multiple video channels. In 2007, we introduced our first integrated security surveillance product, which integrated four video decoders and a system controller and a multiplexor on a single semiconductor. In December 2008, we introduced a new security surveillance product which includes a 16 channel multiplexer and supports the display of multiple standard definition and high definition video sources. We currently sell our security surveillance products to customers for the following applications: embedded digital video recorders, or DVRs, PC-based DVRs, networked video recorders, or NVRs, and multiplexors.

Our automotive infotainment products integrate important functions required to display popular analog video, high definition video and PC graphics signals on a LCD display. These key functions include a video decoder, deinterlacer and scaler. In addition, our newer generation automotive infotainment products integrate a timing controller to interface directly with certain types of LCD displays and image enhancement functionality to improve overall video quality. In January 2008, we announced the introduction of five new LCD display processors designed for the automotive end market. These new products are designed to provide advanced image processing, an integrated programmable timing controller and multiple analog and digital video inputs.

Our consumer products are high performance mixed signal semiconductors that decode analog TV broadcast signals, including NTSC, PAL and SECAM, and popular analog video signals, including composite, S-Video, component and SCART, into a standard digital format. Our consumer products integrate proprietary sync processing, color demodulating and digital 2D and 3D comb filtering, which are the key technologies required for high performance video decoding. We offer a broad range of consumer products at various price points and with varying features. We have developed our video decoder products for applications within the consumer markets such as advanced TV, multifunction LCD monitor, DVD recorder and camcorders. In the future, however, we intend to focus our development efforts specifically on applications for the security surveillance and automotive infotainment markets and as a result, we anticipate our consumer revenues will decline over the next several quarters.

Our other products include early generation mixed signal semiconductors for digital video applications and PCI video decoder products, which are video decoders that utilize peripheral component interconnect, or PCI, technology for personal computer applications.

Although our revenues have grown rapidly since 2004, we do not expect to achieve similar growth rates in the future. We currently expect to increase our expense levels in the future to support increased research and development efforts in order to bring new products to our primary markets. These expenditures may not result in increased revenue or profitability in the future. In addition, our ability to increase our revenues will depend on increased demand for digital video applications in the security surveillance and automotive infotainment markets. Although we believe our two primary markets will experience growth in the next few years, actual growth of these markets is uncertain. In addition, the timing of orders by and shipments to our customers, as well as general trends in our two primary markets, can cause our revenue growth to be inconsistent.

We undertake significant product development efforts well in advance of a product’s release, and in advance of receiving purchase orders from our customers. Our product development efforts, which are focused on developing new designs with broad demand and potential for future derivative products, typically take from six to 24 months until production begins, depending on the product’s complexity. If we secure a design win, the system designer is likely to continue to use the same or enhanced versions of our product across a number of their models, which tends to extend the life cycles of our products. Conversely, if a competitor secures the design win, it may be difficult for us to sell into the customer’s application for an extended period. Our sales cycle typically ranges from six to 24 months. Due to the length of our product development and sales cycle, the majority of our revenues for any period is generally weighted toward products introduced for sale, meaning products for which we commenced placing orders with our manufacturing subcontractors, in the prior one or two years. As a result, our present revenues are not necessarily representative of future sales because our future sales are likely to be comprised of a different mix of products, some of which are now in the development stage.

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As a fabless semiconductor company, we outsource all of our manufacturing, assembly and test functions to third-party vendors primarily located in Taiwan. This business model enables us to reduce our capital expenditures and fixed costs, while focusing our engineering and design resources on our core strength, the design of mixed signal semiconductors for digital video applications.

We sell our products to distributors that fulfill third-party orders for our products. We also sell directly, using independent sales representatives, to original equipment manufacturers, or OEMs, and to original design manufacturers, or ODMs. For the nine months ended September 30, 2009, we derived 76% of our revenues from products sold to distributors and 24% from products sold to OEMs or ODMs. For the year ended December 31, 2008, we derived 79% of our revenues from products sold to distributors and 21% from products sold to OEMs or ODMs.  Our gross margins have not historically been significantly different between sales to distributors and sales to OEMs or ODMs through orders procured by independent sales representatives. However, our operating profit on sales through orders procured by independent sales representatives can be less due to the payment of commissions to sales representatives which we record as sales and marketing expense.

We received an aggregate of 75% and 80% of our revenues from our ten largest customers for the three months ended September 30, 2009 and 2008, respectively. For the three months ended September 30, 2009, Lacewood International Corporation, or Lacewood, a distributor, accounted for 38% of our revenues. For the three months ended September 30, 2008, Lacewood and AV Tech Corporation, or AV Tech, accounted for 37% and 11% of our revenues, respectively. For the nine months ended September 30, 2009, Lacewood accounted for 37% of our revenues. For the nine months ended September 30, 2008, Lacewood and AV Tech accounted for 32% and 11% of our revenues, respectively.

We derive substantially all of our revenues from sales to foreign customers, particularly in Asia, which sales accounted for 97% and 98% of our revenues for the nine months ended September 30, 2009 and 2008, respectively. The table below indicates the percentage of total revenues by geographic location for the periods indicated:

We received 51% and 35% of our revenues from China in the nine months ended September 30, 2009 and 2008, respectively.  The percentage increase between 2009 and 2008 was primarily due to an increase in revenue from our security surveillance customers in China who are benefitting from the relative strength in the Chinese domestic economy. We received 18% and 31% of our revenues from Taiwan in the nine months ended September 30, 2009 and 2008, respectively.  The decrease was primarily due to a decline in revenues from consumer markets, whose products were primarily sold to customers in Taiwan.

We believe that a substantial majority of our revenues will continue to come from customers located in Asia, where most of the electronic devices that use our semiconductors are manufactured. As a result of this regional customer concentration, we may be subject to environmental, economic, cultural and political events as well as other developments that impact our customers in Asia. All of our sales currently are denominated in U.S. dollars. Therefore, an increase in the value of the U.S. dollar relative to foreign currencies could make our products less competitive in international markets. Substantially all of our cost of revenues and a majority of our operating expenses are also denominated in U.S. dollars. As a result, we believe that our overall exposure to foreign exchange risk is low.

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At September 30, 2009, we had two international subsidiaries, one in Japan and one in China. We also have two international branches, one in South Korea and one in Taiwan. At September 30, 2009, 64 of our 165 employees were located in our international subsidiaries and branch offices. Our China and Japan subsidiaries are involved in both product development and technical marketing support. Our Taiwan and Korea branches primarily provide technical marketing support.

It is difficult for us to forecast the demand for our products, in part because of the highly complex supply chain between us and the end markets that incorporate our products. Demand for new features changes rapidly. Distributors and ODMs add an additional layer of complexity. We must, therefore, forecast demand not only from our direct customers, but also from other participants in this multi-level distribution channel. Because of our lengthy product development cycle, it is critical for us to anticipate changes in demand for our various product features and the applications they serve, to allow sufficient time for product design. Our failure to accurately forecast demand can lead to product shortages that can impede production by our customers and harm our relationship with these customers. Conversely, our failure to forecast declining demand or shifts in product mix can result in excess or obsolete inventory.

Generally, the average selling price of our products will decline over the life of the product. Our experience to date is that the decline has not had a material effect on our gross margins, as price reductions have been mitigated by lower per unit costs associated with both high unit volume and the transition of our products to smaller process geometries.

We expect our revenues to be lower in the first calendar quarter of each year. The most significant factor for this decline is because most of our semiconductors are sold to customers located in Asia, primarily to customers located in regions who observe the Lunar New Year holiday. Typically, our customers’ offices are closed for a week or more during the extended holiday period, which negatively impacts our business during the first calendar quarter of the year. As a result of seasonality associated with our customer concentration in Asia, we expect our revenues to be lower in the first calendar quarter of each year.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based upon our condensed unaudited consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed unaudited consolidated financial statements requires us to make estimates and judgments that affect the reported amount of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. We evaluate our estimates on an on-going basis, including those related to inventory valuations, valuation of investments, income taxes and stock-based compensation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making the judgments we make about the carrying values of assets and liabilities that are not readily apparent from other sources. Because these estimates can vary depending on the situation, actual results may differ from the estimates.

We believe the following critical accounting policies affect our more significant judgments used in the preparation of our condensed unaudited consolidated financial statements.

Revenue Recognition.   Revenues from product sales are recognized upon shipment, provided that title and risk of loss has passed to the customer, persuasive evidence of an arrangement exists, the price is fixed or determinable and collectibility is probable. We do not allow for price protection or stock rotation rights with any of our distributors. If we change our practice and allow stock rotation or price protection in the future, we would have to evaluate the consequences on the timing of our revenue recognition, which could lead to the deferral of the revenues subject to such uncertainties unless reasonable estimates of returns or price reductions can be made at the time of shipment.

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Fair Value Measurements.  Effective January 1, 2008, we adopted the authoritative guidance for fair value measurements and the fair value option for financial assets and financial liabilities. The guidance defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements required under other accounting guidance.  The guidance clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants and also requires that a fair value measurement reflect the assumptions market participants would use in pricing an asset or liability based on the best information available. Assumptions include the risks inherent in a particular valuation technique (such as a pricing model) and/or the risks inherent in the inputs to the model. These assumptions are volatile and subject to change as the underlying sources of these assumptions and market conditions change.  Refer to Note 2 to our consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2008 for the fair value hierarchy, and Note 5 to our condensed unaudited consolidated financial statements included in this Quarterly Report on Form 10-Q for inputs to valuation techniques and fair value measurements of financial assets carried at fair value.

Inventory Valuation.   Inventory is valued at the lower of cost or market, computed on a first-in, first-out basis. We evaluate inventory for excess and obsolescence and write-down units that are unlikely to be sold based upon a six month demand forecast. This evaluation may take into account matters including expected demand, anticipated sales price, product obsolescence and other factors. If actual future demand for our products is less than currently forecasted, additional inventory write-downs may be required. Once inventory costs are written down, such revised costs are maintained until the product is sold or scrapped. If a unit that has been written down is subsequently sold, the cost associated with the revenue from this unit is reduced to the extent of the write-down, resulting in an increase in gross profit.

Accounting for Income Taxes.   In accounting for income taxes, we are required to estimate our current tax expense together with assessing temporary differences resulting from differing treatments of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. We must assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. Significant management judgment is required to assess the likelihood that our deferred tax assets will be recovered from future taxable income. At September 30, 2009, our total deferred tax assets were principally comprised of research and other credit carryforwards, stock-based compensation and expense accruals.

We assess the recoverability of our deferred tax assets. To assess the likelihood that the deferred tax assets will be recovered from future taxable income, we considered both positive evidence that indicates a valuation allowance is not needed and negative evidence that indicates a valuation allowance is needed. As of September 30, 2009, we believe that our predictable strong earnings provide ample evidence that no valuation allowance is required at this time as it is more likely than not the deferred tax assets will be realized in the future.

Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining deferred tax assets. In the event that we determine all or part of the net deferred tax assets are not realizable in the future, we will make an adjustment to the valuation allowance that would be charged to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on our financial condition and operating results.

We file income tax returns in the U.S. federal jurisdiction, various states and foreign jurisdictions. We are currently under examination by the Internal Revenue Service for the tax years 2007 and 2008. The outcome of the examination is not known, and therefore, we are unable to estimate the effect of the audit to our financial position, results of operations or cash flows.

Stock-Based Compensation.   For the three and nine months ended September 30, 2009 and 2008, stock-based compensation expense includes compensation costs related to estimated fair values of stock options and awards granted after January 1, 2006 and compensation costs related to unvested stock options at January 1, 2006 based on the intrinsic values.

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For options granted after January 1, 2006, we use the straight-line method for expense attribution. For options granted prior to January 1, 2006, we use the multiple grant approach for expense attribution, which results in substantially higher amounts of amortization in earlier years as opposed to the straight-line method, which results in equal amortization over the vesting period of the options.

The fair value of options granted after January 1, 2006 is estimated on the grant date using the Black-Scholes option valuation model. The expected term assumption calculation was based on historical data as adjusted for any changes in future expectations. We relied exclusively on historical volatility in the expected volatility assumption calculation since we do not have any publicly traded options. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected term of the option and the estimated forfeiture rate is based on our historical forfeiture experience.

The following assumptions are used to value stock options granted in the periods presented:

Stock-based compensation expense for restricted stock awards is determined using the fair value of our stock on the date of the grant and is recognized on a straight-line basis over the service period.

Stock-based compensation expense is allocated among cost of revenues, research and development expenses and selling, general and administrative expenses, respectively, based upon the employee’s job function. We expect to continue to recognize substantial amounts of stock-based compensation expense relating to our employee stock options and awards in future periods.

Results of Operations

The following table is derived from our selected financial data and sets forth our historical operating results as a percentage of revenues: