This Quarterly Report on Form 10Q contains statements relating to expected future results and business trends that are based upon our current estimate, expectations, and projections about the industry, and upon our beliefs, and certain assumptions we have made that are "forward-looking statements" as defined in the Private Securities Litigation Reform Act of 1995. Words such as "anticipates," "guidance," "expects," "intends," "plans," "believes," "seeks," "estimates," "may," "will," "prospects," "outlook," "forecast," and variations of these words or similar expressions are intended to identify "forward-looking statements." In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances, including any underlying assumptions, are "forward-looking statements." Such statements are not guarantees of future performance and are subject to certain risks, uncertainties, and assumptions that are difficult to predict. Therefore, our actual results may differ materially and adversely from those expressed in any "forward-looking statement" as a result of various factors. These factors include, but are not limited to: the timely introduction of new products, demand for, and market acceptance of, new and existing fingerprint sensors in the PC and wireless markets, our ability to secure design wins and these design wins leading to future production, the adoption of our sensors in other applications outside of PC notebooks and wireless devices, the rate at which we increase our activity and opportunities in the wireless market, changes in product mix, the actions of existing or future competitors, the impact of litigation and the impact of the macroeconomic trends on our served markets as well as other risks detailed from time to time in our SEC filings. These "forward-looking statements" are made only as of the date hereof, and we undertake no obligation to update or revise the "forward-looking statements," whether as a result of new information, future events or otherwise.

The following discussion should be read in conjunction with, and is qualified in its entirety by reference to our consolidated financial statements, including the notes thereto. Except for the historical information, the discussions in this section contain forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below.

Overview

We are a leading mixed-signal semiconductor company providing fingerprint authentication sensors and solutions to the PC and wireless device markets. Since our inception in 1998, we have shipped almost 52 million sensors which have been integrated into over 250 different models of laptops, desktops and PC peripherals as well as over 10 million mobile phones. We shipped approximately 3.3 million sensor units in the three months ended October 2, 2009, as compared to 5.3 million sensor units we shipped in the three months ended October 3, 2008.

Since inception, we have invested heavily in research and development and had not achieved profitability prior to the year ended January 2, 2009. We have experienced net losses for each fiscal quarter since our last fiscal year ended January 2, 2009. From our incorporation through 2000, we were primarily engaged in the design and development of our first products, which we began shipping commercially in 2000. Our revenue grew from $13.8 million in 2004 to $63.9 million in 2008, driven primarily by demand in the PC and wireless device markets. We expect sales of our products for use in the PC and wireless device markets to continue to represent a substantial portion of our revenue in the foreseeable future. In the first three quarters of 2009, we experienced a significant decline in revenue, as compared to the same period last year, as customer demand continued to be impacted by weakened macroeconomic conditions. We expect these weakened macroeconomic conditions to continue throughout 2009 and the first portion of 2010, which will adversely impact our revenue.

We primarily sell our products to OEMs, ODMs, or contract manufacturers. Our customers' products are complex and require significant time to define, design and ramp to volume production. Our sales cycle begins with our selling and marketing staff and application engineers engaging with our customers' system designers and management, which is typically a multi-month, or even multi-year, process. If we are successful, a customer will decide to incorporate our solution in its product, which we refer to as a design-win. Because the sales cycles for our products are long, we incur expenses to develop and sell our products, regardless of whether we achieve the design-win and well in advance of generating revenue, if any, from those expenditures. We do not have long-term purchase commitments from any of our customers, as sales of our products are generally made under individual purchase orders. However, once one of our products is incorporated into a customer's design, it is likely to remain designed in for the life cycle of its product although there is no guarantee of how much the customer will buy, if any. We believe this to be the case because a redesign of a product already in production would generally be time consuming and expensive. In September 2008, we issued a press release and held a conference call which, in part, disclosed the loss of a 2009 design in opportunity at one of our significant PC customers. We believe we will start experiencing a revenue decline of approximately $1 million associated with this loss in the fourth quarter of 2009 and revenue will continue to decline throughout the first half of 2010.

We do not own or operate our own semiconductor fabrication, wafer bumping, assembly or test facilities. We depend on independent vendors to manufacture, assemble and test our fingerprint sensor products. By outsourcing manufacturing, we are able to avoid the cost associated with owning and operating our own manufacturing facility and take advantage of the scale of operations these third parties provide.

Our future profitability and rate of growth, if any, will be directly affected by the continued acceptance of our products in the marketplace, as well as the timing and size of orders, product mix, average selling prices and costs of our products, timely introduction of new products and general economic conditions. Our ability to maintain profitability will also be affected by the extent to which we must incur additional expenses associated with building our product and expenses in sales, marketing, development, and general and administrative capabilities to expand our business. The largest component of our operating expenses is personnel costs. Personnel costs consist of salaries, benefits and incentive compensation, including bonuses and stock-based compensation, for our employees. The following are material trends that are creating opportunities and risks to our business, and a discussion of how we are responding:

• The global macroeconomic downturn has accelerated the growth in sales of lower-cost PCs, including netbooks. The fingerprint sensor attach rate in lower-cost PCs is lower relative to more expensive, feature rich models. To increase penetration of the lower-cost PC market, we are focusing development efforts on lower-cost fingerprint sensors and client application software tailored for use in this growing portion of the PC market. We expect to ramp production of our small, lower-cost fingerprint sensor (AES1660) for the PC market, codenamed "Marcy," in the fourth quarter of 2009. These new solutions are tailored for consumer PCs and the growing portion of the lower-cost laptop market.

• Outside of Japan, wireless network carriers are still evaluating the value proposition of integrating fingerprint sensors into devices sold for use on their networks. We expect eventual widespread integration of fingerprint sensors into wireless devices, however, the timing of adoption by wireless network carriers will have a significant impact on our future revenues. In response, we are working with wireless device manufacturers to accelerate adoption of fingerprint sensors by highlighting our Power of Touch features such as personalization and navigation. In addition, we are focused on improving the durability and aesthetics of our sensors for wireless devices through continued development of our new TouchStone packaging technology.

• Weak macroeconomic conditions which began in the fourth quarter of 2008 and continue to impact our financial performance in 2009, resulted in significant declines in shipments of our products as compared to the nine months ended October 3, 2008. In anticipation of these declines in our revenues, we took actions to reduce our expenses including workforce reductions, cancellation of our bonus plan for 2009, salary reductions for select employees, and reductions in numerous discretionary expenses.

Description of Our Revenue, Cost of Revenue and Expenses

Revenue. Our revenue is generated primarily from shipments of our fingerprint authentication sensors and solutions. The price of our products is based upon market and competitive conditions. Therefore, the main factors that impact our revenue are unit volumes and average selling prices.

Cost of revenue and gross margin. We outsource all manufacturing activities associated with our products, which includes wafer fabrication, wafer bumping, assembly and test functions. A significant portion of our cost of revenue consists of the costs to manufacture our products. Cost of revenue also includes items such as equipment depreciation, royalty expense, production planning personnel and related expenses, warranty costs, inventory valuation write-downs and stock-based compensation under ASC Topic 718, Compensation - Stock Compensation and ASC Subtopic 505-50, Equity-Based Payments to Non-Employees (formerly SFAS No. 123, Share Based Payment). The primary factors that impact our cost of revenue are the number of units sold, mix of products sold, wafer and other raw material costs, outsourced manufacturing costs and product yields. In the future, we believe cost of revenue could increase in absolute dollars from an expected increase in revenue or could decline in absolute dollars from a decrease in revenue. Cost of revenue as a percentage of total revenue may increase over time if decreases in average selling prices are not offset by corresponding decreases in our product costs.

We use third-party foundries, bumping, assembly and test subcontractors, which are primarily located in Asia, to manufacture our semiconductor products. We purchase processed wafers from our fabrication suppliers, which are currently Taiwan Seminconductor Manufacturing Company Limited and Chartered Semiconductor Manufactured. We also outsource the bumping, assembly, test and other processing of our products to third-party subcontractors, primarily Chipbond

Technology Corporation, Signetics Corporation and ChipMOS Technologies (Bermuda) Ltd. We do not have long-term agreements with any of our third-party subcontractors. A significant disruption in the operations of one or more of these subcontractors would impact the production of our products and could have a material adverse impact on our business, financial condition and results of operation.

Our gross margin has been and will continue to be affected by a variety of factors, including average selling prices of our products, product mix, and timing of cost reductions for outsourced manufacturing services, inventory write downs and the timing and changes in production yields. In addition, we tend to experience lower yields on the initial production release of a new product.

Research and development expenses. Research and development expenses primarily include personnel, the cost of fabrication masks, engineering development software, depreciation and amortization associated with capital equipment and intellectual property, third-party development support, allocated facilities expense, and stock-based compensation under ASC Topic 718, Compensation - Stock Compensation and ASC Subtopic 505-50, Equity-Based Payments to Non-Employees (formerly SFAS No. 123, Share Based Payment). All research and development costs are expensed as incurred.

We believe that research and development expenses could continue to increase in absolute dollars in the future as we increase our investment in developing new products. Additionally, as a percentage of revenue, these costs fluctuate from one period to another.

Selling and marketing expenses. Selling and marketing expenses consist primarily of salaries and commissions for our sales and marketing personnel, independent sales representative commissions, travel, marketing communications, press releases, advertising, costs for tradeshows, marketing programs, allocated facilities expense, consultants and market studies, and stock-based compensation under ASC Topic 718, Compensation - Stock Compensation and ASC Subtopic 505-50, Equity-Based Payments to Non-Employees (formerly SFAS No. 123, Share Based Payment) . As we align our operating expenses with current economic conditions, we expect selling and marketing expenses to decrease in absolute dollars.

General and administrative expenses. General and administrative expenses consist primarily of general corporate costs, including personnel expenses, financial reporting, corporate governance and compliance and outside legal, audit, tax compliance fees, allocated facilities expense, and stock-based compensation under ASC Topic 718, Compensation - Stock Compensation and ASC Subtopic 505-50, Equity-Based Payments to Non-Employees (formerly SFAS No. 123, Share Based Payment).

Other income (expense) net. Other income (expense) net includes interest income earned on our short term and long term investments of cash and cash equivalents and realized losses on our available-for-sale investments.

Provision for income taxes. As of January 2, 2009, we had federal net operating loss carry forwards of approximately $48.9 million. These federal net operating loss carry forwards will expire commencing in 2018. Utilization of these net operating loss carry forwards may be subject to an annual limitation due to provisions of the Internal Revenue Code of 1986, as amended, that are applicable if we have experienced an "ownership change" in the past, or if an ownership change occurs in the future aggregated with certain other sales of our stock after our initial public offering.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with United States generally accepted accounting principles, or GAAP. These accounting principles require us to make certain estimates and judgments that can affect the reported amounts of assets and liabilities as of the dates of the consolidated financial statements, the disclosure of contingencies as of the dates of the consolidated financial statements, and the reported amount of revenue and expenses during the periods represented. Although we believe that our judgments and estimates are reasonable under the circumstances, actual results may differ from those estimates.

Our critical accounting policies as of October 2, 2009 are consistent with those discussed in our annual report on Form 10-K for the year ended January 2, 2009.

Results of Operations

The following table sets forth selected statement of operations data for the
periods indicated expressed as a percentage of revenue:



                                             Three months ended                    Nine months ended
                                        October 2,         October 3,        October 2,         October 3,
                                           2009               2008              2009               2008

Revenue                                        100 %              100 %             100 %              100 %
Cost of revenue                                 55                 53                54                 52


Gross margin                                    45                 47                46                 48


Operating expenses
Research and development                        35                 25                43                 24
Selling and marketing                           20                 15                23                 15
General and administrative                      31                  7                38                 10


Total operating expenses                        86                 47               104                 49


Loss from operations                           (41 )               -                (58 )               (1 )


Total other income (expense), net                1                  3                 1                  4


Net income (loss)                              (40 )%               3 %             (57 )%               3 %

Comparison of the Three and Nine Months Ended October 2, 2009 and October 3, 2008

Revenue. Our revenue was $10.3 million for the three months ended October 2, 2009 as compared to $18.4 million for the three months ended October 3, 2008, a decrease of $8.1 million, or 44%. Our revenue was $25.8 million for the nine months ended October 2, 2009 as compared to $52.3 million for the nine months ended October 3, 2008, a decrease of $26.5 million, or 51%. During the first three quarters of 2009, we experienced a substantial decline in revenue, as compared to the first three quarters of 2008, as customer demand continued to be impacted by the weakened macroeconomic conditions that began in the fourth quarter of 2008. In addition to depressing overall sales of PC's, the weakened economic conditions have disproportionately reduced the sales of higher-end notebooks which are more likely to include a fingerprint sensor. Our revenue was further impacted in 2009 as PC customers reduced their inventory levels to keep pace with the decline in end-user demand for their laptops which incorporate our sensors. We have also experienced declines in revenue associated with our Wireless market, which has been driven by specific customer related product life cycles.

The reduction in shipments to our PC and Wireless customers was the primary factor which adversely impacted our revenue by $6.5 million and $24.1 million for the three months and nine months ended October 2, 2009 as compared to the same timeframes last year. We are also experiencing declining sales prices at the product level which is considered a typical trend within the semiconductor industry. Our average selling prices ("ASPs"), driven by market conditions and competition within the same, adversely impacted our revenue by $1.6 million and $2.5 million for the three and nine months ended October 2, 2009, respectively, as compared to the same periods last year. We expect these adverse market conditions to continue throughout 2009, which will negatively affect our revenue as compared to 2008.

Cost of revenue and gross margin. Our cost of revenue was $5.6 million for the three months ended October 2, 2009 as compared to $9.7 million for the three months ended October 3, 2008, resulting in a gross profit of $4.7 million for the three months ended October 2, 2009 as compared to $8.7 million for the three months ended October 3, 2008, a decrease of $4.0 million, or 46%. Our gross margin was 45% in the three months ended October 2, 2009 as compared to 47% in the three months ended October 3, 2008. Reduced shipments, an overall decline in ASPs and some changes in product mix were primary causes of the decrease in gross profit. The decline in ASPs was somewhat offset by product cost reductions and manufacturing yield improvements. In addition to the adverse ASP impact, the unfavorable gross margins were impacted by

fixed manufacturing support costs which were lower in absolute dollars in the quarter ended October 2, 2009 as compared to October 3, 2008, but were higher as a percentage of revenue over that same timeframe. The downward pressure on gross margin was offset slightly by reduced inventory provisions taken for the three months and the nine months ended October 2, 2009 as compared to the same timeframes last year. We expect the competitive market conditions to continue to apply downward pressure on our ASPs. If we are unable to reduce our cost to keep up with this ASP erosion, this situation could, in turn, adversely impact our future gross margin performance.

Our cost of revenue was $13.8 million for the nine months ended October 2, 2009 as compared to $27.1 million for the nine months ended October 3, 2008, resulting in a gross profit of $11.9 million for the nine months ended October 2, 2009 and $25.3 million for the nine months ended October 3, 2008, a decrease of $13.4 million, or 53%. Our gross margin was 46% in the nine months ended October 2, 2009 as compared to 48% in the nine months ended October 3, 2008. The decrease in gross profit through the nine months ended October 2, 2009 was driven primarily by reduced demand for our products, an overall decline in ASPs, and, to a lesser extent, changes in product mix.

Research and development expenses. Research and development expenses were $3.6 million for the three months ended October 2, 2009 as compared to $4.6 million for the three months ended October 3, 2008, a decrease of $1.0 million, or 22%. Research and development expenses decreased in absolute dollars, however, as a percentage of revenue they have increased as our revenue were significantly lower in comparison to the quarter ended October 3, 2008. Research and development expenses were 35% and 25% of revenue for the three months ended October 2, 2009 and October 3, 2008, respectively. The decrease in the third quarter of 2009 was mostly due to a decrease in labor and personnel related costs by $0.7 million due to reduced headcount and salary reductions. Additionally, there were decreases in travel costs by $0.1 million, outside services by $0.1 million and supplies by $0.1 million, which is attributed to tight management of spending.

Research and development expenses were $11.1 million for the nine months ended October 2, 2009 and $12.9 million for the nine months ended October 3, 2008, a decrease of $1.8 million, or 14%. The decrease in the first three quarters of 2009 was primarily due to a reduction in contract labor costs of $0.7 million, a decrease on labor related costs of $0.7 million that included a reduction in incentive compensation, the acquisition of development software of $0.3 million in the first quarter of 2008 and a decrease in travel spending of $0.4 million due to more restrictive overseas travel policy. These decreases were partially offset by an increase in direct materials costs of $0.3 million associated with the purchase of wafer masks for development programs.

Selling and marketing expenses. Selling and marketing expenses were $2.0 million for the three months ended October 2, 2009, as compared to $2.7 million for the three months ended October 3, 2008, a decrease of $0.7 million, or 26%. Selling and marketing expenses were 20% and 15% of revenue for the three months ended October 2, 2009 and October 3, 2008, respectively. The decrease in selling and marketing expenses in the third quarter of 2009 resulted from a reduction in labor costs of $0.3 million due to lower headcount and salary reduction actions taken in the first quarter of 2009, a decline in sales commissions by $0.2 million as a result of lower revenue and a reduction in outside services and travel spending by $0.1 million and $0.1million, respectively, due to cost saving initiatives.

Selling and marketing expenses were $5.8 million for the nine months ended October 2, 2009 and $7.8 million for the nine months ended October 3, 2008, a decrease of $2.0 million, or 26%. The decrease in selling and marketing expenses in the first three quarters of 2009 was primarily attributed to a decrease in labor related costs of $0.7 million due to actions taken to reduce headcount and salaries and reduction in incentive compensation, lower sales commissions of $0.5 million as a result of fewer shipments and a decrease in outside services and travel spending of $0.4 million and $0.4 million, respectively, due to strict cost management.

General and administrative expenses. General and administrative expenses were $3.2 million for the three months ended October 2, 2009 and $1.4 million for the three months ended October 3, 2008, an increase of $1.8 million or 129%. General and administrative expenses were 31% and 7% of revenue for the three months ended October 2, 2009 and October 3, 2008, respectively. The increase in general and administrative expenses is primarily related to the additional expense of $1.6 million recorded in the third quarter of 2009, associated with the lawsuit dismissal as a result of the finalization of our formal valuation of the Atrua assets. Outside legal expenses in the third quarter of 2008 were reduced by a legal settlement received in cash of $0.6 million. If not for this offsetting settlement, legal expenses would have been down over this comparative timeframe versus reflecting an increase of $0.3 million. These increases were partially offset with a decrease in labor related costs of $0.1 million attributed to salary reductions.

General and administrative expenses were $9.7 million for the nine months ended October 2, 2009 as compared to $5.1 million for the nine months ended October 3, 2008, an increase of $4.6 million, or 90%. The increase in general and administrative expenses in the first three quarters of 2009 was primarily driven by expense of $3.9 million recorded in the second and third quarter of 2009 associated with the Atrua lawsuit dismissal and asset purchase transaction related fees of

$0.3 million. Outside legal fees in the third quarter of 2008 were reduced by a legal settlement of $0.6 million. If not for this offsetting settlement, legal expenses would have been flat over this comparative timeframe versus reflecting an increase of $0.7 million. These increases were slightly offset by a decrease in labor related costs of $0.3 million due to salary reductions and reduction in incentive compensation.

Other income, net. Other income, net decreased by $0.5 million to a net other income of $0.1 million for the three months ended October 2, 2009 from a net other income of $0.6 million for the three months ended October 3, 2008, primarily due to lower interest income as a result of the maturity of our notes and bonds which were reinvested in the U.S. Treasury and government agency funds and notes as well as an overall decline in interest rates.

Other income, net decreased $1.6 million to a net other income of $0.3 million for the nine months ended October 2, 2009 from a net other income of $1.9 million for the nine months ended October 3, 2008. The decrease in other income in the first three quarters of 2009 was primarily due to lower interest income as a result of the maturity of our notes and bonds which were reinvested in the U.S. Treasury and government agency funds and notes as well as an overall decline in the interest rates.

Liquidity and Capital Resources

Since our inception, we have financed our growth primarily with funds generated . . .