You should read the following discussion together with the unaudited financial statements and related notes appearing elsewhere in this quarterly report. This discussion contains forward-looking statements that involve risks and uncertainties. Any or all of our forward-looking statements in this quarterly report may turn out to be wrong. These forward-looking statements can be affected by inaccurate assumptions we might make or by known or unknown risks and uncertainties. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. Factors which could cause actual results to differ materially include those set forth under in Part II - Item 1A - "Risk Factors," as well as those discussed elsewhere in this quarterly report. See "Forward-Looking Statements."
BUSINESS OVERVIEW
The financial information presented in this quarterly report includes the results of CEVA, Inc. and its subsidiaries. CEVA is the leading licensor of DSP cores and platforms to the semiconductor industry. Our technologies are widely licensed and power some of the world's leading semiconductor and original equipment manufacturer (OEM) companies. In 2008, our licensees shipped over 307 million CEVA-powered chipsets, an increase of 36% over 2007 shipments of 227 million chipsets. We believe there is an industry shift from developing DSP technologies in-house to licensing them from third party IP providers due to the shortening of the design cycle and increased cost associated with ownership and maintenance of such architectures. Furthermore, given the technological complexity of DSP-based applications, there are increased requirements to supplement the basic DSP core IP with additional technologies in the form of integrated application-specific hardware peripherals and software components.
During the past two years, our business has progressed significantly as a result of the wide deployment of our DSP cores with leading handset suppliers such as Samsung, LG Electronics, Nokia, Sony Ericsson, Sharp and ZTE, as well as with a major U.S.-based smartphone manufacturer. This positive trend is evident from our royalty revenues which increased by 58% in 2008 from 2007 and increased 127% when comparing 2008 to 2006. We further anticipate that our royalty revenue for the fourth quarter of 2009 will increase by at least 20% from the third quarter to the fourth quarter of 2009. Based on internal data, we believe our worldwide market share of baseband chips for handsets that incorporate our technologies is approximately 23% of the worldwide handsets volume for the second quarter of 2009, up from 18% for the first quarter of 2009. Our total revenues derived from the handsets market represented 51% of our total annual 2008 revenues, and 81% and 62% of our total revenues for the third quarter and first three quarters of 2009, respectively. Notwithstanding these positive developments, we believe the full scale migration to our DSP cores and technologies in the handsets market has not been fully realized and continues to progress.
Within the handsets market, we believe smartphones and ultra low cost (ULC) phones, especially those targeted at emerging markets, continues to present significant growth opportunities for CEVA. Based on Informa Telecoms & Media estimations, smartphones are expected to account for approximately 13.5% of all new handsets in 2009, growing to 38% overall by 2013. Juniper Research forecasts that by 2014, 50% of the global handset shipments will be for ultra low cost phones. Per Juniper Research, just in the month of August 2009, 15 million new mobile subscribers were added in India. Per Frost & Sullivan, there are 680 million mobile subscribers in China, which equates to only a 51% penetration rate in China. We believe we can benefit from these trends through our leading customer base, including Broadcom, Infineon, Spreadtrum, ST-Ericsson and VIA Telecom.
Another growing market segment is netbooks. Per iSuppli, netbook shipments will grow by 69% in 2009. According to Gartner, netbooks could account for close to 10% of the PC market by the end of 2009. The netbook market poses a substantial, organic growth opportunity from which we are uniquely positioned to benefit. One of our key customers has already announced cooperation with Intel for its 3G modem chip which is being integrated into Intel's ATOM-based Moorestown and Pine Trail-M platforms. Also, Nvidia is partnering with the same customer to offer 3G connectivity around its newly-designed platform, Tegra, which is targeted for Mobile Internet Device (MID).
Beyond the handsets market, we had customers commencing production of chips based on our new mobile multimedia platforms during the latter half of 2008. These multimedia platforms enrich our licensable product offerings and increase our future royalty potential. Also, during the fourth quarter of 2008, a well-known new portable consumer product manufacturer began shipment of a new product powered by our technology. This device is the newest generation of an existing product that is the clear leader in its product category and has been sold in high volumes for the past three years. The latest version of this product includes advanced CEVA-powered multimedia capabilities for the first time.
In January 2009, we announced a new product, CEVA-HD-Audio, which offers high definition audio solutions for the growing home entertainment products such as Blu-ray DVDs, digital TVs, set-top boxes, IPTVs and home gateways. In February 2009, we announced a high performance DSP architecture designed and optimized for advanced wireless 3.5G/4G communications, the

CEVA-XC™. This fully programmable DSP architecture supports multiple air interfaces in software, including the most demanding 4G mobile standards, LTE and WiMAX II, alongside 3G, 3.5G, Wi-Fi, GPS and MobileTV. Supporting multiple air interfaces in a single processor architecture is critical for next-generation handsets and wireless infrastructure equipment, and CEVA-XC™ delivers the performance and scalability needed to address these precise requirements. We believe our new products further highlight the potential for our licensing model and continued royalty revenue growth.
Notwithstanding the various growth opportunities we have outlined above, our business operates in a highly competitive environment. Competition has historically increased pricing pressures for our products and decreased our average selling prices. Some of our competitors have reduced their licensing and royalty fees to attract customers and expand their market share. In order to penetrate new markets and maintain our market share with our existing products, we may need to offer our products in the future at lower prices which may result in lower profits. In addition, our future growth is dependent not only on the continued success of our existing products but also the successful introduction of new products, which requires the dedication of resources into research and development which in turn may increase our operating expenses. We currently anticipate that our operating expenses will increase during the fourth quarter of 2009 in comparison to the prior three quarters of 2009, mainly due to increased investments in research and development, including the addition of new engineers. Nonetheless, we must continue to monitor and control our operating costs and maintain our current level of gross margin in order to offset any future declines in shipment quantities of products based on our technologies or any future declines in any per-unit royalty rates. Moreover, since our products are incorporated into end products of our OEM customers, our business is very dependent on our OEM customers' ability to achieve market acceptance of their end products in the handsets and consumer electronic markets, which are similarly very competitive.
The ever-changing nature of the market also affects our continued business growth potential. For example, the success of our video and audio products are highly dependent on the market adoption of new services and products, such as smartphones, Internet video, the migration from audio players to Personal Multimedia Players (PMP), as well as the migration to Blu-ray DVDs, digital TVs, set-top boxes with high definition audio and IPTVs. In addition, our business is affected by market conditions in emerging markets, such as China, India and Latin America, where the penetration of handsets, especially ULC phones, could generate future growth potential for our business. The maintenance of our competitive position and our future growth also are dependent on our ability to adapt to ever-changing technology, short product life cycles, evolving industry standards, changing customer needs and the trend towards voice, audio and video convergence in the markets that we operate.
Furthermore, the current worldwide economic downturn has resulted in slower economic activity, decreased consumer confidence and spending, reduced corporate profits and capital spending, adverse business conditions and liquidity concerns. The continued economic downturn could cause reduced spending on our products and services. We also operate primarily in the semiconductor industry, which is cyclical, and the recent downturn has resulted in a significant downturn of the semiconductor industry. The result is decreased product demand, excess customer inventories, and accelerated erosion of prices.
Moreover, due to the economic uncertainties, it is extremely difficult for our customers, our vendors and us to accurately forecast and plan future business activities. Therefore, the worldwide economic downturn and specifically the volatility in the semiconductor and consumer electronics industries could seriously impact our revenue and harm our business, financial condition and operating results. As a result, our past operating results should not be relied upon as an indication of future performance.
RESULTS OF OPERATIONS
Total Revenues
Total revenues were $9.7 and $28.3 million for the third quarter and first nine months of 2009, respectively, representing a decrease of 5% and 7%, respectively, as compared to the corresponding periods in 2008. The decrease in total revenues reflected principally lower licensing revenues from our product lines and lower revenues from the provision of technical support to customers and sales of development systems, offset by an increase in our royalty revenues. Five largest customers accounted for 83% and 55% of total revenues for the third quarter and first nine months of 2009, respectively, as compared to 70% and 53% for the comparable periods in 2008. Two customers accounted for 23% and 44% of total revenues for the third quarter of 2009, as compared to three different customers that accounted for 14%, 14% and 26% of total revenues for the third quarter of 2008. Two customers accounted for 19% and 16% of total revenues for the first nine months of 2009, as compared to one customer that accounted for 20% of total revenues for the first nine months of 2008. Because of the nature of our license agreements and the associated large initial payments due, the identity of major customers generally varies from quarter to quarter and we do not believe that we are materially dependent on any one specific customer or any specific small number of licensees. Our total revenues derived from the handsets market represented 81% and 62% of our total revenues for the third quarter and first nine months of 2009, respectively.
We generate our revenues from licensing our technology, which in certain circumstances is modified to customer-specific requirements. Revenues from license fees that involve customization of our technology to customer specifications are recognized in

accordance with Statement of Position ("SOP") 81-1, "Accounting for Performance of Construction-Type and Certain Production-Type Contracts" ("ASC 605-35"). We account for all of our other IP license revenues and related services in accordance with SOP 97-2, "Software Revenue Recognition," as amended ("ASC 985-605").
We generate royalty revenue from our customers based on two models: royalties paid by our customers during the period in which they ship units of chipsets incorporating our technology, which we refer to as "per unit royalties," and royalties which are paid in a lump sum and in advance to cover a pre-determined fixed number of future unit shipments, which we refer to as "prepaid royalties." In either case, these royalties are non-refundable payments and are recognized when payment becomes due, provided no future obligation exists. Prepaid royalties are recognized under our licensing revenue line and accounted for 4% of total revenues for both the first nine months of 2009 and 2008. No prepaid royalties revenue was generated during the three months ended September 30, 2009 and 2008. Only royalty revenue from customers who are paying as they ship units of chipsets incorporating our technology is recognized in our royalty revenue line. These per unit royalties are invoiced and recognized on a quarterly basis in arrears as we receive quarterly shipment reports from our licensees.
Licensing Revenues
Licensing revenues were $5.2 and $14.1 million for the third quarter and first nine months of 2009, respectively, a decrease of 12% and 18% from the third quarter and first nine months of 2008. The decrease in licensing revenues for the third quarter of 2009 as compared to the corresponding period of 2008 resulted mainly from lower revenues from our CEVA-TeakLite DSP core family of products and the inclusion of licensing revenues from u-blox AG to resolve a license dispute in the third quarter of 2008, partially offset by higher revenues from our CEVA-X DSP core family of products. The decrease in licensing revenues for the first nine months of 2009 as compared to the corresponding period of 2008 resulted mainly from the inclusion of the u-blox AG revenue mentioned above and lower revenues from our CEVA-Teak and TeakLite DSP core families of products, partially offset by higher revenues from our CEVA-X IP DSP core family of products. Licensing revenues in 2009 were in general negatively affected by the economic downturn and companies' lowering their research and developments budgets and expenses associated with acquiring new technologies.
Licensing revenues accounted for 54% and 50% of our total revenues for the third quarter and first nine months of 2009, respectively, compared to 59% and 56% for the comparable periods of 2008. During the third quarter of 2009, we concluded six license agreements. Five agreements were for CEVA DSP cores and platforms, and one agreement was for our Bluetooth technology. Target applications for customer deployment are 2G ultra-low cost phones, 3G handsets, Smartphones, mobileTVs, portable multimedia and PassiveOptical Networks (PON). Geographically, three of the six deals concluded were in Europe and three were in the Asia Pacific region.
Royalty Revenues
Royalty revenues were $3.7 and $11.4 million for the third quarter and first nine months of 2009, respectively, an increase of 12% and 13% from the third quarter and first nine months of 2008. Royalty revenues accounted for 38% and 40% of our total revenues for the third quarter and first nine months of 2009, respectively, compared to 32% and 33% for the comparable periods of 2008. Royalty revenues for first nine months of 2009 include $0.9 million of royalties resulting from "catch up" royalties on past shipments from an existing customer. Excluding the "catch up" royalties, the increase in royalty revenues for the third quarter and first nine months of 2009 reflected our market share expansion in the handsets market, as well as new shipments of a portable multimedia device, offset by overall lower shipments of products by our customers in the consumer market due to the global economic downturn and a decrease in the average royalty rate per unit. Our per unit and prepaid royalty customers reported sales of 89 and 213 million chipsets incorporating our technology for the third quarter and first nine months of 2009, respectively, compared to 72 and 228 million for the comparable periods of 2008. The five largest customers paying per unit royalty accounted for 85% and 71% of total royalty revenues for the third quarter and first nine months of 2009, respectively, compared to 82% and 81% for the comparable periods of 2008.
As of September 30, 2009, 21 licensees were shipping products incorporating our technologies pursuant to 29 licensing arrangements. Of the 29 licensing arrangements, 25 are under per unit royalty arrangements and 4 are under prepayment arrangements. As of September 30, 2008, 23 licensees were shipping products incorporating our technologies pursuant to 31 licensing arrangements. Of the 31 licensing arrangements, 23 were under per unit royalty arrangements and 8 were under prepayment arrangements.
Other Revenues
Other revenues were $0.7 and $2.8 million for the third quarter and first nine months of 2009, respectively, a decrease of 23% and 12% from the third quarter and first nine months of 2008, respectively. The decrease in other revenues for the third quarter of

2009, as compared to the corresponding period of 2008, reflected lower support-related revenues and lower sales of development systems, mainly associated with companies' tighter expense control and refraining from extending or renewing support-related agreements. The decrease in other revenues for the first nine months of 2009, as compared to the corresponding period of 2008, reflected lower support-related revenues. Other revenues accounted for 7% and 10% of our total revenues for the third quarter and first nine months of 2009, respectively, compared to 9% and 11% for the comparable periods of 2008. Other revenues include support and training for licensees and sale of development systems.

 Geographic Revenue Analysis

                                       Nine months               Nine months             Third Quarter            Third Quarter
                                          2009                       2008                    2009                      2008
                                       (in millions, except percentages)                  (in millions, except percentages)
United States                    $      3.5           12 %     $   4.5       15 %   $      0.5            5 %   $    2.4        24 %
Europe and Middle East (1) (2)   $     12.7           45 %     $  15.2       50 %   $      3.9           41 %   $    5.5        54 %
Asia Pacific (3) (4) (5)         $     12.1           43 %     $  10.7       35 %   $      5.3           54 %   $    2.3        22 %

(1) Sweden                       $      6.1           22 %     $   6.2       20 %   $      1.7           17 %   $    1.4        14 %
(2) Switzerland                           * )          * )     $     * )      * )            * )          * )   $    2.7        26 %
(3) Japan                        $      3.3           12 %     $   4.1       14 %   $        * )          * )          * )       * )
(4) S. Korea                              * )          * )     $     * )      * )   $        * )          * )   $    1.5        14 %
(5) China                        $      5.4           19 %     $     * )      * )   $      4.2           44 %          * )       * )

*) Less than 10%

Due to the nature of our license agreements and the associated large contract amounts, the geographic split of revenues in absolute dollars generally varies from quarter to quarter.
Cost of Revenues
Cost of revenues were $0.8 and $3.2 million for the third quarter and first nine months of 2009, respectively, compared to $1.1 and $3.5 million for the comparable periods of 2008. Cost of revenues accounted for 9% and 11% of total revenues for the third quarter and first nine months of 2009, respectively, compared to 11% and 12% for the comparable periods of 2008. The decrease for the third quarter of 2009 principally reflected lower customization work for our licensees and lower royalty payback expenses paid to the Office of Chief Scientist of Israel. Royalty payback expenses amounted to 3%-3.5% of the actual sales of certain of our products, the development of which previously received grants from the Office of Chief Scientist of Israel. The decrease for the first nine months of 2009 principally reflected lower customization work for our licensees, partially offset by higher salary and related costs. Included in cost of revenues for the third quarter and first nine months of 2009 was a non-cash equity-based compensation expense of $21,000 and $90,000, respectively, compared to $28,000 and $83,000 for the comparable periods of 2008.
Gross Margin
Gross margins for the third quarter and first nine months of 2009 were 91% and 89%, respectively, compared to 89% and 88% for the comparable periods of 2008, respectively. The increase in gross margins for the third quarter and first nine months of 2009 principally reflected lower licensing revenues offset by higher royalty revenues which have higher gross margins, and a decrease in cost of revenues.
Operating Expenses
Total operating expenses were $7.2 and $21.6 million for the third quarter and first nine months of 2009, respectively, compared to $8.3 and $29.1 million for the comparable periods of 2008. The decrease in total operating expenses for the third quarter of 2009 principally reflects (i) lower salary and related costs, partially as a result of the restructuring of our SATA activities,
(ii) lower marketing expenses, and (iii) higher research grants received from the Office of Chief Scientist of Israel. The decrease in total operating expenses for the first nine months of 2009 principally reflects (i) the fact that a restructuring and reorganization expense of $3.5 million associated with the termination of the Harcourt property lease in Dublin, Ireland was recorded in the first nine months of 2008, (ii) lower salary and related costs, partially as a result of the restructuring of the SATA activities, (iii) lower professional services costs, and (iv) higher research grants received from the Office of Chief Scientist of Israel and the Irish government. We currently anticipate that our operating expenses will increase during the fourth quarter of 2009 in comparison to the prior three quarters of 2009, mainly due to increased investments in research and development, including the addition of new engineers.

Research and Development Expenses, Net Our research and development expenses were $4.1 and $12.1 million for the third quarter and first nine months of 2009, respectively, compared to $4.8 and $15.1 million for the comparable periods of 2008. The net decrease for the third quarter of 2009 principally reflected lower salary and related costs, partially as a result of the termination in employment of a number of SATA-related technology engineers, as well as an increase in research grants received from the Office of Chief Scientist of Israel. The net decrease for the first nine months of 2009 principally reflected lower salary and related costs, partially as a result of the termination in employment of a number of SATA-related technology engineers, an increase in research grants received from the Office of Chief Scientist of Israel and lower project-related expenses. Included in research and development expenses for the third quarter and first nine months of 2009 was a non-cash equity-based compensation expense of $197,000 and $689,000, respectively, compared to $273,000 and $805,000 for the comparable periods of 2008. Research and development expenses as a percentage of total revenues were 42% and 43% for the third quarter and first nine months of 2009, respectively, compared to 47% and 50% for the comparable periods of 2008.
The number of research and development personnel was 124 at September 30, 2009, compared to 123 at September 30, 2008.
Sales and Marketing Expenses
Our sales and marketing expenses were $1.6 and $4.9 million for the third quarter and first nine months of 2009, respectively, compared to $1.8 and $5.4 million for the comparable periods of 2008. The decrease for the third quarter of 2009 principally reflected lower marketing expenses. The decrease for first nine months of 2009 primarily reflects lower commission cost, salary and related costs and marketing expenses. Included in sales and marketing expenses for the third quarter and first nine months of 2009 was a non-cash equity-based compensation expense of $138,000 and $442,000, respectively, compared to $143,000 and $380,000 for the comparable periods of 2008. Sales and marketing expenses as a percentage of total revenues were 17% for both the third quarter and first nine months of 2009, compared to 18% for both the third quarter and first nine months of 2008.
The total number of sales and marketing personnel was 21 at September 30, 2009, compared to 19 at September 30, 2008.
General and Administrative Expenses
Our general and administrative expenses were $1.5 and $4.6 million for the third quarter and first nine months of 2009, respectively, compared to $1.7 and $5.0 million for the comparable periods of 2008. The decrease for the third quarter of 2009 primarily reflected lower professional services costs. The decrease for the first nine months of 2009 primarily reflected lower professional services costs, offset by higher non-cash equity-based compensation expenses. Included in general and administrative expenses for the third quarter and first nine months of 2009 was a non-cash equity-based compensation expense of $329,000 and $989,000, respectively, compared to $343,000 and $816,000 for the comparable periods of 2008. General and administrative expenses as a percentage of total revenues were 16% for both the third quarter and first nine months of 2009, compared to 17% and 16% for the third quarter and first nine months of 2008, respectively.
The number of general and administrative personnel was 24 at both September 30, 2009 and 2008.
Amortization of Other Intangibles
We had no amortization charges for both the third quarter and first nine months of 2009, as compared to $12,000 and $53,000 for the third quarter and first nine months of 2008, respectively. Other intangible assets were fully amortized in 2008.
Reorganization
On January 18, 2008, we signed an assignment agreement with the Harcourt landlord for the surrender and termination of the Harcourt lease in Dublin, Ireland. We paid approximately $5.9 million during the first nine months of 2008 for the termination of the lease and related termination costs, consisting primarily of legal and professional fees. We also successfully managed during the first quarter of 2008 to terminate part of our lease obligation in another office in Limerick, Ireland, where we had unused space. We recorded during the first nine months of 2008 an aggregate of $3.5 million for the above lease terminations as an additional reorganization expense. As a result of the above lease terminations, we have no under-utilized building operating lease obligations.

  Financial Income, Net (in millions)

                                                Nine months         Nine months         Third Quarter         Third Quarter
                                                    2009                2008                 2009                  2008
Financial income, net                           $     1.50          $     1.98          $       0.55           $      0.65
of which:
Interest income and gains and losses from
. . .