CEVA INC - Quarter Report: 2004 March (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

For the quarterly period ended: March 31, 2004

OR

For the transition period from              to             

Commission file number: 000-49842

CEVA, Inc.

(Exact Name of Registrant as Specified in Its Charter)

(408) 514-2900

(Registrant’s Telephone Number, Including Area Code)

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

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date: 18,376,773 shares of common stock, $0.001 par value, as of May 5, 2004.

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FORWARD-LOOKING STATEMENTS

This quarterly report includes forward-looking statements that are subject to a number of risks and uncertainties. All statements, other than statements of historical facts, included in this quarterly report regarding our strategy, future operations, financial position, estimated revenues, projected costs, prospects, plans, and objectives of management are forward-looking statements. The words “will”, “believe”, “anticipate”, “intend”, “estimate”, “expect”, “project”, and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements in this report contain these identifying words. We cannot guarantee future results, levels of activity, performance or achievements and you should not place undue reliance on our forward-looking statements. Our forward-looking statements do not reflect the potential impact of any future acquisitions, mergers, dispositions, joint ventures or strategic alliances. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including the risks described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Factors That Could Affect Our Operating Results” and elsewhere in this quarterly report. We do not assume any obligations to update any of the forward-looking statements we make.

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PART I. FINANCIAL INFORMATION

Item 1.    FINANCIAL STATEMENTS

INTERIM CONDENSED CONSOLIDATED BALANCE SHEETS

U.S. dollars in thousands, except share and per share data

The accompanying notes are an integral part of the interim condensed consolidated financial statements.

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INTERIM CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

U.S. dollars in thousands, except per share data

The accompanying notes are an integral part of the interim consolidated financial statements.

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INTERIM STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)

U.S. dollars in thousands (except share data)

The accompanying notes are an integral part of the interim consolidated financial statements.

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INTERIM CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

U.S. dollars in thousands

The accompanying notes are an integral part of the interim consolidated financial statements.

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NOTES TO THE INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(U.S. dollars in thousands, except share and per share amounts)

NOTE 1:    BUSINESS

CEVA, Inc. licenses Digital Signal Processor (DSP) intellectual property and related technologies. We design, develop and support DSP cores and integrated application solutions that power wireless and digital multimedia products such as cellular phones, music players, digital television and personal digital assistants. Licensees of CEVA technology either source chips for these devices and applications from foundries or manufacture them in-house.

NOTE 2:    BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. For further information, reference is made to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2003.

The consolidated financial statements incorporate the financial statements of the Company and all of its subsidiaries. All significant intercompany balances and transactions have been eliminated on consolidation.

The significant accounting policies applied in the annual consolidated financial statements of the Company as of December 31, 2003, contained in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 12, 2004 (File No. 000-49842), have been applied consistently in these financial statements.

NOTE 3:    GEOGRAPHIC INFORMATION AND MAJOR CUSTOMER DATA

a. Summary information about geographic areas:

The Company manages its business on the basis of one industry segment: the licensing of intellectual property to semiconductor companies and electronic equipment manufacturers (see Note 1 for a brief description of the Company’s business).

The following is a summary of operations within geographic areas:

b. Major customer data as a percentage of total revenues:

The following table sets forth the customers that represented 10% or more of the Company’s net revenue in each of the periods set forth below.

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NOTES TO THE INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(U.S. dollars in thousands, except share and per share amounts)

NOTE 4:    NET INCOME (LOSS) PER SHARE OF COMMON STOCK

Basic net income (loss) per share is computed based on the weighted-average number of shares of Common Stock outstanding during each period. Diluted net income (loss) per share is computed based on the weighted average number of shares of Common Stock outstanding during each period, plus dilutive potential shares of Common Stock considered outstanding during the period, in accordance with Statement of Financial Standard No. 128, “Earnings Per Share”. The potential common shares that were anti-dilutive at March 31, 2003 were 2.6 million shares.

NOTE 5:    STOCK-BASED COMPENSATION PLANS

The Company issues stock options to its employees and directors and provides employees the right to purchase stock pursuant to approved stock option and employee stock purchase programs. The Company has elected to follow Accounting Principles Board Statement No. 25, “Accounting for Stock Options Issued to Employees” (“APB No. 25”), and related interpretations in accounting for its employee stock option plans. Under APB No. 25, when the exercise price of an employee stock option is less than the market price of the underlying stock on the date of grant, compensation expense is recognized. No stock-based employee compensation cost is reflected in the statement of operations for the three-month periods ended March 31, 2003 and 2004 as all options granted under these plans had an exercise price equal to the fair market value of the underlying Common Stock on the date of grant. During the first quarter of 2004, the Company granted options to purchase 382,000 shares of Common Stock, at exercise prices ranging from $8.75 to $11.75 per share, and the Company issued 212,425 shares of Common Stock under its stock option and purchase programs for consideration of $1,433. Options to purchase 5,219,065 shares were outstanding at March 31, 2004. During the comparable period of 2003, the Company granted no options and issued 25,612 shares of Common Stock under its stock option and purchase programs for consideration of $81; options to purchase 3,210,996 shares were outstanding at March 31, 2003.

Under SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”), pro forma information regarding net income (loss) per share is required, and has been determined as if CEVA had accounted for its employee stock options under the fair value method of that Statement. The fair value for these options was estimated at the date of grant using a Black-Schloles option pricing model with the following weighted-average assumptions:

The fair value for rights to purchase awards under the Employee Share Purchase Plan was estimated at the date of grant using the same assumptions above except the expected life was assumed to be 6 months.

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NOTES TO THE INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(U.S. dollars in thousands, except share and per share amounts)

The weighted average fair value of the options granted to the employees of the Company during the three months ended March 31, 2004 was $10.25. There were no options issued during the three months ended March 31, 2003. The exercise prices of such options were equal to the market price of the Company’s Common Stock at the date of the respective option grants.

The following pro forma information includes the effect of the options granted to the Company’s employees. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period.

The pro forma stock compensation expense presented above has been calculated using the accrual method. The Company previously disclosed pro forma stock compensation expense for the quarter ended March 31, 2003 using the straight-line method. For consistency of presentation, the amount has been presented above using the accrual method, which has resulted in an increase in such amount of $2.4 million and an increase in pro-forma basic and diluted loss per share of ($0.133) for the quarter ended March 31, 2003.

NOTE 6:    REORGANIZATION, RESTRUCTURING AND SEVERANCE CHARGE

The Company’s management and board of directors approved reorganization and restructuring plans in 2003, which resulted in total charges of $8.6 million. The charges arose in connection with senior executive management changes in connection with the implementation of our strategic initiative to strengthen our headquarters function in the U.S. Also included were severance charges and employee-related liabilities arising in connection with a head-count reduction, under-utilized building operating lease charges and a charge for redundant assets arising from a reduction in headcount and facility requirements. The reduction in headcount and facility requirements is a result of the realignment of the business to focus on DSP cores and integrated application technologies and the decision to cease the Company’s hard IP manufacturing product line and certain non-strategic technology areas.

Management was required to make certain estimates and assumptions in assessing the underutilized building operating lease charge arising from the reduction in facility requirements. The underutilized building operating lease charge was calculated by taking into consideration (1) the committed annual rental charge associated with the vacant square footage, (2) an assessment of the sublet rents that could be achieved based on current market conditions, vacancy rates and future outlook, (3) the estimated periods that facilities would be empty before being sublet, (4) an assessment of the percentage increases in the primary lease rent and the sublease rent at each five-year rent review, and (5) the application of a discount rate of 4.75% over the remaining period of the lease. There were no revisions to estimates in the quarter ended March 31, 2004.

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NOTES TO THE INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(U.S. dollars in thousands, except share and per share amounts)

The major components of the 2003 reorganization and other charges of which $2,847 is included in accrued expenses and other payables and $1,407 is included in accrued liabilities, at March 31, 2004 are as follows:

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Item 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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. Actual results may differ materially from those indicated by such forward-looking statements. Factors which could cause actual results to differ materially include those set forth under “—Factors That Could Affect Our Operating Results”, as well as those otherwise discussed in this section and elsewhere in this quarterly report. See “Forward-Looking Statements”.

BUSINESS OVERVIEW

CEVA, Inc. is the leading licensor of Digital Signal Processor (DSP) intellectual property and related technologies. We design, develop and support DSP cores and integrated application solutions that power wireless and digital multimedia products such as cellular phones, music players, digital television and personal digital assistants. Licensees of CEVA technology either source chips for these devices and applications from foundries or manufacture them in-house. We include among our customers more than 100 semiconductor and electronic equipment companies, including many of the world’s leading companies in these fields.

We believe that our industry is moving towards open-standard DSP cores and away from traditional proprietary solutions. We also believe that increased semiconductor product complexity and demands for reduced time-to-market have led more companies to decide to license complete application IP solutions, rather than licensing individual components from multiple suppliers. CEVA combines expertise in DSP with integrated application IP solutions – and therefore, we believe, is well positioned to take full advantage of these major industry shifts. To do so we intend to:

RESULTS OF OPERATIONS

Total Revenues

The increase over the first quarter of 2003 principally reflects a combination of higher licensing and royalty revenues, offset by a fall-off of “Hard IP” manufacturing revenues in the 2004 period following the decision in December 2003 to cease our “Hard IP” manufacturing product line and certain other non strategic technology areas. The decrease from the fourth quarter of 2003 primarily reflects a combination of lower royalty revenues and a fall-off of “Hard IP” manufacturing revenues, which was offset by higher revenues from the licensing of our DSP core and integrated application IP and increased revenues from our design and consulting services.

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Licensing and royalty revenues accounted for 84.3% of our total revenues in the first quarter of 2004, compared with 78.9% for the first quarter of 2003 and 83.2% for the fourth quarter of 2003. Revenues from two customers accounted for 19.9% and 17.4% of total revenues in the first quarter of 2004, compared with 22.6% and 10.4% for the first quarter of 2003 and 16.3% and 11.1% for the fourth quarter of 2003. 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.

The Company and its subsidiaries (the “Company”) generate their revenues from licensing intellectual property, which in certain circumstances is modified to customer-specific requirements. Revenues from license fees that involve customization of the Company’s IP to customer specific specifications are recognized in accordance with Statement of Position 81-1 “Accounting for Performance of Construction—Type and Certain Production—Type Contracts”, using contract accounting on a percentage of completion method, over the period from signing of the license through to customer acceptance in accordance with the “Input Method”. The amount of revenue recognized is based on the total license fees under the license agreement and the percentage to completion achieved.

The Company accounts for all of its other IP license revenues in accordance with Statement of Position (“SOP”) 97-2, “Software Revenue Recognition”, as amended. Under SOP 97-2, revenues are recognized when: (1) collection is probable; (2) delivery has occurred; (3) the license fee is otherwise fixed or determinable; (4) persuasive evidence of an arrangement exists and no further obligation exists. SOP 97-2 generally requires revenue earned on licensing arrangements involving multiple elements to be allocated to each element based on the relative fair value of the elements. The Company has also adopted SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions”, for multiple element transactions entered into after January 1, 2000. SOP 98-9 requires that revenue be recognized under the “residual method” when vendor specific objective evidence (“VSOE”) of fair value exists for all undelivered elements and VSOE does not exist for one of the delivered elements. The VSOE of fair value of the undelivered elements (support and maintenance) is determined based on the price charged for the undelivered element when sold separately.

Royalties from licensing the right to use the Company’s IP are recognized when the related sales are made. The Company determines such sales by receiving confirmation of sales subject to royalties from licensees. Non-refundable payments on account of future royalties from similar agreements are recognized upon payment, provided that no future obligation exists.

Licensing and Royalty Revenues

The increase in licensing revenues from the first and fourth quarter of 2003 reflects increased revenues from our DSP cores technology offset by lower revenues from our integrated application IP technologies as certain non-strategic application technologies ceased following the strategic re-alignment of our operations in the fourth quarter of 2003. The strategic re-alignment allowed us to better focus on our key strengths – DSP cores and integrated application IP technologies in the first quarter of 2004.

The increase in royalty revenue in the first quarter of 2004 compared with the first quarter of 2003 was driven by increases in the underlying unit shipments of customers’ products incorporating our Teak DSP core. The decrease from the fourth quarter of 2003 reflected lower per-unit royalties from certain license agreements due to volume pricing.

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We had 26 royalty-paying licensees in the first quarter of 2004, compared with 18 in the first quarter of 2003 and 25 in the fourth quarter of 2003. Royalty-generating licensees reported sales of 19.0 million chips incorporating our technology in the first quarter of 2004, compared with 12.2 million chips in the first quarter of 2003 and 17.5 million chips in the fourth quarter of 2003.

Three royalty-generating licensees accounted for 62% of total unit royalty revenues in the first quarter of 2004. Five royalty-generating licensees accounted for 85% of total unit royalty revenues in the first quarter of 2003. Three royalty-generating licensees accounted for 79% of total unit royalty revenues in the fourth quarter of 2003. One royalty-generating licensee shipped in excess of 5 million units in the first quarter of 2004 and the first and fourth quarters of 2003.

Other Revenues

Other income includes design and consulting services and maintenance and support for licensees.

The decrease from the 2003 periods reflects a fall-off in revenues following the decision in December 2003 to cease our “Hard IP” manufacturing product line, which was offset by higher revenues respectively, from our design and consulting services.

Geographic Revenue Analysis

Due to the nature of our license agreements and the associated potential large individual contract amounts, the geographic spilt of revenues both in absolute and percentage terms generally varies from quarter to quarter depending on the timing of deals in each region.

Cost of Revenues

Cost of revenues accounted for 16.4% of total revenues for the first quarter of 2004, compared with 18.5% and 14.7% for the first and fourth quarters of 2003, respectively. Gross margins for the first quarter of 2004 were 83.6%, compared with 81.5% and 85.3% for the first and fourth quarters of 2003, respectively. The movement in total cost of revenues and gross margins reflected the change in revenue mix compared with the 2003 periods following the decision in December 2003 to cease our “Hard IP” manufacturing product line and a decrease in the portion of revenues derived from higher gross margin royalties.

Operating Expenses

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The increase in total operating expenses before (reorganization and impairment charges) in the first quarter of 2004 compared to the first quarter of 2003 from $7.2 million to $7.4 million, principally reflects increased sales and marketing activity. The decrease in total operating expenses before (reorganization and impairment charges) in the first quarter of 2004 compared to the fourth quarter of 2003 from $8.6 million to $7.4 million reflects a reduction in headcount and facility requirements as a result of the realignment of our business in December 2003 to focus on DSP cores and integrated application technologies and consequently to cease our hard IP manufacturing product lines and certain non-strategic technology areas.

Reorganization, restructuring and severance charges totaled $1.4 million and $5.8 million in the first and fourth quarter of 2003, respectively. These charges in 2003 resulted from the transition of our executive management team to San Jose, severance costs and employee-related liabilities, and provision for underutilized building operating lease obligations in connection with the re-alignment of our business in the fourth quarter. There was also a non-cash charge for impairment of assets of $3.2 million in 2003.

Research and Development Expenses, Net

The decrease in research and development expenses compared to the fourth quarter of 2003 arises from a reduction in headcount and facility requirements as a result of the realignment of the business in December 2003 and the resulting decision to cease our hard IP manufacturing product lines and certain non-strategic technology areas. We recorded research grants from the MAGNET programs of the Chief Scientist of Israel of $81,000 in the first quarter of 2004 compared to $284,000 and $723,000 in the first and fourth quarter of 2003, respectively. Grants received from the Chief Scientist of Israel may become refundable if certain revenues are achieved for products developed under the MAGNET programs.

The number of research and development personnel was 154 at March 31, 2004, compared with 182 at March 31, 2003, and 154 at December 31, 2003.

Sales and Marketing Expenses

The increase in sales and marketing expenses compared to the first quarter of 2003 principally reflects additional sales and marketing efforts relating to the CEVA X architecture. There was a marginal decrease in sales and marketing expenses compared with the fourth quarter of 2003. Sales and marketing expenses as a percentage of total revenues were 18.2% for the first quarter of 2004 compared with 15.5% and 18.7% for the first and fourth quarter in 2003, respectively. The percentage movements reflect the movement in revenues during these periods. The total number of sales and marketing personnel was 21 at March 31, 2004, compared with 20 at both March 31, 2003 and December 31, 2003.

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General and Administrative Expenses

General and administrative expenses were $1.5 million in the first quarters of both 2003 and 2004. The decrease in general and administrative expenses compared to the fourth quarter of 2003 arises from a reduction in facility requirements as a result of the realignment of the business in December 2003. The number of general and administrative personnel was 37 at March 31, 2004 compared with 30 at March 31, 2003 and 32 at December 31, 2003.

Amortization of Other Intangibles

The amount of other intangible assets was $5.2 million at March 31, 2003, $3.5 million at December 31, 2003 and $3.2 million at March 31, 2004. We anticipate ongoing expense in connection with the amortization of remaining intangibles of approximately $222,000 per quarter.

Reorganization and Severance Charge

Our management and board of directors approved reorganization and restructuring plans in 2003, which resulted in total charges of $8.6 million. In the first, third and fourth quarters of 2003, we recorded charges of $1.4 million, $1.4 million and $5.8 million, respectively. The charges arose in connection with senior executive management changes in connection with the implementation of our strategic initiative to strengthen our headquarters function in the U.S. Also included are severance charges and employee-related liabilities arising in connection with a head-count reduction of 40 employees, under-utilized building operating lease charges and a charge for redundant assets arising from a reduction in headcount and facility requirements. The reduction in headcount and facility requirements is a result of the realignment of the business to focus on DSP cores and integrated application technologies and the decision to cease our hard IP manufacturing product lines and certain non-strategic technology areas.

Impairment of Assets

We recorded an impairment charge of $910,000 in the fourth quarter of 2003 in respect of redundant assets, as well as an impairment charge of $973,000 in respect of certain technology acquired. These charges related to the realignment of our business, including the decision to cease manufacturing Hard IP products and certain non-strategic technology areas.

In the fourth quarter of 2003, we also recognized an impairment charge of $1.35 million in relation to a minority investment in a private company. Management assessed the carrying value of the investment after taking into consideration the potential discounted projected future cash flows, the valuation derived from the most recent proposed private placement, the liquidity of the investment and the general market conditions in which this private company operates.

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Other Income, Net

Other income consists of interest earned on investments and foreign exchange movements. The decrease in interest earned in the first quarter of 2004 compared with the first quarter of 2003 reflects lower cash balances on hand. The increase in interest earned compared with the fourth quarter of 2003 reflects a higher proportion of euro-denominated cash balances held throughout the first quarter of 2004 and the associated higher interest rate on euro cash balances. Foreign exchange losses in the first quarter and fourth quarter of 2003 primarily reflect the impact of the appreciation of the euro against the U.S. dollar on our euro liabilities. As a result of the significant currency fluctuations experienced in 2003 on our non-U.S. dollar denominated liabilities, we have sought to hold equivalent non-U.S. dollar cash balances to mitigate losses caused by currency fluctuations; this effort has resulted in a neutral foreign exchange impact in the first quarter of 2004.

Provision for Income Taxes

The provisions for income taxes in the first quarter of 2004 and the fourth quarter of 2003 reflect profits incurred domestically and in certain foreign jurisdictions. There was no provision required in the first quarter of 2003.

LIQUIDITY AND CAPITAL RESOURCES

As of March 31, 2004, we had approximately $58.6 million in cash and cash equivalents.

Net cash used in operating activities for the quarter ended March 31, 2004 was $868,000, compared with $5.4 million of net cash used in operating activities for the comparable period in 2003. Included in the operating cash outflow was $703,000 in connection with restructuring and reorganization costs. The net cash outflow from operating activities for the quarter ended March 31, 2003 included the settlement of merger-related costs of approximately $3 million and cash outflow in connection with restructuring and reorganization costs amounting to approximately $500,000. Of the $4.3 million of restructuring and reorganization costs accrued at March 31, 2004, we expect a cash outflow of approximately $2.9 million during the remainder of 2004, primarily relating to under-utilized building lease payments and employee-related costs, including the repayment of government grants related to employee numbers. Our ongoing cash outflows from operating activities principally relate to payroll-related costs and obligations under our property leases and design tool licenses. Our primary sources of cash inflows are receipts from our debtors and interest earned from our cash holdings. The timing of receipts from debtors is based upon the completion of agreed milestones or agreed dates as set out in our license agreements with customers.

Cash has been used to fund working capital requirements, as well as property and equipment expenditures, which to date have been relatively low due to the fact that our licensing business model requires no manufacturing facilities. Capital equipment purchases of computer hardware and software used in engineering development and furniture and fixtures amounted to approximately $0.9 million in the first quarter of 2004, compared with $86,000 for the comparable period in 2003. The high level of capital expenditures in the first quarter of 2004 was principally due to investment in new design tools and tenant improvements associated with the move of our facility in Israel to new premises. We expect to invest approximately $1.4 million in new design tools in the second quarter of 2004. Proceeds from the sale of property and equipment amounted to $42,000 in the first quarter of 2004 and $38,000 for the comparable period in 2003. We had cash outflow of $30,000 for acquired technology in the first quarter of 2004.

Net cash provided by financing activities of $1.4 million in the first quarter of 2004 and $81,000 for the comparable period in 2003 reflects proceeds from the issuance of shares upon the exercise of employee stock options and the issuance of shares under our employee stock purchase plan.

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We believe that our current cash on hand, along with cash from operations, will provide sufficient capital to fund our operations for at least the next 12 months. We cannot assure you, however, that the underlying assumed levels of revenues and expenses will prove to be accurate.

Operating leasehold obligations are principally on our leasehold properties located in the United States, Ireland, Israel and the United Kingdom. An amount of $2,745 included in Operating Lease Obligations – Leasehold properties has been provided in the restructuring accrual at March 31, 2004.

Other operating lease obligations relate to license agreements entered into for design tools of $1.3 million and obligations under motor vehicle leases of $968,000.

Purchase obligations consist of capital commitments of $1.4 million, principally for design tools, and operating purchase order commitments of $489,000.

CRITICAL ACCOUNTING POLICIES, ESTIMATES AND ASSUMPTIONS

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (U.S. GAAP). These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions upon which we rely are reasonable based upon information available to us at the time made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected. The significant accounting policies that we believe are the most critical to aid in fully understanding and evaluating our reported financial results include those related to the following:

Revenue Recognition

Significant management judgments and estimates must be made and used in connection with the recognition of revenue in any accounting period. Material differences in the amount of revenue in any given period may result if these judgments or estimates prove to be incorrect or if management’s estimates change on the basis of the development of the business or market conditions. We believe that our management judgments and estimates have been applied consistently and have been reliable historically.

A portion of our revenue is derived from license agreements that entail the customization of our application IP to the customer’s specific requirements. Revenues from initial license fees for such arrangements are recognized based on the percentage of completion method over the period from signing of the license through to customer acceptance, as such IP requires significant modification or customization that takes time to complete. The percentage of completion is measured by monitoring progress using records of actual time incurred to date in the project compared with the total estimated project requirement, which corresponds to the costs related to earned revenues. Estimates of total project requirements are based on prior experience of customization, delivery and acceptance of the same or similar technology and are reviewed and updated regularly by management.

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We believe that the use of the percentage of completion method is appropriate as we have the ability to make reasonably dependable estimates of the extent of progress towards completion, contract revenues and contract costs. In addition, contracts executed include provisions that clearly specify the enforceable rights regarding services to be provided and received by the parties to the contracts, the consideration to be exchanged and the manner and terms of settlement. In all cases we expect to perform our contractual obligations and our licensees are expected to satisfy their obligations under the contract. The complexity of the estimation process and the issues related to the assumptions, risks and uncertainties inherent in the application of the percentage of completion method of accounting affect the amounts of revenue and related expenses reported in our consolidated financial statements. A number of internal and external factors can affect our estimates, including labor rates, utilization and specification and testing requirement changes.

Allowances for Doubtful Accounts

We make judgments as to our ability to collect outstanding receivables and provide allowances for a portion of receivables when collection becomes doubtful. Provisions are made based upon a specific review of all significant outstanding receivables. In determining the provision, we analyze our historical collection experience and current economic trends. If the historical data we use to calculate the allowance provided for doubtful accounts do not reflect our future ability to collect outstanding receivables, additional provisions for doubtful accounts may be needed and the future results of operations could be materially affected.

Accounting for Income Taxes

Significant judgment is required in determining our worldwide income tax expense provision. In the ordinary course of a global business, there are many transactions and calculations where the ultimate tax outcome is uncertain. Some of these uncertainties arise as a consequence of cost reimbursement arrangements among related entities, the process of identifying items of revenue and expense that qualify for preferential tax treatment and segregation of foreign and domestic income and expense to avoid double taxation. Although we believe that our estimates are reasonable, the final tax outcome of these matters may be different than that which is reflected in our historical income tax provisions and accruals. Such differences could have a material effect on our income tax provision and net income (loss) in the period in which such determination is made.

Goodwill

Under Financial Accounting Standards Board Statement No. 142, “Goodwill and Other Intangible Assets” (SFAS 142), goodwill and intangible assets deemed to have indefinite lives are no longer amortized but are subject to annual impairment tests based on estimated fair value in accordance with SFAS 142.

In October 2003, we completed our annual impairment test and assessed the carrying value of goodwill as required by SFAS 142. The goodwill impairment test compared the carrying value of CEVA (the “reporting unit”) with the fair value at that date. Because the market capitalization exceeded the carrying value significantly, no impairment arose. No indicators of impairment were identified between the date of the annual impairment test and year end or during the first quarter of 2004.

Should our market capitalization decline, in assessing the recoverability of our goodwill, we may be required to make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. This process is subjective and requires judgment at many points throughout the analysis. If our estimates or related assumptions change in subsequent periods or if actual cash flows are below our estimates, we may be required to record impairment charges for these assets not previously recorded.

Other Intangible Assets

Other intangible assets are amortized to the Statement of Operations over the period during which benefits are expected to accrue, currently estimated at five years. We are required to test intangible assets for impairment whenever events or circumstances indicate that the value of the assets may be impaired. Factors we consider important, which could trigger impairment include:

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Where events and circumstances are present which indicate that the carrying value may not be recoverable, we will recognize an impairment loss. Such impairment loss is measured by comparing the fair value of the asset with its carrying value. The determination of the value of such intangible assets requires management to make assumptions regarding future business conditions and operating results in order to estimate future cash flows to determine the fair value of the respective assets. If the asset’s carrying value is not recoverable through the related cash flows, the asset is considered to be impaired. The impairment is measured by the difference in the asset’s carrying amount and its fair value, based on the best information available, including market prices or discounted cash flow analysis. If these estimates or the related assumptions change in the future, we could be required to record additional impairment charges.

Reorganization, restructuring and severance charge

Our management and board of directors approved reorganization and restructuring plans in 2003, which resulted in total charges of $8.6 million. In the first, third and fourth quarters of 2003, we recorded charges of $1.4 million, $1.4 million and $5.8 million, respectively, as described above.

We were required to make certain estimates and assumptions in assessing the operating lease obligations arising from a reduction in facility requirements. The underutilized building operating lease charge was calculated by taking into consideration (1) the committed annual rental charge associated with the vacant square footage, (2) an estimate of the sublet rents that could be achieved based on current market conditions, vacancy rates and future outlook, (3) an estimate of the percentage increases in the head lease rent and the sublease rent at each five-year rent review, and (4) the application of a discount rate of 4.75% over the remaining period of the lease. If these estimates or the related assumptions change in the future, we could be required to record a reduction in or additional restructuring charges. No changes in the estimates or related assumptions were identified in the quarter ended March 31, 2004.

RECENT ACCOUNTING PRONOUNCEMENTS

In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities (“FIN 46”). This interpretation clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements”, to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The provisions of FIN 46 were revised in December 2003 to be effective for financial statement periods ended after December 15, 2003. The adoption of FIN 46 did not have a material impact on the consolidated financial statements of the Company.

FACTORS THAT COULD AFFECT OUR OPERATING RESULTS

We caution you that the following important factors, among others, could cause our actual future results to differ materially from those expressed in forward-looking statements made by or on behalf of us in filings with the Securities and Exchange Commission, press releases, communications with investors and oral statements. Any or all of our forward-looking statements in this quarterly report, and in any other public statements we make, may turn out to be wrong. They can be affected by inaccurate assumptions we might make or by known or unknown risks and uncertainties. Many factors mentioned in the discussion below will be important in determining future results. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make in our reports filed with the Securities and Exchange Commission.

RISKS RELATING TO OUR MARKETS

The industries in which we license our technology have experienced a challenging period of slow growth that has negatively impacted and could continue to negatively impact our business and operating results.

The primary customers for our products are semiconductor design and manufacturing companies, system OEMs and electronic equipment manufacturers, particularly in the telecommunications field. These industries are highly cyclical and have been subject to significant economic downturns at various times, particularly in recent periods. These downturns are characterized by production overcapacity and reduced revenues, which at times may encourage semiconductor companies or electronic product manufacturers to

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reduce their expenditure on our technology. During 2001, the semiconductor industry as a whole experienced the most severe contraction in its history, with total semiconductor sales worldwide declining by more than 30%, according to the Semiconductor Industry Association. The market for semiconductors used in mobile communications was particularly hard hit, with the overall decline in sales worldwide estimated by Gartner Dataquest to have been well above 30%. These adverse conditions stabilized but did not improve during the course of 2002. During the course of 2003 and the first quarter of 2004, a recovery appeared to begin. If this apparent recovery is not sustained through 2004 and beyond, however, our business could be further materially and adversely affected.

The markets in which we operate are highly competitive, and as a result we could experience a loss of sales, lower prices and lower revenue.

The markets for the products in which our technology is used are highly competitive. Aggressive competition could result in substantial declines in the license fees that we are able to charge for our intellectual property. It could also cause our existing customers to move their orders to our competitors. Many of our competitors are large companies that have significantly greater financial and other resources than we have.

In addition, we may face increased competition from smaller, niche semiconductor design companies in the future. Some of our customers may also decide to satisfy their needs through in-house design and production. We compete on the basis of price, product quality, design cycle time, reliability, performance, customer support, name recognition and reputation, and financial strength. Our inability to compete effectively on these bases could have a material adverse effect on our business, results of operations and financial condition.

Our operating results fluctuate from quarter to quarter due to a variety of factors, including our lengthy sales cycle, and are not a meaningful indicator of future performance.

In some quarters our operating results could be below the expectations of securities analysts and investors, which could cause our stock price to fall. Factors that may affect our quarterly results of operations in the future include, among other things:

We rely significantly on revenue derived from a limited number of licensees.

We expect that a limited number of licensees, varying in identity from period-to-period, will account for a substantial portion of our revenues in any period. Moreover, license agreements for our DSP cores have not historically provided for substantial ongoing license payments, although they may provide for royalties based on product shipments. Significant portions of our anticipated future revenue, therefore, will likely depend upon our success in attracting new customers or expanding our relationships with existing customers. Our ability to succeed in these efforts will depend on a variety of factors, including the performance, quality, breadth and depth of our current and future products and our sales and marketing skills. Our failure to obtain future customer licenses would impede our future revenue growth.

We depend on market acceptance of third-party semiconductor intellectual property.

Our future growth will depend on the level of acceptance by the market of our third-party, licensable intellectual property model and the variety of intellectual property offerings available on the market, which to a large extent are not in our control. If the market shifts and third-party SIP is no longer desired by our customers, our business, results of operations and financial condition could be materially harmed.

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We depend on the success of our licensees to promote our solutions in the marketplace.

We do not sell our technology directly to end-users; we license our technology primarily to semiconductor companies and to electronic equipment manufacturers, who then incorporate our technology into the products they sell. Because we do not control the business practices of our licensees, we do not influence the degree to which they promote our technology or set the prices at which they sell products incorporating our technology. We cannot assure you that our licensees will devote satisfactory efforts to promoting our solutions. In addition, our unit royalties from licenses are totally dependent upon the success of our licensees in introducing products incorporating our technology and the success of those products in the marketplace. If we do not retain our current licensees and continue to attract new licensees, our business may be harmed.

We depend on a limited number of key personnel who would be difficult to replace.

Our success depends to a significant extent upon our key employees and senior management; the loss of the service of these employees could materially harm us. Competition for skilled employees in our field is intense. We cannot assure you that we will be successful in attracting and retaining the required personnel.

RISKS RELATING TO OUR

SEPARATION FROM DSP GROUP

Restrictions on our ability to take certain actions could inhibit our growth.

The agreement governing our separation from DSP Group (For further information, reference is made to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2003) restricts us from liquidating, disposing of or discontinuing our DSP cores licensing business during the two-year period following our spin-off, which will end November 1, 2004. Although we have no plans to take any such steps, such restrictions, as well as our agreement to indemnify DSP Group if we do not comply with these restrictions, could limit our flexibility. In addition, these restrictions and indemnification obligations could make us a less attractive acquisition or merger candidate during this period.

We could be subject to joint and several liability for taxes of DSP Group.

As a former member of a group filing consolidated income tax returns with DSP Group, we could be liable for federal income taxes of DSP Group and other members of the consolidated group, including taxes, if any, incurred by DSP Group on the distribution of our stock to the stockholders of DSP Group. DSP Group has agreed to indemnify us against these taxes, other than taxes for which we have agreed to indemnify DSP Group pursuant to the terms of the tax indemnification and allocation agreement and separation agreement we entered into with DSP Group.

Some of our directors and executive officers may have conflicts of interest because of their ownership of DSP Group’s common stock or position with DSP Group.

Some of our directors and executive officers, including Eliyahu Ayalon, who serves as the chairman of the board of directors of DSP Group; Gideon Wertheizer, our Executive Vice President—CEVA DSP Cores; and Issachar Ohana, our Vice President, Worldwide Sales, hold a significant number of shares of DSP Group’s common stock and options to purchase shares of DSP Group’s common stock. Ownership of DSP Group’s common stock by certain of our directors and executive officers could create, or appear to create, conflicts of interest when they are faced with decisions that could have different implications for DSP Group and us.

ADDITIONAL RISKS RELATING TO OUR BUSINESS

Our success will depend on our ability to manage our geographically dispersed operations successfully.

Although we are headquartered in San Jose, California, most of our employees are located in Ireland and Israel. Accordingly, our ability to compete successfully will depend in part on the ability of a limited number of key executives located in geographically dispersed offices to integrate management, address the needs of our customers and respond to changes in our markets. If we are unable to effectively manage our remote operations, our business may be harmed.

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Our operations in Israel may be adversely affected by instability in the Middle East region.

One of our principal research and development facilities is located in, and some of our directors and officers are residents of, Israel. Although substantially all of our sales currently are being made to customers outside Israel, we are nonetheless directly influenced by the political, economic and military conditions affecting Israel. Any major hostilities involving Israel could significantly harm our business, operating results and financial condition.

In addition, certain of our officers and employees are currently obligated to perform annual reserve duty in the Israel Defense Forces and are subject to being called for active military duty at any time. Although we have operated effectively under these requirements since our inception, we cannot predict the effect of these obligations on the company in the future. Our operations could be disrupted by the absence, for a significant period, of one or more of our officers or key employees due to military service.

If we are unable to meet the changing needs of our end-users or to address evolving market demands, our business may be harmed.

The markets for programmable DSP cores and application IP are characterized by rapidly changing technology, emerging markets and new and developing end-user needs, requiring significant expenditure for research and development. We cannot assure you that we will be able to introduce systems and solutions that reflect prevailing industry standards on a timely basis, to meet the specific technical requirements of our end-users or to avoid significant losses due to rapid decreases in market prices of our products, and our failure to do so may seriously harm our business. In addition, the reduction in the number of our employees in connection with our recent restructuring efforts could adversely affect our ability to attract or retain customers who require certain R&D capabilities from their IP providers.

We may seek to expand our business through acquisitions that could result in diversion of resources and extra expenses.

We may pursue acquisitions of businesses, products and technologies, or establish joint venture arrangements in the future that could expand our business. The negotiation of potential acquisitions or joint ventures, as well as the integration of acquired or jointly developed businesses, technologies or products could cause diversion of management’s time and our resources. We may not be able to successfully integrate acquired businesses or joint ventures with our operations. If we were to make any acquisition or enter into a joint venture, we may not experience the intended benefits. If future acquisitions or joint ventures disrupt our operations, or if we have difficulty integrating the businesses or technologies we acquire, our business, financial condition and results of operations could suffer.

We may not be able to adequately protect our intellectual property.

Our success and ability to compete depend in large part upon the protection of our proprietary technologies. We rely on a combination of patent, copyright, trademark, trade secret, mask work and other intellectual property rights, confidentiality procedures and licensing arrangements to establish and protect our proprietary rights. These agreements and measures may not be sufficient to protect our technology from third-party infringement, or to protect us from the claims of others. As a result, we face risks associated with our patent position, including the potential need to engage in significant legal proceedings to enforce our patents, the possibility that the validity or enforceability of our patents may be denied, the possibility that third parties will be able to compete against us without infringing our patents and the possibility that our products may infringe patent rights of third parties.

Our tradenames or trademarks may be registered or utilized by third parties in countries other than those in which we have registered them, impairing our ability to enter and compete in these markets. If we were forced to change any of our brand names, we could lose a significant amount of our brand equity.

Our business will suffer if we are sued for infringement of the intellectual property rights of third parties or if we cannot obtain licenses to these rights on commercially acceptable terms.

Although we are not currently involved in any litigation, we are subject to the risk of adverse claims and litigation alleging infringement of the intellectual property rights of others. There are a large number of patents held by others, including our competitors, pertaining to the broad areas in which we are active. We have not, and cannot reasonably, investigate all such patents. From time to time, we have become aware of patents in our technology areas and have sought legal counsel regarding the validity of such patents and their impact on how we operate our business, and we will continue to seek such counsel when appropriate in the future. Claims against us may require us to enter into license arrangements or result in protracted and costly litigation, regardless of the merits. Any necessary licenses may not be available or, if available, may not be obtainable on commercially reasonable terms. If we cannot obtain necessary licenses on commercially reasonable terms, we may be forced to stop licensing our technology, and our business would be seriously harmed.

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Our business depends on OEMs and their suppliers obtaining required complementary components.

Some of the raw materials, components and subassemblies included in the products manufactured by our OEM customers are obtained from a limited group of suppliers. Supply disruptions, shortages or termination of any of these sources could have an adverse effect on our business and results of operations due to the delay or discontinuance of orders for products containing our IP, especially our DSP cores, until those necessary components are available.

The future growth of our business depends in part on our ability to license to system OEMs and small-to-medium-sized semiconductor companies directly and to expand our sales geographically.

Historically a substantial portion of the revenues from the licensing of our products has been derived in any period from a relatively small number of licensees. Because of the substantial license fees we charge, our customers tend to be large semiconductor companies or vertically integrated system OEMs. Part of our current growth strategy is to broaden the adoption of our products by small to mid-size companies by offering versions of our products targeted at these companies. In addition we plan to continue expanding our sales to include additional geographies. Asia, in particular, is a region we have targeted for growth. If we are unable to effectively develop and market our intellectual property through these models, our revenues will continue to be dependent on a smaller number of licensees and a less geographically dispersed pattern of licensees, which could harm our business and results of operations.

ADDITIONAL RISKS RELATING TO OUR

INTERNATIONAL OPERATIONS

The Israeli tax benefits that we currently receive and the government programs in which we participate require us to meet certain conditions and may be terminated or reduced in the future, which could increase our costs.

We enjoy certain tax benefits in Israel, particularly as a result of the “Approved Enterprise” status of our facilities and programs. To maintain our eligibility for these tax benefits, we must continue to meet certain conditions, relating principally to adherence to the investment program filed with the Investment Center of the Israeli Ministry of Industry and Trade and to periodic reporting obligations. We believe that we will be able to continue to meet such conditions. Should we fail to meet such conditions in the future, however, these benefits would be cancelled and we would be subject to corporate tax in Israel at the standard rate of 36% and could be required to refund tax benefits already received. In addition, we cannot assure you that these grants and tax benefits will be continued in the future at their current levels or otherwise. The termination or reduction of certain programs and tax benefits (particularly benefits available to us as a result of the Approved Enterprise status of our facilities and programs) or a requirement to refund tax benefits already received may seriously harm our business, operating results and financial condition.

Our corporate tax rate may increase, which could adversely impact our cash flow, financial condition and results of operations.

We have significant operations in the Republic of Ireland and a substantial portion of our taxable income historically has been generated there. Currently, some of our Irish subsidiaries are taxed at rates substantially lower than U.S. tax rates. Although there is no expectation of any changes to Irish tax law, if our Irish subsidiaries were no longer to qualify for these lower tax rates or if the applicable tax laws were rescinded or changed, our operating results could be materially adversely affected. In addition, because our Irish and Israeli operations are owned by subsidiaries of a U.S. corporation, distributions to the U.S. corporation, and in certain circumstances undistributed income of the subsidiaries, may be subject to U.S. tax. Moreover, if U.S. or other foreign tax authorities were to change applicable foreign tax laws or successfully challenge the manner in which our subsidiaries’ profits are currently recognized, our overall taxes could increase, and our business, cash flow, financial condition and results of operations could be materially adversely affected.

Item 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK