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United States

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the Period Ended September 30, 2005

or

For The Transition Period from              to             

Commission File Number 0-15449

CALIFORNIA MICRO DEVICES CORPORATION

(Exact name of registrant as specified in its charter)

(408) 263-3214

(Registrant’s telephone number, including area code)

Not applicable

(Former name, former address, and former fiscal year if changed since last report)

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

Applicable Only to Corporate Issuers

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

The number of shares of the registrant’s Common Stock outstanding as of October 31, 2005 was 22,147,657.

Total Number of Pages is 36

Exhibit Index is on Page 31

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California Micro Devices Corporation

Form 10-Q for the Quarter ended September 30, 2005

INDEX

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

California Micro Devices Corporation

CONDENSED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

See Notes to Financial Statements.

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California Micro Devices Corporation

CONDENSED BALANCE SHEETS

(In thousands, except share data)

See Notes to Financial Statements.

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California Micro Devices Corporation

CONDENSED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

See Notes to Financial Statements.

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

California Micro Devices Corporation

NOTES TO CONDENSED FINANCIAL STATEMENTS

(Unaudited)

1. Basis of Presentation

The accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) 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 of the information and footnotes required by U.S. GAAP for complete financial statements. The condensed financial statements should be read in conjunction with the financial statements included with our annual report on Form 10-K for the fiscal year ended March 31, 2005. In the opinion of management, the accompanying unaudited condensed financial statements contain all adjustments (consisting of only normal recurring adjustments) necessary to present fairly the financial position of California Micro Devices Corporation (the “Company”, “we”, “us” or “our”) as of September 30, 2005, and the results of operations for the three month and six month periods ended September 30, 2005 and cash flows for the six month periods ended September 30, 2005 and 2004. Results for the three and six month periods are not necessarily indicative of fiscal year results.

2. Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Our estimates are based on historical experience, input from sources outside of the Company, and other relevant facts and circumstances. Actual results could differ from these estimates, and such differences could be material.

3. Stock Based Compensation

As allowed under Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock Based Compensation,” we account for our employee stock plans in accordance with the provisions of Accounting Principles Board’s Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees” and have adopted the disclosure only provisions of SFAS 123. Stock based awards to non-employees are accounted for in accordance with SFAS 123 and EITF 96-18 “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” Fair value for these awards is calculated using the Black-Scholes option pricing model, which requires that we estimate the volatility of our stock, an appropriate risk-free interest rate, estimated time until exercise of the option, and our expected dividend yield. The Black-Scholes model was developed for use in estimating the fair value of traded options that do not have specific vesting schedules and are ordinarily transferable. The calculation of fair value is highly sensitive to the expected life of the stock based award and the volatility of our stock, both of which we estimate based primarily on historical experience. As a result, the pro forma disclosures are not necessarily indicative of pro forma effects on reported financial results for future years.

We generally recognize no compensation expense with respect to employee stock grants as the exercise price is at the market price of our common stock at the date of grant. Had we recognized compensation for the grant date fair value of employee stock grants in accordance with SFAS 123, our net income and net income per share would have been revised to the pro forma amounts shown below (in thousands, except per share data) For pro forma purposes, the estimated fair value of our stock based grants is amortized over the vesting period for stock options granted under our stock option plans, and the purchase period for stock purchases under our stock purchase plan.

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4. Net Income Per Share

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

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Options to purchase 653,296 and 1,597,753 shares of common stock were outstanding during the three and six month periods ended September 30, 2005, respectively, but were not included in the computation of diluted earnings per share because the exercise price of the stock options was greater than the average closing share trading price reported by Nasdaq (“Average Trading Price”) of the common shares during each of the periods ended September 30, 2005. For the three and six months ended September 30, 2005, all outstanding warrants were included in the computation of diluted earning per share, because the exercise prices of the warrants were less than the Average Trading Price of the common shares during the periods.

Options to purchase 756,027 and 462,030 shares of common stock were outstanding during the three and six month periods ended September 30, 2004, respectively, but were not included in the computation of diluted earnings per share because the exercise price of the stock options was greater than the Average Trading Price of the common shares during each of the periods ended September 30, 2004. For the three and six months ended September 30, 2004, all outstanding warrants were included in the computation of diluted earning per share, because the exercise prices of the warrants were less than the Average Trading Price of the common shares during the periods.

5. Inventories

The components of inventory consist of the following (in thousands):

6. Comprehensive Income

Comprehensive income is principally comprised of net income and unrealized gains or losses on our available for sale securities. Comprehensive income for the three and six month periods ended September 30, 2005 and 2004 was as follows (in thousands):

7. Income Taxes

For the three and six month period ended September 30, 2005 we recorded income tax provisions of $63,000 and $77,000, respectively for federal and state income taxes. For the three and six month periods ended September 30, 2004 we recorded income tax provisions of $68,000 and $128,000, respectively for federal and state income taxes. Our effective tax rate benefited from our ability to utilize loss carry forwards and other credits; however, the benefit was limited by alternative minimum tax provisions.

We have provided a valuation allowance against our net deferred tax assets due to the uncertainties surrounding our ability to generate sufficient taxable income in future periods to realize the tax benefits of our loss carry forwards. Although we had experienced quarterly taxable income beginning with the second quarter of fiscal 2004, we experienced a loss in the fourth quarter of fiscal 2005 and we have a prior history of losses. In addition, the industry in which we operate is highly cyclical, so there are uncertainties as to our future profitability. If we continue to produce taxable income in future periods, we may reverse a portion of our valuation allowance. This may produce income rather than expense from income taxes on our financial statements in the period in which we reverse a portion of our valuation allowance. We will continue to evaluate our ability to realize the net deferred tax assets.

8. Long Term Debt

On September 30, 2004, we entered into an amended loan agreement with Silicon Valley Bank. Under this one year agreement, for which there were $55,000 of commitment and related fees, the bank provided a $15 million credit line, subject to financial and other covenants contained in the agreement. The agreement expired on September 28, 2005. On October 25, 2005, we entered into an amended loan agreement with Silicon Valley Bank which extended the $15 million credit line for

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one year from the original September 28, 2005 termination date. There was $11,000 of associated fees for the one year facility. We granted the bank a continuing security interest in all of our assets other than our intellectual property. The agreement prohibits our paying cash dividends. Borrowings under this agreement bear interest at the current prime rate, and interest is payable monthly. The bank may withdraw the commitment if we fail to comply with the covenants, if there is a material adverse change in our business, operations or condition, if we become insolvent or if other specified events or conditions occur. (See Note 15 Subsequent Events).

In September 2004, we entered into a three year software lease with Synopsys at an interest rate of 5%. We accounted for the agreement as a capital lease. Under the agreement, we made the first of three annual lease payments of $82,000 in October 2004. The amount capitalized is $246,000. The outstanding capital lease obligation as of September 30, 2005 was approximately $164,000, and prepaid interest was $9,000. Interest expense on the lease during the three months ended September 30, 2005 was $2,984.

Total fixed assets purchased under capital leases and the associated accumulated amortization was as follows (in thousands):

Amortization expense for fixed assets purchased under capital leases is included in the line item titled “amortization” on our condensed statements of cash flows.

9. Short Term Investments

Cash and cash equivalents represent cash and money market funds.

Short term investments represent investments in debt securities with remaining maturities less than one year. We invest our excess cash in high quality financial instruments. We have classified our marketable securities as available for sale securities. Our available for sale securities have contractual maturities of 365 days or less and are carried at fair value, with unrealized gains and losses reported in a separate component of shareholders’ equity. Because we have the ability and intent to hold these investments until a recovery of fair value, which may be at maturity, we do not consider the investments to be other than temporarily impaired at September 30, 2005, and March 31, 2005. Realized gains and losses and declines in value judged to be other than temporary, if any, on available for sale securities are included in other income (expense). Net interest on securities classified as available for sale is also included in other (income) expense, net. The cost of securities sold is based on the specific identification method.

Short term investments were as follows (in thousands):

During the three month and six months periods ended September 30, 2005, net unrealized holding loss of $12,000 and $15,000, respectively, were included in accumulated other comprehensive income.

10. Recent Accounting Pronouncements

On June 1, 2005 the FASB issued SFAS 154, “Accounting Changes and Error Corrections,” which replaces APB 20, “Accounting Changes,” and SFAS 3, “Reporting Accounting Changes in Interim Financial Statements.” SFAS 154 applies to all voluntary changes in accounting principle, and changes the requirements for accounting for and reporting of a change in accounting principle. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Earlier application is permitted for accounting changes and corrections of errors made in fiscal years beginning after June 1, 2005. We do not expect our adoption of this new standard to have a material impact on our financial position, results of operations or cash flows.

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In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”). SFAS 123(R) replaces SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”. The new standard requires companies to recognize compensation cost relating to share based payment transactions in their financial statements. That cost is to be measured based on the fair value of the equity or liability instruments issued. SFAS 123(R) also includes some changes regarding the timing of expense recognition and the treatment of forfeitures. SFAS 123(R) indicates that it is effective for reporting periods beginning after June 15, 2005. In March 2005, the SEC released Staff Accounting Bulletin No. 107, “Share-Based Payment” (“SAB 107”), which provides interpretive guidance related to the interaction between SFAS 123(R) and certain SEC rules and regulations. It also provides the SEC staff’s views regarding valuation of share based payment arrangements. In April 2005, the SEC amended the compliance dates for SFAS 123(R), to allow companies to implement the standard at the beginning of their next fiscal year, instead of the next reporting period beginning after June 15, 2005. We plan to adopt SFAS 123R effective April 1, 2006 as permitted by the SEC. We are currently evaluating the impact SFAS 123(R) and SAB 107 will have on our financial statements.

11. Significant Customers

During the three months ended September 30, 2005, we had one original equipment manufacturer, Motorola, that comprised 43% of our net sales and one distributor, RDL Electronics, that comprised 12% of our net sales. During the six months ended September 30, 2005, we had one original equipment manufacturer, Motorola, that comprised 39% of our net sales and one distributor, RDL Electronics, that comprised 15% of our net sales.

During the three months ended September 30, 2004, we had three original equipment manufacturers Motorola, Guidant and LG Electronics, that comprised 21%, 13% and 11% respectively of our net sales, and one distributor, Epco, that comprised 14% of our net sales. During the six months ended September 30, 2004, we had two original equipment manufacturers, Motorola and Guidant, that comprised 18% and 16%, respectively, of our net sales, and one distributor, Epco, that comprised 15% of our net sales.

12. Stock Issuances

On May 3, 2004, we closed our public offering of 1,300,000 shares of common stock at a price of $15.00 per share with net proceeds of $18.0 million, after deducting the underwriting discount of $1.1 million and offering expenses of $368,000.

On May 24, 2004 and June 7, 2004, some of the investors in prior private placements and one of our placement agents exercised some of the warrants they had been granted in such private placements or had purchased from investors in such private placements. In total, such investors and placement agent exercised warrants for 36,663 shares at an exercise price of $3.00 per share resulting in total proceeds of approximately $110,000 and exercised warrants for 225,179 shares with an exercise price of $4.36 per share resulting in total proceeds of approximately $982,000, respectively. On September 19, 2005, an investor in one of our prior private placements exercised warrants for 29,412 shares at an exercise price of $4.36 per share resulting in total proceeds of approximately $128,000. These warrant exercises were affected without registration under the Federal Securities Act of 1933, as amended, in reliance upon the exemption provided by Section 4(2) of such Act and Rule 506 promulgated under such Section as the holders were accredited institutional investors.

Also during the three month and six month periods ended September 30, 2005 we issued the following shares of common stock under our employee stock option and employee stock purchase plans:

13. Restructuring

On October 19, 2004, our board of directors approved a plan to close our manufacturing operation in Tempe, Arizona and other associated activities. The action was the result of our strategic plan to focus our product development and sales and marketing efforts on selected markets, actively manage our product life cycles and outsource our manufacturing operations. The Tempe wafer fabrication facility was the final internal manufacturing operation to be closed. The plan identified employees to be terminated, impaired assets consisting of real estate and manufacturing equipment, and other shutdown costs.

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On March 31, 2005 our board of directors approved the termination of additional employees as a modification to the original plan.

Employee terminations are as follows:

The restructuring costs are shown in the statement of operations in the line item titled “Restructuring”. A summary of the costs to close the Tempe facility are as follows (in thousands):

As of September 30, 2005, the real estate and manufacturing equipment identified under the plan have been sold and the remaining activities include the termination of two employees and one contract.

14. Contingencies

Environmental

We have been subject to a variety of federal, state and local regulations in connection with the discharge and storage of certain chemicals used in our manufacturing processes, which are now fully outsourced to independent contract manufacturers. We have obtained all necessary permits for such discharges and storage, and we believe that we have been in substantial compliance with the applicable environmental regulations. Industrial waste generated at our facilities was either processed prior to discharge or stored in double-lined barrels until removed by an independent contractor. With the completion of our Milpitas site remediation and the closure of our Tempe facility during fiscal 2005, we now expect our environmental compliance costs to be minimal.

Guarantees

We enter into certain types of contracts from time to time that require us to indemnify parties against third party claims. These contracts primarily relate to (1) certain agreements with our directors and officers under which we may be required to indemnify them for liabilities arising out of their efforts on behalf of the company; and (2) agreements under which we have agreed to indemnify our contract manufacturers and customers for claims arising from intellectual property infringement. The conditions of these obligations vary and generally a maximum obligation is not explicitly stated. Because the obligated amounts under these types of agreements often are not explicitly stated, the overall maximum amount of the obligations cannot be reasonably estimated. We have not recorded any associated obligations at September 30, 2005 or March 31, 2005. We carry coverage under certain insurance policies to protect ourselves in the case of any unexpected liability; however, this coverage may not be sufficient.

15. Subsequent Events

On October 25, 2005, we entered into an amended loan agreement with Silicon Valley Bank which extended the $15 million credit line for one year from the original September 28, 2005 termination date. There was $11,000 of associated fees for the one year facility. We granted the bank a continuing security interest in all of our assets other than our intellectual property. The agreement prohibits our paying cash dividends. Borrowings under this agreement bear interest at the current prime rate and interest is payable monthly. The bank may withdraw the commitment if we fail to comply with the covenants, if there is a material adverse change in our business, operations or condition, if we become insolvent or if other specified events or conditions occur.

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

In this discussion, “CMD,” “we,” “us” and “our” refer to California Micro Devices Corporation. All trademarks appearing in this discussion are the property of their respective owners. This discussion should be read in conjunction with the other financial information and financial statements and related notes contained elsewhere in this report.

Forward Looking Statements

This discussion and report contain forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such forward looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward looking statements are not historical facts and are based on current expectations, estimates, and projections about our industry; our beliefs and assumptions; and our goals and objectives. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” and “estimates,” and variations of these words and similar expressions are intended to identify forward looking statements. Examples of the kinds of forward looking statements in this report include statements regarding the following:

(1) our expectation as to future levels of research and development expense; (2) our expectation that our average unit sales price for like products will decline approximately 15% per year; (3) our expectation that our gross margin will continue to improve over the next several quarters toward our target range of 39% to 41%; (4) our expectation that the sale of previously reserved inventories will continue at minimal levels in future quarters; (5) our expectations about our fiscal 2006 income tax rate; (6) our expectation that our future environmental compliance costs will be minimal; (7) our plan to adopt SFAS 123R on April 1, 2006; (8) our plan when determining our unaudited financial results during fiscal 2006 to continue to utilize supplemental procedures to verify the effectiveness of our three-way match of the goods received to our suppliers’ invoices and our purchase orders until we have obtained sufficient evidence of its operating effectiveness; and (9) our anticipation that our existing cash, cash equivalents and short term investments will be sufficient to meet our anticipated cash needs over the next 12 months. These statements are only predictions, are not guarantees of future performance, and are subject to risks, uncertainties, and other factors, some of which are beyond our control, are difficult to predict, and could cause actual results to differ materially from those expressed or forecasted in the forward looking statements. These risks and uncertainties include, but are not limited to, our expectation that customers will not change their minds and order end of life products remaining in our inventory but which we have already written off; whether we will decide to invest more or less in research and development due to market conditions, technology discoveries, or other circumstances; whether our product mix changes, our unit volume decreases materially, we experience price erosion due to competitive pressures, or our contract manufacturers and assemblers raise their prices to us or we experience lower yields from them or we are unable to realize expected cost savings in certain manufacturing and assembly processes; whether there will be any changes in tax accounting rules; whether it takes us longer than expected to fully implement and verify the three-way match, for example due to issues of vendor incompatibility; whether we encounter any unexpected environmental clean-up issues with our Tempe facility; whether we discover any further contamination at our Topaz Avenue Milpitas facility; and whether we will have large unanticipated cash requirements, as well as other risk factors detailed in this report, especially under the caption “Risk Factors and Other Factors That Could Affect Future Results” at the end of this discussion in this under Item 2. Except as required by law, we undertake no obligation to update any forward looking statement, whether as a result of new information, future events, or otherwise.

Overview

We design and sell application specific analog semiconductor products for high volume applications in the mobile handset, personal computer and digital consumer electronics markets which we describe as our core markets. We are a leading supplier of application specific integrated passive (ASIP^™) devices for mobile handsets that provide electromagnetic interference (EMI) filtering and electrostatic discharge (ESD) protection and of ASIP devices for personal computers, personal computer peripherals and digital consumer electronics that provide low capacitance ESD protection. Both types of ASIP devices are used primarily to protect various interfaces, both external and internal, used in our customers’ products. Our ASIP devices, built using our proprietary silicon manufacturing process technology, provide the function of multiple passive components in a single semiconductor device. They occupy significantly less space, cost our customers less, taking into account the total cost of implementation, and offer increased performance and reliability compared to traditional solutions based on discrete passive components. Some of our ASIP devices also integrate active analog elements to provide additional functionality.

We also offer selected active analog devices that complement our ASIP devices. They include integrated LED drivers and interface circuits for mobile handsets and power management devices for digital consumer electronics products. Our active analog device solutions use industry standard manufacturing processes for cost effectiveness.

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Within the past four years, we have streamlined our operations and become completely fabless using independent providers of wafer fabrication services. We have focused our marketing and sales on strategic customers in our three core markets. As a part of this process, we have reduced the number of our actively marketed products from approximately 5,000 to less than 200 while at the same time increasing our unit volume shipments from less than 25 million units in the quarter ended March 31, 2001 to approximately 200 million units in the quarter ended September 30, 2005.

End customers for our semiconductor products are original equipment manufacturers (OEMs) including Dell Inc., Hewlett-Packard Company, Kyocera Wireless Corp., LG Electronics, Motorola, Inc., Pantech Co., Ltd., Samsung Electronics Co., Ltd. and Sony Corporation. We sell to some of these end customers through original design manufacturers (ODMs), including Arima Computer Corporation, BenQ Corporation, Compal Electronics, Inc. and Quanta Computer, Inc., and contract electronics manufacturers (CEMs), including Flextronics International Ltd., Foxconn (Hon Hai Precision Industry Co., Ltd.) and Solectron Corporation. We use a direct sales force, manufacturers’ representatives and distributors to sell our products.

We operate in one operating segment and most of our physical assets are located outside the United States. Assets located outside the United States include product inventories and manufacturing equipment consigned to our contract wafer manufacturers, assemblers and test houses.

Results of Operations

Net sales

Net sales by market were as follows (in millions):

Net sales for the three month period ended September 30, 2005 were $18.5 million, an increase of approximately $1.4 million or 8% from the $17.1 million of net sales for the three month period ended September 30, 2004. Net sales for the six month period ended September 30, 2005 were $33.2 million, a decrease of approximately $300,000 or less than 1% from the $33.5 million of net sales for the six month period ended September 30, 2004. Within the past year we have exited the non-core Medical and Other markets so our sales in those markets declined from $4.1 million and $8.0 million in the three and six month periods ended September 30, 3004 to zero in the three and six month periods ended September 30, 2005. Net sales from products for our core markets (mobile handsets, personal computers and digital consumer electronics) for the three month period ended September 30, 2005 were $18.5 million compared to $13.0 million in the three month period ended September 30, 2004, an increase of 42%. Net sales from products for our core markets during the six month period ended September 30, 2005 were $33.2 compared to $25.5 million for the six month period ended September 30, 2004, an increase of 30%. These increases in sales in products for our core markets exceeded the sales we eliminated by exiting our non-core markets for the three month period ended September 30, 2005 and approximately matched the sales we eliminated by exiting our non-core markets for the six month period ended September 30, 2005. Our overall average unit price declined to $0.09 from $0.16 and our average unit price for products for our core markets declined to $0.09 from $0.12 during the three month period ended September 30, 2005 compared to the three month period ended September 30, 2004. The difference between the overall average unit price and the average unit price for products for our core markets in the September 30, 2004 period reflects the impact of the higher priced products for our non-core markets which we no longer sell. The average unit price for products for our core markets has declined by 24% during the year over year period. Of this decline, 14% represents the weighted average decline in products that sold in both periods and the remaining 10% of the decline is due to changes in the mix of products and to introducing products with a lower than average selling price primarily due to the lower selling prices of many of our products for the mobile handset market compared to that of our other products for the personal computer and digital consumer markets. In the future we expect our average unit selling price for like products to decline at a rate of approximately 15% per annum.

Our growth in sales from products for the mobile handset market was primarily the result of increased penetration (as measured by the average number of our parts per total handsets shipped), and secondarily the result of market growth. Sales from products for the personal computer and digital consumer market remained relatively flat. The absence of product sales for the medical market was the result of our discontinuing these products during the fourth quarter of fiscal 2005 and the absence of sales of other products was the result of our end of life programs for our legacy products.

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Units shipped during the three and six month periods ended September 30, 2005 increased to approximately 200 million units and approximately 360 million units from approximately 101 million and 209 million units in the three and six month periods ended September 30, 2004.

Comparison of Cost of Sales, Gross Margin and Expenses

The table below shows our net sales, cost of sales, gross margin and expenses, both in dollars and as a percentage of net sales, for the three and six month periods ended September 30, 2005 and 2004 (in thousands):

Cost of Sales

Cost of sales increased by approximately $1.3 million for the three month period ended September 30, 2005 compared to the three month period ended September 30, 2004 primarily due to the following reasons:

Cost of sales increased by approximately $1.0 million for the six month period ended September 30, 2005 compared to the six month period ended September 30, 2004 primarily due to the following reasons:

The cost of sales increase from volume of products for our core markets was primarily driven by a 55% and a 40% increase in sales in our products used in mobile handsets for the three and six month periods ended September 30, 2005, respectively. There was a decrease in cost of sales related to the end of our product sales for non-core markets for both the three and six month periods ended September 30, 2005 as we exited those markets and eliminated our sales.

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The increase in net inventory reserve expense was due to a decline in the sales of previously reserved inventory. The benefits related to sales of previously reserved inventory for the three month periods ended September 30, 2005 and 2004 were approximately $28,000 and $200,000, respectively, and for the six month periods ended September 30, 2005 and 2004 were approximately $160,000 and $400,000, respectively. We expect the sale of previously reserved inventories to continue at minimal levels in future quarters.

The cost reductions of products for our core markets were primarily the result of process cost reductions, lower subcontractor costs (both by sourcing with lower cost subcontractors and by cost reductions at existing subcontractors) and product redesigns for both the three and six month periods ended September 30, 2005 and 2004.

Gross Margin

Gross margin increased by approximately $150,000 for the three month period ended September 30, 2005 compared to the three month period ended September 30, 2004 primarily due to the following reasons:

Gross margin as a percentage of net sales decreased to 38% for the three month period ended September 30, 2005, compared to 40% for the three month period ended September 30, 2004. Our gross margin had declined during the second half of fiscal 2005 to a low of 27% during the fourth quarter as our cost reductions lagged our sales price decreases and the requirement to reserve excess inventory. The increase this quarter continued the trend from last quarter when our gross margin was 34%. Our target gross margin is 39% to 41%. We expect, based on our assumptions for the size and timing of unit sales, unit pricing and cost reductions that our gross margin will continue to improve over the next several quarters toward this target. However, if our assumptions were to be incorrect, our gross margin could fail to improve to our target range or could decline.

Gross margin decreased by approximately $1.3 million for the six month period ended September 30, 2005 compared to the six month period ended September 30, 2004 primarily due to the following reasons:

Research and Development. Research and development expenses consist primarily of compensation and related costs for employees, prototypes, masks and other expenses for the development of new products, process technology and packages. The changes in research and development expenses for the three and six month periods ended September 30, 2005, compared to the same periods in 2004 were as follows: