DSP GROUP INC /DE/ (Form: 10-Q, Received: 11/09/2004 15:08:45)

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2004

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number 0-23006

DSP GROUP, INC.

(Exact name of registrant as specified in its charter)


Delaware		94-2683643
(State or other jurisdiction of incorporation or organization)		(I.R.S. employer identification number)

3120 Scott Boulevard, Santa Clara, California		95054
(Address of Principal Executive Offices)		(Zip Code)

Registrant’s telephone number, including area code: (408) 986-4300

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 ¨

As of November 1, 2004, there were 28,006,106 shares of Common Stock ($.001 par value per share) outstanding.

INDEX

DSP GROUP, INC.


		Page No.
*PART I. FINANCIAL INFORMATION*
Item 1.	Financial Statements (Unaudited) Condensed consolidated balance sheets— September 30, 2004 and December 31, 2003 (audited)	3
	Condensed consolidated statements of income— three and nine months ended September 30, 2004 and 2003	5
	Condensed consolidated statements of cash flows— nine months ended September 30, 2004 and 2003	6
	Condensed consolidated statements of stockholders’ equity— three and nine months ended September 30, 2004 and 2003	7
	Notes to condensed consolidated financial statements— September 30, 2004	9
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	31
Item 4.	Controls and Procedures	31

*PART II. OTHER INFORMATION*
Item 1.	Legal Proceedings	31
Item 6.	Exhibits and Reports on Form 8-K	32

SIGNATURES		33

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

DSP GROUP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(US dollars in thousands)


	September 30, 2004		December 31, 2003
	(Unaudited)		(Audited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	91,272	$	36,812
Held-to-maturity marketable securities and bank deposits		52,252		42,490
Trade receivables, less allowance for returns of $123 in September 30, 2004 and December 31, 2003 and for doubtful accounts of $803 in September 30, 2004 and $708 in December 31, 2003		16,151		15,844
Deferred income taxes		1,326		1,326
Other accounts receivable and prepaid expenses		1,440		1,462
Inventories		8,549		8,466

TOTAL CURRENT ASSETS		170,990		106,400

LONG-TERM ASSETS:
Held-to-maturity marketable securities		193,540		197,071
Investments in equity securities of traded companies		—		47,138
Long-term prepaid expenses and lease deposits		583		513
Severance pay fund		3,019		2,360

Deferred income taxes		641		—

TOTAL LONG-TERM ASSETS		197,793		247,082

PROPERTY AND EQUIPMENT, NET		6,556		7,108

OTHER ASSETS

Intangible assets, net		1,616		2,076

Goodwill		1,500		5,804

TOTAL OTHER ASSETS		3,116		7,880

TOTAL ASSETS	$	378,445	$	368,470

Note: The balance sheet at December 31, 2003 has been derived from the audited financial statements at that date.

See notes to condensed consolidated financial statements.

DSP GROUP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(US dollars in thousands)


	September 30, 2004			December 31, 2003
	(Unaudited)			(Audited)
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Trade payables	$	13,937		$	11,221
Accrued compensation and benefits		8,237			9,000
Income taxes payables		24,177			11,107
Accrued expenses and other accounts payable		14,087			14,185

TOTAL CURRENT LIABILITIES		60,438			45,513

LONG-TERM LIABILITIES:
Accrued severance pay		3,353			2,555
Deferred income taxes		—			14,592
Other long-term liabilities		—			1,429

TOTAL LONG-TERM LIABILITIES		3,353			18,576

STOCKHOLDERS’ EQUITY:
Preferred stock, $0.001 par value - Authorized shares - 5,000,000 at September 30, 2004 and December 31, 2003; issued and outstanding shares - none at September 30, 2004 and December 31, 2003		—			—
Common stock, $0.001 par value - Authorized shares: 50,000,000 at September 30, 2004 and December 31, 2003; issued and outstanding shares: 27,976,973 at September 30, 2004 and 28,615,884 at December 31, 2003		28			29
Additional paid-in capital		186,906			174,700
Treasury stock		(29,318	)		(1,192	)
Accumulated other comprehensive income		70			23,045
Retained earnings		156,968			107,799

TOTAL STOCKHOLDERS’ EQUITY		314,654			304,381

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	378,445		$	368,470

Note: The balance sheet at December 31, 2003 has been derived from the audited financial statements at that date.

See notes to condensed consolidated financial statements.

DSP GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

(US dollars in thousands, except per share amounts)


	Three Months Ended September 30,				Nine Months Ended September 30,
	2004		2003		2004		2003
Product revenues and other	$	46,232	$	47,178	$	128,956	$	114,739
Cost of product revenues and other		23,401		25,643		66,177		63,626

Gross profit		22,831		21,535		62,779		51,113
Operating expenses:
Research and development		8,463		6,704		23,327		17,402
Sales and marketing		2,929		3,429		9,014		8,616
General and administrative		1,718		1,899		5,258		5,006
Impairment of goodwill		—		—		4,304		—
In-process research and development write-off		—		—		—		2,727

Total operating expenses		13,110		12,032		41,903		33,751

Operating income		9,721		9,503		20,876		17,362
Other income:
Interest and other income, net		2,069		2,112		6,353		5,945
Capital gains		15,460		—		44,448		241

Income before provision for income tax		27,250		11,615		71,677		23,548
Provision for income taxes		6,870		1,975		21,812		4,154

Net income	$	20,380	$	9,640	$	49,865	$	19,394

Net earnings per share:
Basic	$	0.72	$	0.34	$	1.73	$	0.70
Diluted	$	0.69	$	0.32	$	1.64	$	0.66

Weighted average number of shares used in per share computations of:
Basic		28,411		28,168		28,779		27,677
Diluted		29,358		30,142		30,337		29,343

See notes to condensed consolidated financial statements.

DSP GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(US dollars in thousands)


	Nine Months Ended September 30,
	2004			2003
Net cash provided by operating activities	$	26,078		$	23,753
Investing activities:
Purchase of held-to-maturity marketable securities and bank deposits		(102,183	)		(152,296	)
Proceeds from sales and maturity of held-to-maturity marketable securities and bank deposits		94,444			114,525
Purchases of property and equipment		(1,269	)		(1,818	)
Proceeds from sale of available-for-sale marketable securities		55,457			508
Cash received from discontinued operation		—			4,058
Payment for investment in Teleman Multimedia Inc. assets		(1,450	)		(2,100	)

Net cash provided by (used in) investing activities		44,999			(37,123	)

Financial activities:
Issuance of Common Stock and Treasury Stock for cash upon exercise of options and upon purchase of Common Stock under employee stock purchase plan		13,252			22,614
Purchase of Treasury Stock		(29,869	)		(13,847	)

Net cash provided by (used in) financing activities		(16,617	)		8,767
Increase (decrease) in cash and cash equivalents	$	54,460		$	(4,603	)
Cash and cash equivalents at beginning of period	$	36,812		$	39,919
Cash and cash equivalents at end of period	$	91,272		$	35,316

See notes to condensed consolidated financial statements.

DSP GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(UNAUDITED)

(US dollars in thousands)


Three Months Ended September 30, 2004	Number of Common Stock		Common Stock			Additional Paid-In Capital		Treasury Stock			Retained Earnings			Other Comprehensive Income (Loss)			Total Comprehensive Income			Total Stockholders’ Equity
Balance at June 30, 2004	29,399		$	29		$	186,359	$	—		$	136,716		$	9,981					$	333,085
Net income	—			—			—		—			20,380			—		$	20,380			20,380
Realized gain on available-for-sale marketable securities, net	—			—			—		—			—			(9,915	)		(9,915	)		(9,915	)
Realized gain from hedging activities, net	—			—			—		—			—			4			4			4

Total comprehensive income																	$	10,469
Issuance of common Stock upon purchase of ESPP shares	38			(	*		547		—			—			—						547
Purchase of Treasury Stock	(1,487	)		(1	)		—		(29,868	)		—			—						(29,869	)
Issuance of Treasury Stock upon exercise of stock options by employees	27			(	*		—		550			(128	)		—						422

Balance at September 30, 2004	27,977		$	28		$	186,906	$	(29,318	)	$	156,968		$	70					$	314,654


Three Months Ended September 30, 2003
Balance at June 30, 2003	27,476		$	27		$	161,513	$	(5,579	)	$	100,380		$	7,041					$	263,382
Net income	—			—			—		—			9,640					$	9,640			9,640
Unrealized gain on available-for-sale marketable securities, net	—			—			—		—			—			8,134			8,134			8,134
Realized gain from hedging activities, net	—			—			—		—			—			(377	)		(377	)		(377	)

Total comprehensive income																	$	17,397
Issuance of Treasury Stock upon purchase of ESPP shares	28			(	*		—		603			(256	)		—						347
Issuance of Common Stock upon exercise of stock options by employees	858			1			11,508		—			—			—						11,509
Purchase of Treasury Stock	(360	)		(	*		—		(7,871	)		—			—						(7,871	)
Issuance of Treasury Stock upon exercise of stock options by employees	591			1			—		12,847			(7,411	)		—						5,437

Balance at September 30, 2003	28,593		$	29		$	173,021	$	—		$	102,353		$	14,798					$	290,201

(*	Represents an amount lower than $1.

See notes to condensed consolidated financial statements.

DSP GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(UNAUDITED)

(US dollars in thousands)


Nine Months Ended September 30, 2004	Number of Common Stock		Common Stock			Additional Paid-In Capital		Treasury Stock			Retained Earnings			Other Comprehensive Income (Loss)			Total Comprehensive Income			Total Stockholders’ Equity
Balance at December 31, 2003	28,616		$	29		$	174,700	$	(1,192	)	$	107,799		$	23,045					$	304,381
Net income	—			—			—		—			49,865			—		$	49,865			49,865
Realized gain on available-for-sale marketable securities, net	—			—			—		—			—			(22,908	)		(22,908	)		(22,908	)
Realized gain from hedging activities, net	—			—			—		—			—			(67	)		(67	)		(67	)

Total comprehensive income																	$	26,890
Issuance of Common Stock upon exercise of stock options by employees	732			(	*		11,659		—			—			—						11,659
Issuance of Treasury Stock upon purchase of Common Stock under employee stock purchase plan	32			(	*		—		732			(326	)		—						406
Issuance of Common Stock upon purchase of Common Stock under ESPP	38			(	*		547		—			—			—						547
Purchase of Treasury Stock	(1,487	)		(1	)		—		(29,868	)		—			—						(29,869	)
Issuance of Treasury Stock upon exercise of stock options by employees	46			(	*		—		1,010			(370	)		—						640

Balance at September 30, 2004	27,977		$	28		$	186,906	$	(29,318	)	$	156,968		$	70					$	314,654


Nine Months Ended September 30, 2003
Balance at December 31, 2002	27,248		$	27		$	156,443	$	—		$	90,772		$	476					$	247,718
Net income	—			—			—		—			19,394			—		$	19,394			19,394
Unrealized gain on available-for-sale marketable securities, net	—			—			—		—			—			14,158			14,158			14,158
Unrealized gain from hedging activities, net	—			—			—		—						164			164			164

Total comprehensive income																	$	33,716
Issuance of Common Stock upon exercise of stock options by employees	1,322			1			16,280		—			—			—						16,281
Issuance of Treasury Stock upon purchase of Common Stock under ESPP	28			(	*		—		603			(256	)		—						347
Issuance of Common Stock upon purchase of Common Stock under ESPP	24			(	*		298		—			—			—						298
Purchase of Treasury Stock	(646	)		(	*		—		(13,847	)		—			—						(13,847	)
Issuance of Treasury Stock upon exercise of stock options by employees	617			1			—		13,244			(7,557	)		—						5,688

Balance at September 30, 2003	28,593		$	29		$	173,021	$	—		$	102,353		$	14,798					$	290,201

(*	Represents an amount lower than $1.

See notes to condensed consolidated financial statements.

DSP GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004

(UNAUDITED)

NOTE A—BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The accompanying unaudited condensed consolidated financial statements of DSP Group, Inc. (the “Company”) 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 of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and for the nine months ended September 30, 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 the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

Impairment of VoicePump goodwill

VoicePump, Inc. (“VoicePump”), a wholly owned subsidiary of the Company, is a U.S. corporation primarily engaged in the design, research and development and marketing of software applications for Voice over Digital Subscriber Line (VoDSL) and Voice over Internet Protocol (VoIP).

The Company’s investment in VoicePump included the excess of its purchase price over the net assets acquired which was attributed to goodwill. Under Statement of Financial Accounting Standard (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”) goodwill acquired in a business combination shall not be amortized. As a result, the Company ceased amortization of the goodwill related to the acquisition of VoicePump after December 31, 2001. The book value of the goodwill was approximately $ 5.8 million as of that date.

The Company assesses the carrying value of goodwill in accordance with SFAS No. 142, under which goodwill acquired in a business combination for which the date is on or after July 1, 2001, should not be amortized, but tested for impairment at least annually or between annual tests in certain circumstances, and written down when impaired. Goodwill attributable to the Company’s reporting unit as defined under SFAS No. 142 was tested for impairment by comparing its fair value with its carrying value.

During the second quarter of 2004, the Company decided to stop developing products targeted at the VoIP gateway market and to focus its efforts on VoIP telephony products. The first step of the goodwill impairment test included the determination of the fair value of VoicePump using the income approach based on the discounted cash flow model. This evaluation indicated that the carrying amount of VoicePump exceeded its fair value. In accordance with SFAS No. 142, if the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test shall be performed to measure the amount of the impairment loss. During the second step of the evaluation, the Company allocated the fair value of VoicePump to all of its assets and liabilities (including unrecognized intangible assets) as if VoicePump had been acquired in a business combination. The excess of the fair value of VoicePump over the amounts assigned to its assets and liabilities is the implied fair value of goodwill and was estimated to be approximately $1.5 million. As a result, the Company recorded a charge associated with the impairment of goodwill of VoicePump in the amount of $4.3 million in the second quarter of 2004. The expense is included in the Company’s operating expenses for the nine month ended September 30, 2004 under “Impairment of goodwill”.

NOTE B—INVENTORIES

Inventories are stated at the lower of cost or market value. Cost is determined using the average cost method. The Company periodically evaluates the quantities on hand relative to current and historical selling prices and historical and projected sales volume. Based on these evaluations, provisions are made in each period to write inventory down to its net realizable value. Inventories are composed of the following (in thousands):


	September 30, 2004		December 31, 2003
	(Unaudited)		(Audited)
Work-in-process	$	3,250	$	2,593
Finished goods		5,299		5,873

	$	8,549	$	8,466

NOTE C—NET EARNINGS PER SHARE

Basic net earnings per share are computed based on the weighted average number of shares of Common Stock outstanding during the period. For the same periods, diluted net earnings per share further include the effect of dilutive stock options outstanding during the period, all in accordance with SFAS No. 128, “Earnings per Share.” The following table sets forth the computation of basic and diluted net earnings per share (in thousands, except per share amounts):


	Three months ended September 30,				Nine months ended September 30,
	2004		2003		2004		2003
	Unaudited
Net income	$	20,380	$	9,640	$	49,865	$	19,394
Earnings per share:
Basic	$	0.72	$	0.34	$	1.73	$	0.70
Diluted	$	0.69	$	0.32	$	1.64	$	0.66

Weighted average number of shares of Common Stock outstanding during the period used to compute basic net earnings per share		28,411		28,168		28,779		27,677
Incremental shares attributable to exercise of outstanding options (assuming proceeds would be used to purchase Treasury Stock)		947		1,974		1,558		1,666

Weighted average number of shares of Common Stock used to compute diluted net earnings per share		29,358		30,142		30,337		29,343

NOTE D—INVESTMENTS IN MARKETABLE SECURITIES AND BANK DEPOSITS

The following is a summary of the held-to-maturity marketable securities and bank deposits (in thousands):


	Amortized Cost				Unrealized Gains (Loss)						Estimated Fair Value
	September 30, 2004		December 31, 2003		September 30, 2004			December 31, 2003			September 30, 2004		December 31, 2003
Obligations of states and political subdivisions	$	127,271	$	99,244	$	(773	)	$	(259	)	$	126,498	$	98,985
Corporate obligations		118,521		140,317		348			2,012			118,869		142,329

	$	245,792	$	239,561	$	(425	)	$	1,753		$	245,367	$	241,314

The amortized cost of held-to-maturity marketable securities and bank deposits at September 30, 2004 by contractual maturities are shown below (in thousands):


	Amortized Cost		Estimated Fair Value
Due in one year or less	$	52,252	$	52,716
Due after one year		193,540		192,651

	$	245,792	$	245,367

NOTE E—INCOME TAXES

The effective tax rate used in computing the provision for income taxes is based on projected fiscal year income before taxes, including estimated income by tax jurisdiction. The difference between the effective tax rate and the statutory rate is due primarily to foreign tax holiday and tax-exempt income in Israel. Tax provision for the nine months ended September 30, 2004 included the provision for taxes associated with the sale of the AudioCodes stock at a rate of 37% of the capital gain. Tax provision as a percentage of pre-tax income other than the capital gains associated with the sale of the AudioCodes stock and the Tomen Stock was 17% for the three and the nine months ended September 30, 2004.

NOTE F—SIGNIFICANT CUSTOMERS

The Company sells its products to customers primarily through a network of distributors and representatives. Revenues derived from sales through one distributor, Tomen Electronics Corporation (“Tomen Electronics”), accounted for 75% and 78% of the Company’s total revenues for the three months ended September 30, 2004 and 2003, respectively. Additionally, Tomen Electronics accounted for 78% and 79% of the Company’s total revenues for the nine months ended September 30, 2004 and 2003, respectively. The Japanese market and the original equipment manufacturers (OEMs) that operate in that market are among the largest suppliers in the world with significant market share in the U.S. market for residential wireless products. Tomen Electronics sells the Company’s products to a limited number of customers. One customer, Panasonic Communications Co., Ltd. (“Panasonic”), has continually accounted for a majority of the sales of Tomen Electronics. The loss of Tomen Electronics as a distributor and the Company’s inability to obtain a satisfactory replacement in a timely manner would harm its sales and results of operations. Additionally, the loss of Panasonic or Tomen Electronics’ inability to thereafter effectively market the Company’s products would also harm the Company’s sales and results of operations.

NOTE G—INVESTMENTS IN EQUITY SECURITIES OF TRADED COMPANIES

The following is a summary of investments in equity securities of traded companies as of September 30, 2004 and December 31, 2003 (in thousands):


	Cost				Unrealized gains				Estimated fair value
	September 30, 2004		December 31, 2003		September 30, 2004		December 31, 2003		September 30, 2004		December 31, 2003
AudioCodes, Ltd. (1)	$	—	$	10,726	$	—	$	35,739	$	—	$	46,465
Tomen Corporation (2)		—		281		—		392		—		673

	$	—	$	11,007	$	—	$	36,131	$	—	$	47,138

(1)

AudioCodes, Ltd.: AudioCodes, Ltd. (“AudioCodes”) is an Israeli corporation primarily engaged in the design, research and development of hardware and software products that enable simultaneous transmission of voice and data over networks.

During the first quarter of 2004, the Company sold 2,000,000 shares of AudioCodes’ ordinary shares for gross proceeds of approximately $25,647,000, resulting in a capital gain of approximately $20,827,000.

During the second quarter of 2004, the Company sold 801,000 shares of AudioCodes’ ordinary shares for gross proceeds of approximately $9,600,000, resulting in a capital gain of approximately $7,670,000.

During the third quarter of 2004, the Company sold the remaining 1,650,000 shares of AudioCodes’ ordinary shares for gross proceeds of approximately $19,436,000, resulting in a capital gain of approximately $15,460,000.

The consolidated balance sheet as of December 31, 2003 included an unrealized gain on available-for-sale marketable securities of $ 22,516, net of unrealized tax expenses of $ 15,232, in the investment in AudioCodes.

(2) Tomen Corporation: In September 2000, the Company invested approximately $485,000 (50.0 million Yen) in shares of its Japanese distributor’s parent company, Tomen Ltd. (“Tomen”), as part of a long strategic relationship. Tomen’s shares are traded on the Japanese stock exchange. The Company accounted for its investment in Tomen in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” as available-for-sale marketable securities. During the first quarter of 2004, the Company sold all of its holdings in Tomen for gross proceeds of approximately $773,000, resulting in a capital gain of approximately $490,000.

NOTE H—DERIVATIVE INSTRUMENTS

SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”), requires companies to recognize all of its derivative instruments as either assets or liabilities in the statement of financial position at fair value. For derivative instruments that are designated and qualify as a cash flow hedge (i.e., hedging the exposure to variability in expected future cash flows that is attributable to a particular risk), the effective portion of the gain or loss on the derivative

instrument is reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Any gain or loss on a derivative instrument in excess of the cumulative change in the present value of future cash flows of the hedged item is recognized in current earnings during the period of change.

To protect against the increase in value of forecasted foreign currency cash flow resulting from salary and rent payments in New Israeli Shekels (“NIS”) during the year, the Company has instituted a foreign currency cash flow hedging program. The Company hedges portions of the anticipated payroll and lease payments of its Israeli facilities denominated in NIS for a period of one to twelve months with put options and forward contracts. These forward contracts and put options are designated as cash flow hedges, as defined by SFAS No. 133, and are all effective as hedges of these expenses.

As of September 30, 2004 the Company recorded comprehensive income in the amount of $70,000 from its put options and forward contracts in respect to anticipated payroll and rent payments expected in 2004 and 2005. Such amounts will be recorded into earnings in the fourth quarter of 2004 and in the first quarter of 2005.

NOTE I—CONTINGENCIES

The Company is involved in certain claims arising in the normal course of business. However, the Company believes that the ultimate resolution of these matters will not have a material adverse effect on its financial position, results of operations or cash flows.

NOTE J—SHARE REPURCHASE

During the third quarter of 2004, the Company repurchased 1,487,000 shares of Common Stock at an average purchase price of $20.10 per share, for a total consideration of $29,869,000. See Note M(3) for additional information.

NOTE K—ACCOUNTING FOR STOCK-BASED COMPENSATION

The Company accounts for stock-based compensation in accordance with the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”) and Financial Accounting Standards Board Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation” (“FIN No. 44”). Under APB No. 25, when the exercise price of an employee’s options equals or is higher than the market price of the underlying Common Stock on the date of grant, no compensation expense is recognized. Under Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”), pro-forma information regarding net income and income per share is required, and has been determined as if the Company had accounted for its employee stock options under the fair value method of SFAS No. 123.

The fair value of these options is amortized over their vesting period and estimated at the date of grant using a Black-Scholes multiple option pricing model with the following weighted average assumptions for the three and the nine months periods ended September 30, 2004 and 2003:


	Three months ended September 30,				Nine months ended September 30,
	2004		2003		2004		2003
	Unaudited
Risk free interest	3.5	%	1	%	3.5	%	1	%
Dividend yields	0	%	0	%	0	%	0	%
Volatility	0.39		0.47		0.39		0.47
Expected life	2.9		2.9		2.9		2.9

The following table illustrates the effect on net income and earnings per share, assuming that the Company had applied the fair value recognition provision of SFAS No. 123 on its stock-based employee compensation (in thousands, except per share amounts):


	Three months ended September 30,				Nine months ended September 30,
	2004		2003		2004		2003
	Unaudited
Net income as reported	$	20,380	$	9,640	$	49,865	$	19,394

Less - stock-based compensation expense determined under fair value method for all awards, net of related tax effects:	$	2,922	$	2,205	$	8,792	$	6,422

Pro forma net income	$	17,688	$	7,435	$	41,073	$	12,972

Basic earnings per share, as reported	$	0.72	$	0.34	$	1.73	$	0.70

Pro forma basic earnings per share	$	0.61	$	0.26	$	1.43	$	0.47

Diluted earnings per share, as reported	$	0.69	$	0.32	$	1.64	$	0.66

Pro forma diluted earnings per share	$	0.59	$	0.25	$	1.35	$	0.44

NOTE L—NEW ACCOUNTING PRONOUNCEMENTS

In March 2004, the Financial Accounting Standards Board approved the consensus reached on the Emerging Issues Task Force (EITF) Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-1”). The objective of this Issue is to provide guidance for identifying impaired investments. EITF 03-1 also provides new disclosure requirements for investments that are deemed to be temporarily impaired.

The accounting provisions of EITF 03-1 are effective for all reporting periods beginning after June 15, 2004, while the disclosure requirements are effective only for annual periods ending after June 15, 2004. The Company has evaluated the impact of the adoption of EITF 03-1 and does not believe the impact will be significant to the Company’s overall results of operations or financial position.

NOTE M— SUBSEQUENT EVENTS

During October 2004, the Company entered into an asset purchase agreement pursuant to the terms of which the Company acquired substantially all of the assets of Bermai Inc, a US corporation (“Bermai”), for a total consideration of $5,000,000 plus transaction costs. Bermai developed an advanced Wi-Fi technology based on the 802.11 protocol that is optimized for quality of service for video streaming applications. The assets purchased by the Company consisted of property and equipment, and other assets (including intangible assets such as intellectual property and contractual rights) used by Bermai in the conduct of its business.

The consideration in the amount of $5,000,000 was paid in cash during October 2004.

In October 2004, the Board Of Directors of the Company authorized management to repurchase an additional 2,500,000 shares of the Company’s common stock in open-market and in privately negotiated transactions. Approximately 1,300,000 shares remain available for repurchase from the Board’s previous repurchase authorizations. Accordingly, the total number of shares currently authorized for repurchase is approximately 3,800,000.

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

We have included the following overview to provide you with some perspective about the information contained in this section, as well as a better understanding of the key drivers and concerns of our business. The overview summarizes how we generate revenue and what are some of our significant expenses, as well as review the status of our business in the context of industry-wide trends and explain our management’s views on the implication and significance of these trends.

OVERVIEW

DSP Group is a fabless semiconductor company that is a leader in providing chip-sets to telephone equipment manufacturers that incorporate our chip-sets into consumer products for the residential wireless telecommunication market. Our chip-sets incorporate advanced technologies, such as DSP processors, communications technologies, highly advanced radio frequency (RF) devices and in-house developed Voice-over-Internet-Protocol (VoIP) hardware and software technologies. Our products include 900MHz, 1.9GHz (Digital Enhanced Cordless Telecommunications (DECT)), 2.4GHz and 5.8GHz chip-sets for cordless telephones, Bluetooth for voice, data and video communication, and solutions for digital voice recorders (DVRs) and VoIP applications and other voice-over-packet applications. Our current primary focus is cordless telephony as our 2.4GHz and 5.8GHz chip-sets represented approximately 87% of our total revenues for both the third quarter and the first nine months of 2004.

During recent years we have become a worldwide leader in developing and marketing Total Telephony Solutions ^™ for a wide range of applications for wireless residential markets. The key factor that enabled us to grow our business, improve our profitability and increase our market share over the previous years is our ability to combine and integrate our expertise in DSP cores technology with proprietary advanced RF devices, communications technologies and speech-processing algorithms. We believe we were able to penetrate the residential wireless telephony market and increase our market share and customer base by taking advantage of three trends in the market: (1) the move from wired to wireless products, (2) the transformation from analog-based to digital-based technologies for telephony products, and (3) the shift in bandwidth from 900MHz to 2.4GHz technologies, as well as the recent shift from 2.4GHz to 5.8GHz technologies. Our focus on the convergence of these three trends has allowed us to offer products with more features, and better range, security and voice quality. One additional factor that contributed significantly to our revenue growth over the past few years is the market acceptance of our pioneer multi-hand-set solutions for cordless telephony.

To keep pace with the market trends for our products and services, including the rapidly changing nature of the technology, short product life cycles and evolving industry standards, we are continually investing in research and development. Products that we are developing in 2004 include a DECT (1.9GHz) hip-set for the European market, a new chip-set that includes video capabilities for the European and U.S. markets and a new Bluetooth chip-set. Our planned future lines of products are intended to integrate video, voice and data, as well as other communications technologies such as VoIP and Wi-Fi, and thereby enable us to strengthen our position as a leading supplier of multimedia communications products.

Recently we announced that we are working on an IP cordless phone project that is anticipated to enable connectivity to a broadband line feeding VoIP with cordless phone capabilities. In addition, we have started the development of a new feature that is anticipated to enable connectivity of cellular phones to residential fixed-line phones. We also recently reached a significant and strategic milestone for the company by introducing our first DECT standard - 1.9GHz chip-sets for the European market—and by delivering our first shipment of initial quantities of these chip-sets to a key customer.

During October 2004, we entered into an asset purchase agreement pursuant to the terms of which we acquired substantially all of the assets of Bermai Inc, a U.S. corporation, for a total consideration of $5,000,000 plus transaction costs. Bermai developed an advanced Wi-Fi technology based on the 802.11 protocol that is optimized for quality of service for video streaming applications. The assets purchased from Bermai consisted of property and equipment, and other assets, mainly, intangible assets such as intellectual property. We plan to leverage this technology to further develop and offer new communications products. We believe the current investment in Wi-Fi technology may allow us in the future to develop products that will improve the quality of video wireless communication in the residence, and may increase our market share in IP phones that combine the Wi-Fi communication channel in the same system that connects to a broadband connection feeding VoIP. To optimize the benefits of the Bermai acquisition, we will need to increase our operating expenses, mainly

in research and development, in the fourth quarter of 2004 and future periods. We currently anticipate that we will hire approximately 30 to 40 employees for research and development projects relating to the technology acquired from Bermai.

Despite our historical growth, our business operates in a highly competitive environment, characterized by changing standards and rapid introduction of new products. Competition has historically increased pricing pressures for our products and decreased our average selling prices. In order to penetrate new markets and maintain our market share with our traditional products we may need to offer our products in the future at lower prices than we currently anticipate, which may result in lower profits. In addition, as we are a fabless company, global market trends such as “over-capacity” problems in fabrication facilities may increase our raw material costs and thus decrease our gross margins. We must continue to monitor and control costs, improve operating yields and maintain our current level of gross margin in order to offset future declines in average selling prices. In addition, our future growth is also dependent on the continued market deployment and acceptance of our existing 2.4 GHz and 5.8GHz digital products. Also, since our products are incorporated into end products of our OEM customers, our business is very dependent on their ability to achieve market acceptance of their end products in consumer electronic markets, which are similarly very competitive.

As an example, the second half of 2004 can be characterized as a challenging environment for the consumer electronics industry. The overall picture shows that this industry may be encountering demand and inventory issues across different product lines which have adversely impacted, and may continue to adversely impact, our business. Over the course of the last few months, we have obtained updates from our distributors regarding the apparent slowdown in demand and build-up of inventory in the consumer electronics industry. As a result, our distributors have decreased their projected revenue figures for our chip-sets due to weaker demand for the second half of 2004. This reduction in projected revenue from our distributors is anticipated to reduce both our revenues and profitability in the fourth quarter of 2004.

There are also several emerging market trends that challenge our ability to continue to grow our business. We believe that new developments in the home residential market may adversely affect our operating results. For example, the rapid deployment of new communication access methods, including mobile, broadband, cable and VoIP connections, as well as the projected lack of growth in products using fixed-line telephony, meaning communication through phones connected to telephone lines, would reduce our revenues derived from, and unit sales of, cordless telephony products, which is currently our primary focus. Our ability to maintain our growth will depend on the expansion of our product lines to capitalize on the emerging communication access methods and on our success in developing and selling a portfolio of “system-on-a-chip” solutions that integrate video, voice, data and communication technologies in a wider multimedia market. Our business may also be affected by the outcome of the current competition between cell phone operators and fixed line operators for the provision of residential communication. Our revenues are currently primarily generated from sales of chip-sets used in cordless phones that are based on fixed-line telephony. As a result, a decline in the use of fixed-line telephony for residential communication would adversely affect our financial condition and operating results. In view of the current market trends, our currently planned future products are anticipated to enable connectivity of cellular phones to fixed-line phones and also will include VoIP capabilities. We currently plan to begin shipment of such products during 2005. However, we cannot provide any assurances about if and when these future features and products we develop will achieve market acceptance.

Moreover, in order to increase our sales volume and expand our business, we recognize that we will need to penetrate new markets. Thus, we have started to penetrate the European market. In 2003, we achieved the first two design wins for our new DECT products targeted for the European market and recently began to deliver initial shipments of DECT products to a key customer. However, revenues anticipated to be generated from DECT products and sales to new markets will be insignificant for the remainder of 2004. In order to develop new products and penetrate new markets, we will need to increase our operating expenses, mainly in research and development and applications engineering, for the remainder of 2004 and future periods. However, we cannot provide any assurances that we will successfully develop new products and services targeted at the new markets or that these products and services will achieve sufficient market acceptance to generate meaningful revenues for us.

We believe that our DECT products will drive our growth in 2005 and 2006, and products for home communication, including Wi-Fi products, in 2006 and beyond. However, our ability to expand into new markets may not occur and may require us to substantially increase our operating expenses. As a result, you should not rely upon our past operating results as an indication of future performance.

RESULTS OF OPERATIONS

During the third quarter of 2004, we had year-over-year revenue decrease of 2%. Our net income reached a level of 44% of revenues. Our gross profit increased by 6% as compared to the third quarter of 2003. Our operating expenses for the third quarter of 2004, which amounted to $13.1 million, increased 9% from the same period in 2003. The increase was mainly a result of a significant increase in research and development expenses, primary attributed to the hiring of new employees. Total number of employees increased from 199 as of September 30, 2003 to 249 as of September 30, 2004.

Total Revenues. Our total revenues were $46.2 million for the third quarter of 2004, as compared to $47.2 million for the third quarter of 2003. This 2% decrease was primary due to a lower demand for our 2.4GHz single hand-set chip-sets, offset by an increase in sales of our 2.4GHz multi-handsets and 5.8GHz products. 2.4 GHz single hand-set sales decreased by 88% while sales of 2.4GHz multi-hand-set and 5.8GHZ products increased by 83% during the same period. As is typical in the semiconductor consumer industry, we experienced pricing pressures for our current products and, as a result, a decline in average selling prices. However, the impact of the decline in average selling prices was substantially offset by an increase in the number of products sold for the same period. We cannot provide any assurances, however, that we will be able to offset future declines in average selling prices with an offsetting increase in the number of products sold. Total revenues for the first nine months of 2004 increased to $128.9 million from $114.7 million for the same period in 2003. This increase of 12% in the first nine months of 2004 was primarily as a result of higher demand from both existing and new original equipment manufacturer (OEM) customers, especially in Asia Pacific and Japan, for our 5.8GHz and 2.4GHz multi-hand-set products. Our revenues in Asia Pacific increased by 17% and 25% during the third quarter and the first nine months of 2004, respectively, in comparison to the same periods in 2003. Revenues from 5.8GHz products represented 17% of our total revenues in the third quarter 2004 as compared to 7% of total revenues in the third quarter of 2003, which represented an increase of 259% in sales of 5.8GHZ products.

Based on updates provided to us by our distributors, we believe the second half of 2004, including the third quarter, can be characterized as a challenging environment for the consumer electronics industry. The overall picture shows that this industry is encountering demand and inventory issues across different product lines which have adversely impacted our business. According to our distributors, there is an apparent slowdown in demand and build-up of inventory in the consumer electronics industry. As a result, during the recent months, our distributors have decreased their projected revenue figures for our chip-sets due to weaker demand for the fourth quarter of 2004. This reduction in projected revenue from our distributors is anticipated to reduce both our revenues and profitability for the fourth quarter of 2004.

We also generate revenues from the licensing of our TrueSpeech algorithms and from other software development and related service agreements. However, license fees and per unit royalties from TrueSpeech licensees and revenues from other software development and related service agreements have not been significant to date, and we do not expect them to increase significantly in the future.

Export sales represented approximately 99% of our total revenues in both the third quarter of 2004 and 2003 as well as in the first nine months of 2004 and 2003. All export sales are denominated in U.S. dollars. The following table includes the breakdown of revenues for the periods indicated by geographic location (in thousands):


	Three months ended September 30,				Nine months ended September 30,
	2004		2003		2004		2003
United States	$	525	$	415	$	1,018	$	994
Japan		34,581		36,927		100,936		91,099
Europe		344		612		1,850		2,577
Asia Pacific (excluding Japan)		10,782		9,224		25,152		20,069

Total revenues	$	46,232	$	47,178	$	128,956	$	114,739

As our products are generally incorporated into consumer products sold by our OEM customers, our revenues are affected by seasonal buying patterns of consumer products sold by our OEM customers that incorporate our products. The fourth quarter in any given year is usually the strongest quarter of sales for our OEM customers and, as a result, the third quarter in any given year is usually the strongest quarter for our revenues as our OEM customers request increased shipments of our products in anticipation of the fourth quarter holiday season. This trend can be generally observed from reviewing our quarterly information and results of operations. However, the consumer electronics industry is encountering various challenges in the second half of 2004, including lower demand and build-up of inventory. These trends have adversely impacted our third quarter 2004 financial results.

Significant Customers and Products. Revenues through one distributor, Tomen Electronics Corporation, accounted for 75% and 78% of our total revenues for the three months ended September 30, 2004 and 2003, respectively. Additionally, Tomen Electronics accounted for 78% and 79% of our total revenues for the nine months ended September 30, 2004 and 2003, respectively.

The Japanese market and the OEMs that operate in that market are among the largest suppliers for residential wireless products in the world with significant market share in the U.S. market. Tomen Electronics sells our products to a limited number of customers. One customer, Panasonic Communications Co., Ltd., has continually accounted for a majority of the sales to Tomen Electronics. The loss of Tomen Electronics as a distributor and our inability to obtain a satisfactory replacement in a timely manner would harm our sales and results of operations. Additionally, the loss of Panasonic or Tomen Electronics’ inability to thereafter effectively market our products would also harm our sales and results of operations.

Revenues from our 2.4GHz and 5.8GHz digital products represented 87% of our total revenues for the three and the nine months ended September 30, 2004. We believe that sales of these product lines will continue to represent a substantial percentage of our revenues in the remainder of 2004 and in future years as we are seeing a continuing decline in sales for some of our older products, including the 900 MHz products. In addition, we witnessed an increase in sales of multi-hand-set products, in comparison to a decrease in single-hand-set sales. For the long-term, we believe that the rapid deployment of new communication access methods, as well as the projected lack of growth in fixed-line telephony, will reduce our total revenues derived from, and unit sales of, cordless telephony products, including future sales of our 2.4GHz and 5.8GHz products. We believe that in order to maintain our growth, we will need to expand our product lines and develop a portfolio of “system-on-a-chip” solutions that will integrate video, voice, and data, as well as communications technologies in a broader multimedia market.

Gross Profit. Gross profit as a percentage of total revenues increased to 49% for the third quarter of 2004 from 46% for the third quarter of 2003. Gross profits as a percentage of total revenues increased to 49% for the nine months ended September 30, 2004 from 45% for the same period in 2003. The increase in gross profit mainly was due to our ability to offset the continued decline in the average selling prices of our products with a greater reduction in manufacturing costs and lower other expenses related to cost of goods sold. The reduction in material and manufacturing costs represented approximately 80% of the overall reduction in the average cost per chip while a combination of other factors, such as continuing improvements in our yield percentages, represented approximately 20% of the overall reduction in the average cost per chip.

However, we cannot guarantee that our ongoing efforts in cost reduction will be successful or that they will keep pace with the anticipated continued decline in average selling prices of our processors. Our gross profit of 49% for the third quarter of 2004 was particularly high due to a combination of factors during the period as described above. We do not believe that the 49% gross profit figure is sustainable over the long term. Our gross profit may decrease in the future due to a variety of factors, including the continued decline in the average selling prices of our products, our failure to achieve the corresponding cost reductions, roll-out of new products in any given period and our failure to introduce new engineering processes. Also, future increases in the pricing of silicon wafers or in other production costs may affect our ability to implement cost reductions. As we are a fabless company, global market trends such as “over-capacity” problems in fabrication facilities may also increase our raw material costs and thus decrease our gross profit.

As gross profit reflects the sale of chips and chip-sets that have different margins, changes in the mix of products sold have impacted and will impact our gross profit in future periods. Moreover, penetration of new competitive markets, such as the European DECT market or move to new platforms or production processes for existing products, could require us to reduce sale prices or increase the cost per product and thus harm our total gross profit in future periods. As a result, you should not rely on our past gross profit figures as an indication of future results.

Research and Development Expenses. Our research and development expenses increased to $8.5 million for the third quarter of 2004 from $6.7 million for the third quarter of 2003. For the first nine months of 2004, research and development expenses increased to $23.3 million from $17.4 million for the same period in 2003. The increase in 2004 was primarily attributed to increased salary expenses, mainly due to a greater number of research and development employees, as well as increased subcontracting, consulting and tape-out expenses. As of September 30, 2004, we had 167 research and development employees, as compared to 123 as of September 30, 2003. The increase in the nine months period of 2004 as compared to the same period in 2003 was also attributed to expenses incurred by our Korean subsidiary, established in connection with the Teleman acquisition, which began its operations during June 2003. Research and

development expenses for the third quarter and for the first nine months of 2004 also included expenses in the amount of $150,000 and $460,000, respectively, related to the amortization of workforce and patents acquired from Teleman in May 2003. Our research and development expenses as a percentage of total revenues were 18% and 14% for the three months ended September 30, 2004 and 2003, respectively, and 18% and 15% for the nine months ended September 30, 2004 and 2003, respectively. This increase in research and development expenses as a percentage of total revenues in both comparable periods was due to the increase in absolute dollars of the research and development expenses. The increase in research and development expenses as a percentage of total revenues in the third quarter of 2004 as compared to the same period in 2003 was also a result of the decrease in revenues during the third quarter of 2004.

As our research and development staff is currently working on various projects simultaneously, we anticipate that we will need to hire additional research and development staff for the development of new products for the European DECT market. In addition, we have announced that we anticipate hiring approximately 30 to 40 employees in order to develop our future Wi-Fi technologies. As a result, our research and development expenses in absolute dollars and as a percentage of total revenues will increase in the fourth quarter of 2004 and future periods.

Research and development expenses consist mainly of payroll expenses to employees involved in research and development activities, expenses related to tape-out and mask work, subcontracting and engineering expenses, depreciation and maintenance fees related to equipment and software tools used in research and development and facilities expenses associated with research and development.

Sales and Marketing Expenses. Our sales and marketing expenses decreased to $2.9 million in the third quarter of 2004 from $3.4 million in the third quarter of 2003. The decrease in sales and marketing expenses was mainly due to lower commissions paid to our distributors and representatives due to lower revenues and due to lower rate of commission paid in 2004. This was partly offset by higher levels of salary expenses, mainly due to a greater number of application support employees as well as to higher travel and related expenses during the third quarter of 2004. For the nine months ended September 30, 2004, sales and marketing expenses were $9.0 million as compared to $8.6 million for the same period in 2003. The increase was primarily attributed to higher levels of salary, travel and related expenses. Our sales and marketing expenses as a percentage of total revenues were 6% and 7% for the three months ended September 30, 2004 and 2003, respectively, and 7% and 8% for the nine months ended September 30, 2004 and 2003, respectively.

Sales and marketing expenses consist mainly of sales commissions to our representatives and distributors, payroll expenses to direct sales and marketing employees, trade show expenses and facilities expenses associated with sales and marketing.

General and Administrative Expenses. Our general and administrative expenses were $1.7 million for the three months ended September 30, 2004, as compared to $1.9 million for the three months ended September 30, 2003. The decrease in general and administrative expenses in the third quarter of 2004 was mainly due to decrease in salary expenses of our Israeli subsidiary due to a change in the benefits payment percentage paid by employers under Israeli laws. For the first nine months of 2004, general and administrative expenses were $5.3 million compared to $5.0 million for the same period in 2003. The increase was attributed mainly to higher payroll and related expenses offset by the decrease in salary expenses of our Israeli subsidiary, as explained above . General and administrative expenses as a percentage of total revenues were 4% for the three and the nine months ended September 30, 2004 and 2003.

General and administrative expenses consist mainly of payroll for management and administrative employees, expenses related to investor relations, accounting and legal fees, as well as facilities expenses associated with general and administrative activities.

Impairment of goodwill. During the second quarter of 2004, we recorded an expense of $4.3 million resulting from the impairment of goodwill related to VoicePump, Inc. our wholly owned subsidiary that sells to the VoIP gateway market. As a result of our decision to stop developing products targeted at this market and to focus our efforts on VoIP telephony products, we wrote down the value of goodwill associated with the VoicePump acquisition from its historical book value of $5.8 million to the estimated fair value of $1.5 million.

In-Process Research and Development Write-off. During the second quarter of 2003, we recorded a one-time expense item in the amount of approximately $2.7 million related to the write–off of in-process research and development associated with the Teleman acquisition. This amount represented research and development expenses related to technologies that did not reach technological feasibility and for which there was no future alternative use, as determined on the acquisition date.

Interest and Other Income. Interest and other income, net, was $2.1 million for both for the three months ended September 30, 2004 and 2003. Interest and other income, net, increased to $6.4 million for the nine months ended September 30, 2004 from $5.9 million for the nine months ended September 30, 2003. The increase was primarily due to higher levels of cash, cash equivalents and held-to-maturity marketable securities.

Capital gains from sale of available-for-sale marketable securities. During the first quarter of 2004, we sold 2,000,000 shares of AudioCodes’ ordinary shares for gross proceeds of approximately $25.6 million, resulting in a capital gain of approximately $20.8 million. During the second quarter of 2004, we sold an additional 801,000 shares of AudioCodes’ ordinary shares for gross proceeds of approximately $9.6 million, resulting in a capital gain of approximately $7.7 million. During the third quarter of 2004, we sold the remaining 1,650,000 shares of AudioCodes’ ordinary shares for gross proceeds of approximately $19.4 million, resulting in a capital gain of approximately $15.5 million.

During the first quarter of 2004, we sold all of our holdings in Tomen Corporation for gross proceeds of approximately $0.7 million, resulting in a capital gain of approximately $0.5 million.

In May 2003, we sold our remaining holdings in Tower Semiconductor for $508,000 and recorded a capital gain of $0.2 million.

Provision for Income Taxes. Our tax provision for the third quarter of 2004 and for the first nine months of 2004 was $6.9 million and $21.8 million, respectively. Our tax provision for the third quarter of 2003 and for the first nine months of 2003 was $2.0 million and $4.2 million, respectively. Tax provision for both the third quarter and the first nine months of 2004 included the provision for taxes associated with the sale of the AudioCodes’ stock at an annual rate of 37% of the capital gain. Tax provision as a percentage of pre-tax income for other than capital gains associated with the sale of the AudioCodes stock and Tomen stock was 17% for both the three and the nine months ended September 30, 2004.

In 2004 and 2003 we benefited for tax purposes from foreign tax holiday and tax-exempt income in Israel. DSP Group Ltd., our Israeli subsidiary, was granted “Approved Enterprise” status by the Israeli government with respect to six separate investment plans. Approved Enterprise status allows our Israeli subsidiary to enjoy a tax holiday for a period of two to four years and a reduced corporate tax rate of 10%-25% for an additional six or eight years, on each investment plan’s proportionate share of taxable income. The tax benefits under these investment plans are scheduled to expire starting 2005 through to 2017.

LIQUIDITY AND CAPITAL RESOURCES

Operating Activities. We generated $26.1 million and $23.8 million of cash and cash equivalents from our operating activities during the first nine months of 2004 and 2003, respectively. The increase in net cash provided by operating activities in the first nine months of 2004 as compared to the same period in 2003 resulted mainly from higher net income for 2004 as well as from the increase in accounts receivables in 2003 in the amount of $13.3 million as compared to an increase of $0.3 million in the same period in 2004. This was offset by an increase of $2.9 million and $3.5 million in accrued compensation and benefits and in accrued expenses and other accounts payables, respectively, during the first nine months of 2003.

Investing Activities. We invest excess cash in marketable securities of varying maturity, depending on our projected cash needs for operations, capital expenditures and other business purposes. During the first nine months of 2004, we purchased $102.2 million of investments classified as held-to-maturity marketable securities, as compared to $152.3 million during the first nine months of 2003. During the same periods, $94.4 million and $114.5 million, respectively, of investments classified as held-to-maturity marketable securities matured and were sold.

Our capital equipment purchases for the first nine months of 2004, consisting primarily of research and development software and computers, totaled $1.3 million, as compared to $1.8 million for the first nine months of 2003.

Cash proceeds from the sale of available-for-sale marketable securities, consisting of the AudioCodes and Tomen stock, amounted to $55.5 million during the first nine months of 2004. Proceeds from sales of the Tower Semiconductor stock during the nine months periods ended September 30, 2003 were $0.5 million.

As part of our acquisition of Teleman’s assets for an aggregate consideration of $5.25 million in cash, including transaction costs of approximately $0.25 million, we paid $1.45 million and $2.1 million during the periods ended September 30, 2004 and September 30, 2003, respectively. We are obligated to make one additional payment of $1.45 million on May 16, 2005.

During the nine months ended September 30, 2003, we collected approximately $4.1 million from customers of the DSP cores licensing business that was transferred to Ceva, our then wholly-owned subsidiary which subsequently combined with Parthus Technology plc to form ParthusCeva, Inc., in November 2002. This amount was included under cash received from discontinued operations in our condensed consolidated statements of cash flows.

Financing Activities. During the nine months ended September 30, 2004, we received $13.3 million upon the exercise of employee stock options and through purchases made by our employees pursuant to our employee stock purchase plan, as compared to $22.6 million during the nine months ended September 30, 2003.

During the nine months ended September 30, 2004, as authorized by our share repurchase program, we repurchased approximately 1,487,000 shares of our common stock, at an average purchase price of $20.10 per share, for a total aggregate amount of approximately $29.9 million. During the nine months ended September 30, 2003, as authorized by our share repurchase program, we repurchased approximately 646,000 shares of our common stock, at an average purchase price of $20.88 per share, for a total aggregate amount of approximately $13.8 million.

At September 30, 2004, our principal source of liquidity consisted of cash and cash equivalents totaling approximately $91.3 million, and held-to-maturity marketable securities and cash deposits of approximately $245.8 million. The market value of securities classified as held-to-maturity and cash deposits amounted to $245.4 million as of September 30, 2004.

Our working capital at September 30, 2004 was approximately $110.6 million, and our backlog as of September 30, 2004 was $26.8 million. As we generate most of our cash flows from our operating activities, we believe that our current cash, cash equivalents, cash deposits and marketable securities, and our forecasted positive cash flows for future periods, will be sufficient to meet our cash requirements for both the short and long term.

In addition, as part of our business strategy, we occasionally evaluate potential acquisitions of businesses, products and technologies. Accordingly, a portion of our available cash may be used at any time for the acquisition of complementary products or businesses. Such potential transactions may require substantial capital resources, which may require us to seek additional debt or equity financing. We cannot assure you that we will be able to successfully identify suitable acquisition candidates, complete acquisitions, integrate acquired businesses into our current operations, or expand into new markets. Furthermore, we cannot assure you that additional financing will be available to us in any required time frame and on commercially reasonable terms, if at all. See “Factors Affecting Future Operating Results—We may engage in future acquisitions that could dilute our stockholders’ equity and harm our business, results of operations and financial condition.” for more detailed information.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk. It is our policy not to enter into interest rate derivative financial instruments, except for hedging of foreign currency exposures discussed below. We do not currently have any significant interest rate exposure since we do not have any financial obligation and our financial assets are measured on a held-to-maturity basis.

Foreign Currency Exchange Rate Risk. As a significant part of our sales and expenses are denominated in U.S. dollars, we have experienced only insignificant foreign exchange gains and losses to date, and do not expect to incur significant gains and losses in 2004. However, due to the volatility in the exchange rate of the New Israeli Shekel (NIS) versus the U.S. dollar, we decided to hedge part of the risk of a devaluation of the NIS, which could have an adverse effect on the expenses that we incur in the State of Israel. For example, to protect against an increase in value of forecasted foreign currency cash flows resulting from salary payments denominated in NIS during 2004 and lease payments for our Israeli facilities, we instituted a foreign currency cash flow hedging program using put options and forward contracts.

These option and forward contracts are designated as cash flow hedges, as defined by SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, and are all effective as hedges of these expenses. For more information about our hedging activity, see Note H to the attached Notes to Consolidated Financial Statement for the period ended September 30, 2004.

FACTORS AFFECTING FUTURE OPERATING RESULTS

This Form 10-Q contains forward-looking statements concerning our future products, expenses, revenue, liquidity and cash needs as well as our plans and strategies. These forward-looking statements are based on current expectations and we assume no obligation to update this information. Numerous factors could cause our actual results to differ significantly from the results described in these forward-looking statements, including the following risk factors.

We rely on a primary distributor for a significant portion of our total revenues and the failure of this distributor to perform as expected would materially reduce our future sales and revenues.

We sell our products to customers primarily through a network of distributors and representatives. Particularly, revenues derived from sales through our Japanese distributor, Tomen Electronics Corporation, accounted for 75% of our total revenues for the third quarter of 2004, and 78% for the nine months ended September 30, 2004. Our future performance will depend, in part, on this distributor to continue to successfully market and sell our products. Furthermore, Tomen Electronics sells our products to a limited number of customers. One customer, Panasonic Communications Co., Ltd, has continually accounted for a majority of the sales through Tomen Electronics. The loss of Tomen Electronics as our distributor and our inability to obtain a satisfactory replacement in a timely manner would materially harm our sales and results of operations. Additionally, the loss of Panasonic and Tomen Electronics’ inability to thereafter effectively market our products would also materially harm our sales and results of operations.

Because our products are components of end products, if OEMs do not incorporate our products into their end products or if the end products of our OEM customers do not achieve market acceptance, we may not be able to generate adequate sales of our products.

Our products are not sold directly to the end-user; rather, they are components of end products. As a result, we rely upon original equipment manufacturers (OEMs) to incorporate our products into their end products at the design stage. Once an OEM designs a competitor’s product into its end product, it becomes significantly more difficult for us to sell our products to that OEM because changing suppliers involves significant cost, time, effort and risk for OEM. As a result, we may incur significant expenditures on the development of a new product without any assurance that an OEM will select our product for design into its end product and without this “design win,” it becomes significantly more difficult to sell our products. Moreover, even after an OEM agrees to design our product into its end product, the design cycle is long and may be delayed due to factors beyond our control, which may result in the end product incorporating our products not to reach the market until long after the initial “design win” with the OEM. For example, one of our OEM customers has decided to delay the launch of new products incorporating the Bluetooth and video products. As a result, our future revenue and profitability may be adversely affected. Furthermore, we rely on the end products of our OEM customers that incorporate our products to achieve market acceptance. Many of our OEM customers face intense competition in their markets. If end products that incorporate our products are not accepted in the marketplace, we may not achieve adequate sales volume of our products, which would have a negative effect on our results of operations.

The slow economic recovery and related uncertainties may adversely impact our revenues and profitability.

Slower economic activity, increased fuel and power costs, decreased consumer confidence, reduced corporate profits and capital spending, unemployment, adverse business conditions and liquidity concerns in the telecommunications, semiconductor and related industries, and recent international conflicts and terrorist and military activity have resulted in a slow economic recovery after the downturn in worldwide economic conditions. If the economy continues to recover at a slow pace, we may experience a slowdown in customer orders, an increase in the number of cancellations and rescheduling of backlog. We cannot predict the timing, strength and duration of any economic recovery in the telecommunications and semiconductor industries. In addition, the new developments with the Iraqi conflict can be expected to place further pressure on

economic conditions in the United States and worldwide. These conditions make it difficult for our customers, our vendors and for us to accurately forecast and plan future business activities. If such conditions continue or worsen, our business, financial condition and results of operations may be materially and adversely affected.

We generate a significant amount of our total revenues from the sale of Integrated Digital Telephony (IDT) products and our business and operating results may be materially adversely affected if we do not continue to succeed in the highly competitive IDT market.

Sales of our Integrated Digital Telephony (IDT) products comprised 91% of our total revenues for the third quarter of 2004. Specifically, sales of our 2.4GHz and 5.8GHz products comprised 87% of our total revenues for the third quarter of 2004, and we expect that our 2.4GHz and 5.8GHz products will continue to account for a substantial portion of our revenues in 2004. As a result, any adverse change in the digital IDT market or in our ability to compete and maintain our competitive position in that market would harm our business, financial condition and results of operations. The IDT market is extremely competitive and we expect that competition will only increase. Our existing and potential competitors in each of our markets include large and emerging domestic and foreign companies, many of whom have significantly high-level financial, technical, manufacturing, marketing, sale and distribution resources and management expertise. It is possible that we may one day be unable to respond to increased price competition for IDT processors or other products through the introduction of new products or reduction of manufacturing costs. This inability would have a material adverse effect on our business, financial condition and results of operations. Likewise, any significant delays by us in developing, manufacturing or shipping new or enhanced products for the IDT market also would have a material adverse effect on our business, financial condition and results of operations.

In addition, we believe new developments in the home residential market may adversely affect the revenues we derive from our IDT products. For example, the rapid deployment of new communication access methods, including mobile, broadband, cable and VoIP connections, may reduce the market for products using fixed-line telephony, meaning communication through phones connected to telephone lines. This decrease in demand would reduce our revenues derived from, and unit sales of, our cordless telephony products.

Our business may also be affected by the outcome of the current competition between cell phone operators and fixed line operators for the provision of residential communication. Our revenues are currently primarily generated from sales of chip-sets used in cordless phones that is based on fixed-line telephony. As a result, a decline in the use of fixed-line telephony for residential communication would adversely affect our financial condition and operating results.

Because our quarterly operating results may fluctuate significantly, the price of our common stock may decline.

Our quarterly results of operations may vary significantly in the future for a variety of reasons, many of which are outside our control, including the following:

•

fluctuations in volume and timing of product orders;

•

changes in demand for our products due to seasonal consumer buying patterns and other factors;

•

timing of new product introductions by us or our customers or competitors;

•

changes in the mix of products sold by us or our competitors;

•

fluctuations in the level of sales by our OEM customers and other vendors of end products incorporating our products;

•

the timing and size of expenses, including expenses to develop new products and product improvements;

•

mergers and acquisitions by us, our competitors, and existing and potential customers; and

•

general economic conditions, including the changing economic conditions in the United States and worldwide.

Each of the above factors is difficult to forecast and could harm our business, financial condition and results of operations. Also, we sell our products to OEM customers that operate in consumer markets. As a result, our revenues are affected by seasonal buying patterns of consumer end products sold by our OEM customers that incorporate our products and the market acceptance of such products supplied by our OEM customers. The fourth quarter in any given year is usually the strongest quarter for sales by our OEM customers in the consumer markets, and thus, our third quarter in any given year is usually the strongest quarter for revenues as our OEM customers request increased shipments of our products in anticipation of the increased activity in the fourth quarter. By contrast, the first quarter in any given year is usually the weakest quarter for us.

Our average selling prices continue to decline which may materially adversely affect our profitability.

We have experienced and continue to experience a decrease in the average selling prices of our IDT processors, which we have to date been able to partially offset on an annual basis through manufacturing cost reductions by achieving a higher level of product integration and improving our yield percentages. However, there is no guarantee that our ongoing efforts will be successful or that they will keep pace with the anticipated, continued decline in average selling prices of our IDT processors, which could ultimately lead to a decline in revenues and have a negative effect on our gross margins.

Because we depend on independent foundries to manufacture all of our integrated circuit products, we are subject to additional risks that may materially disrupt our business.

All of our integrated circuit products are manufactured by independent foundries. While these foundries have been able to adequately meet the demands of our increasing business, we are and will continue to be dependent upon these foundries to achieve acceptable manufacturing yields, quality levels and costs, and to allocate to us a sufficient portion of their foundry capacity to meet our needs in a timely manner.

A significant majority of our integrated circuit products at this time is manufactured by one independent foundry. We have entered into a short-term supply arrangement with this foundry pursuant to which it is obligated to supply a specified amount of products to us for a specific period. We may incur charges to this foundry if we fail to utilize all the quantities of products reserved for us in accordance with this arrangement, which may increase our operating expenses and adversely affect our operating profit.

While we currently believe we have adequate capacity to support our current sales levels pursuant to our arrangement with our foundries, we may encounter capacity shortage issues in the future. In the event of a worldwide shortage in foundry capacity, we may not be able to obtain a sufficient allocation of foundry capacity to meet our product needs or we may incur additional costs to ensure specified quantities of products and services. Over-capacity at the current foundries we use, or future foundries we may use, to manufacture our integrated circuit products may lead to increased operating costs and lower gross margins. In addition, such a shortage could lengthen our products’ manufacturing cycle and cause a delay in the shipment of our products to our customers. This could ultimately lead to a loss of sales of our products, harm our reputation and competitive position, and our revenues could be materially reduced. Our business could also be harmed if our current foundries terminate their relationship with us and we are unable to obtain satisfactory replacements to fulfill customer orders on a timely basis and in a cost-effective manner.

In addition, foundries in Taiwan produce a significant portion of our integrated circuit products. As a result, earthquakes, aftershocks or other natural disasters in Asia, or adverse changes in the political situation in Taiwan, could preclude us from obtaining an adequate supply of wafers to fill customer orders and could harm our reputation, business, financial condition, and results of operations.

Because the manufacture of our products is complex, the foundries on which we depend may not achieve the necessary yields or product reliability that our business requires.

The manufacture of our products is a highly complex and precise process, requiring production in a highly controlled environment. Changes in manufacturing processes or the inadvertent use of defective or contaminated materials by a foundry could adversely affect the foundry’s ability to achieve acceptable manufacturing yields and product reliability. If the foundries we currently use do not achieve the necessary yields or product reliability, our customer relationships could suffer. This could ultimately lead to a loss of sales of our products and have a negative effect on our gross margins and results of operations.

Furthermore, there are other significant risks associated with relying on third-party foundries, including:

•

risks due to the fact that we have reduced control over production cost, delivery schedules and product quality;

•

less recourse if problems occur as the warranties on wafers or products supplied to us are limited; and

•

increased exposure to potential misappropriation of our intellectual property.

Because we have significant international operations, we may be subject to political, economic and other conditions relating to our international operations that could increase our operating expenses and disrupt our business.

Although a majority of end users of the consumer products that incorporate our products are located in the U.S., we are dependent on sales to OEM customers, located outside of the U.S., that manufacture these consumer products. We expect that international sales will continue to account for a significant portion of our net product sales for the foreseeable future. For example, export sales, primarily consisting of IDT speech processors shipped to manufacturers in Europe and Asia Pacific, including Japan, represented 99% of our total revenues for the third quarter of 2004. As a result, the occurrence of any negative international political, economic or geographic events could result in significant revenue shortfalls. These shortfalls could cause our business, financial condition and results of operations to be harmed. Some of the risks of doing business internationally include:

•

unexpected changes in regulatory requirements;

•

fluctuations in the exchange rate for the United States dollar;

•

imposition of tariffs and other barriers and restrictions;

•

burdens of complying with a variety of foreign laws;

•

political and economic instability; and

•

changes in diplomatic and trade relationships.

Because we have significant operations Israel, we may be subject to political, economic and other conditions affecting Israel that could increase our operating expenses and disrupt our business.

Our principal research and development facilities are located in the State of Israel and, as a result, at September 30, 2004, 198 of our 249 employees were located in Israel, including 135 out of 167 of our research and development personnel. In addition, although we are incorporated in Delaware, a majority of our directors and executive officers are residents of Israel. Although substantially all of our sales currently are being made to customers outside of Israel, we are nonetheless directly influenced by the political, economic and military conditions affecting Israel. Since the establishment of the State of Israel in 1948, a number of armed conflicts have taken place between Israel and its Arab neighbors and a state of hostility, varying in degree and intensity, has led to security and economic problems for Israel. Israel’s economy has been subject to numerous destabilizing factors, including a period of rampant inflation in the early to mid-1980s, low foreign exchange reserves, fluctuations in world commodity prices, military conflicts and civil unrest. In addition, Israel and companies doing business with Israel have been the subject of an economic boycott by the Arab countries since Israel’s establishment. Moreover, as a result of the hostilities and unrest presently occurring within Israel, the future of the peace efforts between Israel and its Arab neighbors is uncertain. A number of our employees based in Israel are currently obligated to perform annual military reserve duty and are subject to being called to active duty at any time under emergency circumstances. Any major hostilities involving Israel, or the interruption or curtailment of trade between Israel and its present trading partners, or significant destabilization of Israel’s economy could significantly harm our business, operating results and financial condition.

Our future profits may be diminished if the current Israeli tax benefits that we enjoy are reduced or withheld.

We receive certain tax benefits in Israel, particularly as a result of the “Approved Enterprise” status of our facilities and programs. To be eligible for tax benefits, we must 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. Although we have met such conditions in the past, should we fail to meet such conditions in the future, 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. We cannot assure you that such grants and tax benefits will be continued in the future at their current levels, if at all. The tax benefits under these investment plans are scheduled to expire starting in 2005 through 2017. 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 have a material adverse effect on our business, operating results and financial condition.

Our failure, and the failure of our OEM customers, to obtain the necessary complementary components required to produce various products could diminish the sales of our products.

Our IDT speech processor products require an external component in the finished product to provide Analog Random Access Memory circuits (ARAMs) and flash memory which are supplied by third party manufacturers. Temporary fluctuations in the pricing and availability of these components could negatively impact sales of our IDT speech processors, which could in turn harm our business, financial condition and results of operations. In addition, some of the raw materials, components and subassemblies included in the end products manufactured by our OEM customers, which also incorporate our products, are obtained from a limited group of suppliers. Supply disruptions, shortages or termination of any of these sources associated with the manufacturing processes of our OEM customers could have an adverse effect on our business and results of operations due to a delay or discontinuance of orders for our products by our OEM customers until those necessary components are available for their end products.

We may engage in future acquisitions that could dilute our stockholders’ equity and harm our business, results of operations and financial condition.

We have pursued, and will continue to pursue, growth opportunities through internal development and acquisition of complementary businesses, products and technologies. We are unable to predict whether or when any other prospective acquisition will be completed. The process of integrating an acquired business may be prolonged due to unforeseen difficulties and may require a disproportionate amount of our resources and management’s attention. We cannot assure you that we will be able to successfully identify suitable acquisition candidates, complete acquisitions, integrate acquired businesses into our operations, or expand into new markets. Further, once integrated, acquisitions may not achieve comparable levels of revenues, profitability or productivity as our existing business or otherwise perform as expected. The occurrence of any of these events could harm our business, financial condition or results of operations. Future acquisitions may require substantial capital resources, which may require us to seek additional debt or equity financing.

Future acquisitions by us could result in the following, any of which could seriously harm our results of operations or the price of our stock:

•

issuance of equity securities that would dilute our current stockholders’ percentages of ownership;

•

large one-time write-offs;

•

the incurrence of debt and contingent liabilities;

•

difficulties in the assimilation and integration of operations, personnel, technologies, products and information systems of the acquired companies;

•

diversion of management’s attention from other business concerns;

•

contractual disputes;

•

risks of entering geographic and business markets in which we have no or only limited prior experience; and

•

potential loss of key employees of acquired organizations.

Third party claims of infringement or other claims against us could adversely affect our ability to market our products, require us to redesign our products or seek licenses from third parties, and seriously harm our operating results and disrupt our business.

As is typical in the semiconductor industry, we have been and may from time to time be notified of claims that we may be infringing patents or intellectual property rights owned by third parties. We also have in the past agreed to, and may from time to time in the future agree to, indemnify a licensee of our products for claims against the licensee by a third party based on claims that our products infringe patents or other intellectual property rights of that third party. Our obligation to indemnify a licensee, if valid, may result in significant expense to us, and could adversely affect our operating results for the period that such obligation matures.

If it appears necessary or desirable, we may try to obtain licenses for those patents or intellectual property rights that we are allegedly infringing. Although holders of these types of intellectual property rights commonly offer these licenses, we cannot assure you that licenses will be offered or that the terms of any offered licenses will be acceptable to us. Our failure to obtain a license for key intellectual property rights from a third party for technology used by us could cause us to incur substantial liabilities and to suspend the manufacturing of products utilizing such technology.

Alternatively, we could be required to expend significant resources to develop non-infringing technology. We cannot assure you that we would be successful in developing non-infringing technology.

We may not be able to adequately protect or enforce our intellectual property rights, which could harm our competitive position.

Our success and ability to compete is in part dependent upon our internally-developed technology and other proprietary rights, which we protect through a combination of copyright, trademark and trade secret laws, as well as through confidentiality agreements and licensing arrangements with our customers, suppliers, employees and consultants. In addition, we have filed a number of patents in the United States and in other foreign countries with respect to new or improved technology that we have developed. However, the status of any patent involves complex legal and factual questions, and the breadth of claims allowed is uncertain. Accordingly, we cannot assure you that any patent application filed by us will result in a patent being issued, or that the patents issued to us will not be infringed by others. Also, our competitors and potential competitors may develop products with similar technology or functionality as our products, or they may attempt to copy or reverse engineer aspects of our product line or to obtain and use information that we regard as proprietary. Moreover, the laws of certain countries in which our products are or may be developed, manufactured or sold, including Hong Kong, Japan and Taiwan, may not protect our products and intellectual property rights to the same extent as the laws of the United States. Policing the unauthorized use of our products is difficult and may result in significant expense to us and could divert the efforts of our technical and management personnel. Even if we spend significant resources and efforts to protect our intellectual property, we cannot assure you that we will be able to prevent misappropriation of our technology. Use by others of our proprietary rights could materially harm our business and expensive litigation may be necessary in the future to enforce our intellectual property rights.

Our operating results may fluctuate significantly due to the cyclicality of the semiconductor industry, which could adversely affect the market price of our common stock.

We operate in the semiconductor industry, which is cyclical and subject to rapid technological change and evolving industry standards. From time to time, the semiconductor industry has experienced significant downturns such as the one we recently experienced and from which the industry is slowly recovering. These downturns are characterized by diminished product demand, excess customer inventories, accelerated erosion of prices and excess production capacity. These factors could cause substantial fluctuations in our revenues and in our results of operations. The recent downturn we experienced was, and future downturns in the semiconductor industry may be, severe and prolonged. Also the slow recovery from the recent downturn and the failure of this industry to fully recover from the current downturn could seriously impact our revenue and harm our business, financial condition and results of operations. The semiconductor industry also periodically experiences increased demand and production capacity constraints, which may affect our ability to ship products in future periods. Our quarterly results may vary significantly as a result of the general conditions in the semiconductor industry, which could cause our stock price to decline.

Because the markets in which we compete are highly competitive, and many of our competitors have greater resources than we do, we cannot be certain that our products will be accepted in the marketplace or capture market share.

The markets in which we operate are extremely competitive and characterized by rapid technological change, evolving standards, short product life cycles and price erosion. We expect competition to intensify as current competitors expand their product offerings and new competitors enter the market. Given the highly competitive environment in which we operate, we cannot be sure that any competitive advantages enjoyed by our current products would be sufficient to establish and sustain our new products in the market. Any increase in price or competition could result in the erosion of our market share, and would have a negative impact on our financial condition and results of operations.

In each of our business activities, we face current and potential competition from competitors that have significantly greater financial, technical, manufacturing, marketing, sales and distribution resources and management expertise than we do. These competitors may also have pre-existing relationships with our customers or potential customers. Further, in the event of a manufacturing capacity shortage, these competitors may be able to manufacture products when we are unable to do so. Our principal competitors in the cordless market include National Semiconductor, Philips, Oki Electronic, Micro Linear and Infineon. Our principal competitors in the VoP market include Conexant Systems Inc. (formerly GlobalVirata), AudioCodes, Texas Instruments, Broadcom, Infineon and Oki Electronic. Our principal competitors with respect to digital speech compression technologies include AT&T and Motorola.

Furthermore, due to various new developments in the home residential market, we may be required to enter into new markets with competitors that have more established presence, and significantly greater financial, technical, manufacturing, marketing, sales and distribution resources and management expertise than we do. For example, the rapid deployment of new communication access methods, including mobile, broadband, cable and VoIP connections, as well as the projected lack of growth in products using fixed-line telephony, meaning communication through phones connected to telephone lines, will require us to expand our current product lines and develop a portfolio of “system-on-a-chip” solutions that integrate video, voice, data and communication technologies in a wider multimedia market. The expenditure of greater resources to expand our product lines, and develop and sell a portfolio of “system-on-a-chip” solutions may increase our operating expenses and reduce our gross profit. We cannot assure you that we will succeed in developing and introducing new products that are responsive to market demands.

We face intense competition and our operating expenses may increase disproportionately as we try to penetrate the European DECT market with our new products.

As an expansion of our business, we are currently developing chip-sets for the European Digital Enhanced Cordless Telecommunications (DECT) market. We face intense competition in this market from current, well-established competitors that have significant financial, technical, manufacturing, marketing, sales and distribution resources and management expertise. Although we are leveraging our expertise in developing chip-sets for the U.S. market, there are key differences in technology for the European market. As with the development of any new technology, we may encounter unforeseeable delays and other problems, and thus we cannot provide any assurances that we will achieve our development milestones or our new products will gain market acceptance. As a result, the penetration of the European market is anticipated to increase our headcount and operating expenses in the fourth quarter of 2004 and future periods. However, we cannot assure you that the significant expenditures we will incur will translate into meaningful sales and revenue for our DECT products. Also, in order to penetrate the new market, we may need to offer our products at lower prices than we currently anticipate, which may result in lower profits. Our inability to penetrate the European DECT market and recover the significant expenditures we will incur to develop products for this new market may adversely affect our business, financial condition and results of operations.

Because our products are complex, the detection of errors in our products may be delayed, and if we deliver products with defects, our credibility will be harmed, the sales and market acceptance of our products may decrease and product liability claims may be made against us.

Our products are complex and may contain errors, defects and bugs when introduced. If we deliver products with errors, defects or bugs, our credibility and the market acceptance and sales of our products could be significantly harmed. Furthermore, the nature of our products may also delay the detection of any such error or defect. If our products contain errors, defects and bugs, then we may be required to expend significant capital and resources to alleviate these problems. This could result in the diversion of technical and other resources from our other development efforts. Any actual or perceived problems or delays may also adversely affect our ability to attract or retain customers. Furthermore, the

existence of any defects, errors or failures in our products could lead to product liability claims or lawsuits against us or against our customers. We generally provide our customers with a standard warranty for our products, generally lasting one year from the date of purchase. Although we attempt to limit our liability for product defects to product replacements, we may not be successful, and customers may sue us or claim liability for the defective products. A successful product liability claim could result in substantial cost and divert management’s attention and resources, which would have a negative impact on our financial condition and results of operations.

Our executive officers and key personnel are critical to our business, and because there is significant competition for personnel in our industry, we may not be able to attract and retain such qualified personnel.

Our success depends to a significant degree upon the continued contributions of our executive management team, and our technical, marketing, sales customer support and product development personnel. The loss of significant numbers of such personnel could significantly harm our business, financial condition and results of operations. We do not have any life insurance or other insurance covering the loss of any of our key employees. Because our products are specialized and complex, our success depends upon our ability to attract, train and retain qualified personnel, including qualified technical, marketing and sales personnel. However, the competition for personnel is intense and we may have difficulty attracting and retaining such personnel.

We are exposed to fluctuations in currency exchange rates.

A significant portion of our business is conducted outside the United States. Export sales to manufacturers in Europe and Asia Pacific, including Japan, represented 99% of our total revenues for the third quarter of 2004 as well as for each of 2002 and 2003 fiscal years. Although most of our revenue and expenses are transacted in U.S. dollars, we may be exposed to currency exchange fluctuations in the future as business practices evolve and we are forced to transact business in local currencies. Moreover, part of our expenses in Israel are paid in Israeli currency, which subjects us to the risks of foreign currency fluctuations between the U.S. dollar and the New Israeli Shekel (NIS) and to economic pressures resulting from Israel’s general rate of inflation. Our primary expenses paid in NIS are employee salaries and lease payments on our Israeli facilities. As a result, an increase in the value of Israeli currency in comparison to the U.S. dollar could increase the cost of our technology development, research and development expenses and general and administrative expenses. From time to time, we use derivative instruments in order to minimize the effects of currency fluctuations, but our hedging positions may be partial, may not exist at all in the future or may not succeed in minimizing our foreign currency fluctuation risks.

Because the markets in which we compete are subject to rapid changes, our products may become obsolete or unmarketable.

The markets for our products and services are characterized by rapidly changing technology, short product life cycles, evolving industry standards, changes in customer needs, demand for higher levels of integration, growing competition and new product introductions. Also, we are seeing a decline in sales of our single hand-set 2.4 GHz products. For example, we are seeing a continuing decline in sales of some of our older products, including the 900 MHz products. Our ability to adapt to these changes and to anticipate future standards, and the rate of adoption and acceptance of those standards, will be a significant factor in maintaining or improving our competitive position and prospects for growth. If new industry standards emerge, our products or our customers’ products could become unmarketable or obsolete, and we could lose market share. We may also have to incur substantial unanticipated costs to comply with these new standards. If our product development and improvements take longer than planned, the availability of our products would be delayed. Any such delay may render our products obsolete or unmarketable, which would have a negative impact on our ability to sell our products and our results of operations.

Because of changing customer requirements and emerging industry standards, we may not be able to achieve broad market acceptance of our products. Our success is dependent, in part, on our ability to:

•

successfully develop, introduce and market new and enhanced products at competitive prices and in a timely manner in order to meet changing customer needs;

•

convince leading OEMs to select our new and enhanced products for design into their own new products;

•

respond effectively to new technological changes or new product announcements by others;

•

effectively use and offer leading technologies; and

•

maintain close working relationships with our key customers.

We cannot be sure that we will be successful in these pursuits, that the growth in demand will continue or that our products will achieve market acceptance. Our failure to develop and introduce new products that are compatible with industry standards and that satisfy customer requirements, and the failure of our products to achieve broad market acceptance, could have a negative impact on our ability to sell our products and our results of operations.

Specifically, we believe new technological developments in the home residential market may adversely affect our operating results. For example, the rapid deployment of new communication access methods, including wireless, broadband, cable and VoIP connections, as well as the projected lack of growth in products using fixed-line telephony, meaning communication through phones connected to telephone lines, would reduce our total revenues derived from, and unit sales of, cordless telephony products. Our ability to maintain our growth will depend on the expansion of our product lines to capitalize on the emerging access methods and on our success in developing and selling a portfolio of “system-on-a-chip” solutions that integrate video, voice, data and communication technologies in a wider multimedia market, as well as on our success in developing and selling DECT and video products. We anticipate hiring additional research and development personnel to develop new products for the European DECT market, as well as new features for the connectivity from fix-line telephony to cellular phones, including Wi-Fi technology acquired from Bermai, Inc. in October 2004. As a result, our research and development expenses in absolute dollars and as a percentage from total revenues will increase in the fourth quarter of 2004, and future periods. We cannot assure you that we will generate sufficient revenues to offset the additional expenses associated with research and development. Furthermore, there are no assurances that we will succeed in expanding our product lines, or develop and sell in a timely manner a portfolio of “system-on-a-chip” solutions.

We may experience difficulties in transitioning to smaller geometry process technologies or in achieving higher levels of design integration, which may result in reduced manufacturing yields, delays in product deliveries and increased expenses.

A growing trend in our industry is the integration of greater semiconductor content into a single chip to achieve higher levels of functionality. In order to remain competitive, we must achieve higher levels of design integration and deliver new integrated products on a timely basis. This will require us to expend greater research and development resources, and may require us to modify the manufacturing processes for some of our products, to achieve greater integration. We periodically evaluate the benefits, on a product-by-product basis, of migrating to smaller geometry process technologies to reduce our costs. Although this migration to smaller geometry process technologies has helped us to offset the declining average selling prices of our IDT products, this effort may not continue be successful. Also, because we are a fabless semiconductor company, we depend on our foundries to transition to smaller geometry processes successfully. We cannot assure you that our foundries will be able to effectively manage the transition. In case our foundries or we experience significant delays in this transition or fail to efficiently implement this transition, our business, financial condition and results of operations could be materially and adversely affected.

Our certificate of incorporation and bylaws contain anti-takeover provisions that could prevent or discourage a third party from acquiring us.

Our certificate of incorporation and bylaws contain provisions that may prevent or discourage a third party from acquiring us, even if the acquisition would be beneficial to our stockholders. We have a staggered board, which means it will generally take two years to change the composition of our board. Our board of directors also has the authority to fix the rights and preferences of shares of our preferred stock and to issue such shares without a stockholder vote. We also have a rights plan in place. It is possible that these provisions may prevent or discourage third parties from acquiring us, even if the acquisition would be beneficial to our stockholders. In addition, these factors may also adversely affect the market price of our common stock, and the voting and other rights of the holders of our common stock.

Our stock price may be volatile so you may not be able to resell your shares of our common stock at or above the price you paid for them.

Announcements of developments related to our business, announcements by competitors, quarterly fluctuations in our financial results, changes in the general conditions of the highly dynamic industry in which we compete or the

national economies in which we do business, and other factors could cause the price of our common stock to fluctuate, perhaps substantially. In addition, in recent years, the stock market has experienced extreme price fluctuations, which have often been unrelated to the operating performance of affected companies. These factors and fluctuations could have a material adverse effect on the market price of our common stock.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Quantitative and Qualitative Disclosures About Market Risk.”

ITEM 4. CONTROLS AND PROCEDURES

As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in this report.

There has been no change in our internal control over financial reporting that occurred during our most recent fiscal quarter that has materially affected or is reasonably likely to materially affect our internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

We are involved in certain claims arising in the normal course of business. However, we believe that the ultimate resolution of these matters will not have a material adverse effect on its financial position, results of operations, or cash flows.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

The table below sets forth the information with respect to repurchases of our common stock during the three months ended September 30, 2004.


Period	(a) Total Number of Shares Purchased	(b) Average Price Paid per Share		(c) Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs	(d) Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs (1)
Month #1 (June 1, 2004 to June 30, 2004)	—		—	—	2,774,000	(2)
Month #2 (July 1, 2004 to August 31, 2004)	1,044,000	$	20.50	1,044,000	1,730,000
Month #3 (September 1, 2004 to September 30, 2004)	443,800	$	19.00	443,800	1,286,200
TOTAL	1,487,800	$	20.10	1,487,800	1,286,200

(1)

In July 2003, we announced that our Board of Directors had approved a share repurchase program, pursuant to which up to 2.5 million shares of our common stock may be repurchased. As of September 30, 2004, up to 1.3 million shares of our common stock remained available for repurchase pursuant to our Board’s July 2003 authorization. On October 19, 2004, our Board of Directors approved an increase of 2.5 million shares available for repurchase such that an aggregate of 3.8 million shares of our common stock are available for repurchase under our share repurchase program. The repurchase program is being affected from time to time, depending on market conditions and other factors, through open market purchases and privately negotiated transactions. The repurchase program has no set expiration or termination date.

(2)	The number represents the number of shares of our common stock that remained available for repurchase pursuant to our Board’s July 2003 authorization.

ITEM 6. EXHIBITS



		Exhibit 10.4		Form of Option Agreement for Israeli Directors under the Amended and Restated 1993 Director Stock Option Plan.

		Exhibit 10.5		Form of Option Agreement for Non-Israeli Directors under the Amended and Restated 1993 Director Stock Option Plan.

		Exhibit 10.44		Manufacturing Capacity Agreement, effective as of July 1, 2004, by and among DSP Group, Inc., DSP Group, Ltd, and Taiwan Semiconductor Manufacturing Company Ltd.†

		Exhibit 31.1		Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

		Exhibit 31.2		Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

		Exhibit 32.1		Certification of the Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

		Exhibit 32.2		Certification of the Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

†	Portions of this exhibit have been redacted and filed separately with the Commission along with a confidential treatment request.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this quarterly report on Form 10Q to be signed on its behalf by the undersigned thereunto duly authorized.


	DSP GROUP, INC. (Registrant)

Date: November 9, 2004	By:	/s/ MOSHE ZELNIK
		Moshe Zelnik, Vice President of Finance, Chief
		Financial Officer and Secretary
		(Principal Financial Officer and Principal Accounting Officer)

Exhibit 10.4

DSP GROUP, INC. 1993 DIRECTOR STOCK OPTION PLAN

APPENDIX A - ISRAEL

STOCK OPTION AGREEMENT

Unless otherwise defined herein, the terms defined in the 1993 Director Stock Option Plan (the “Plan”) and the Appendix A – Israel to the Plan (the “Appendix”) shall have the same defined meanings in this Stock Option Agreement.

I. NOTICE OF STOCK OPTION GRANT

You have been granted an option to purchase Common Stock of DSP Group, Inc. (the “Company”), subject to the terms and conditions of the Plan, the Appendix and this Stock Option Agreement, as follows:


Date of Grant
Vesting Commencement Date

Exercise Price per Share		$

Total Number of Shares Granted

Total Exercise Price		$

Type of Option	¨	Approved 102 Option:

		Capital Gain Option (CGO); ¨ or

		Ordinary Income Option (OIO) ¨

		¨ Unapproved 102 Option

		¨ 3(i) Option

Term/Expiration Date

II. AGREEMENT

1. Grant of Option . The Administrator hereby grants to the Optionee named in the Notice of Grant attached as Part I. of this Agreement (the “Optionee”), an option (the “Option”) to purchase a number of Shares, as set forth in the Notice of Grant, at the exercise price per share set forth in the Notice of Grant (the “Exercise Price”), subject to the terms and conditions of the Plan and the Appendix, both of which are incorporated herein by reference. Subject to Section 13(b) of the Plan, in the event of a conflict between the terms and conditions of the Plan and the Appendix and the terms and conditions of this Stock Option Agreement, the terms and conditions of the Plan and the Appendix shall prevail. The option granted hereunder is a [ First Option] [Subsequent Option], as defined in the Plan.

2. Exercise of Option.

a. Right to Exercise . This Option shall vest and become exercisable as to one-third of the Shares on the first anniversary of the date of grant of this Option, and shall vest and become exercisable as to one-third of the Shares at the end of each twelve-month period thereafter. In the event of Optionee’s death, disability (as defined in Section 22(e)(3) of the Internal Revenue Code of 1986, as amended) or other termination of Optionee’s Continuous Status as a Director, the exercisability of the Option is governed by the applicable provisions of the Plan and the Appendix.

b. Method of Exercise . This Option is exercisable by delivery of an exercise notice, in the form attached as Exhibit A (the “Exercise Notice”), which shall state the election to exercise the Option, the number of Shares in respect of which the Option is being exercised (the “Exercised Shares”), and such other representations and agreements as may be required by the Company pursuant to the provisions of the Plan. The Exercise Notice shall be signed by the Optionee and shall be delivered in person or by certified mail to the Secretary of the Company. The Exercise Notice shall be accompanied by payment of the aggregate Exercise Price and any required withholding or other taxes as to all Exercised Shares. This Option shall be deemed to be exercised upon receipt by the Company of such fully executed Exercise Notice accompanied by such aggregate Exercise Price.

No Shares shall be issued pursuant to the exercise of this Option unless such issuance and exercise complies with all relevant provisions of law and the requirements of any stock exchange or quotation service upon which the Shares are then listed. Assuming such compliance, for income tax purposes the Exercised Shares shall be considered transferred to the Optionee on the date the Option is exercised with respect to such Exercised Shares.

3. Method of Payment . Payment of the aggregate Exercise Price shall be by any of the following, or a combination thereof, at the election of the Optionee:

a. Cash; or

b. Check; or

c. Delivery of a properly executed Exercise Notice, together with such other documentation as the Administrator and the broker, if applicable, shall require to effect an exercise of the Option and delivery to the Company of the sale proceeds required to pay the Exercise Price; or

d. Surrender of other Shares which (i) in the case of Shares acquired upon exercise of an option, have been owned by the Optionee for more than six (6) months on the date of surrender; and (ii) have a Fair Market Value on the date of surrender equal to the aggregate Exercise Price of the Exercised Shares; or

e. Any combination of the above methods.

4. Non-Transferability of Option and Shares .

a. The Option may not be transferred in any manner other than by will or by the laws of descent and distribution and may be exercised during the lifetime of the Optionee only by the Optionee. As long as the Option or Shares purchased pursuant thereto is held by the Trustee on behalf of the Optionee in accordance with Section 4 of the Appendix, all rights of the Optionee over the Shares are personal, cannot be transferred, assigned, pledged or mortgaged, other than by will or laws of descent and distribution.

b. If the Option is an Approved 102 Option, subject to the provisions of Section 102 and any rules or regulation or orders or procedures promulgated thereunder, the Optionee shall not be entitled to sell or release from trust any Share received upon the exercise

of an Approved 102 Option and/or any Share received subsequently following any realization of rights, including without limitation, bonus shares, until the lapse of the Holding Period required under Section 102 of the Ordinance.

c. If the Option is an Unapproved 102 Option and the Optionee ceases to be a Director, the Optionee shall extend to the Company a security or guarantee for the payment of tax due at the time of sale of Shares, all in accordance with the provisions of Section 102 and the rules, regulation or orders promulgated thereunder.

5. Term of Option . This Option may be exercised only within the term set out in the Notice of Grant, and may be exercised during such term only in accordance with the Plan, the Appendix and the terms of this Stock Option Agreement.

6. Taxes .

(a) Any tax consequences arising from the grant or exercise of the Option, from the payment for the Shares covered thereby or from any other event or act (of the Company and/or its Affiliates, the Trustee or the Optionee), hereunder, shall be borne solely by the Optionee. The Company and/or its Affiliates and/or the Trustee shall withhold taxes according to the requirements under the applicable laws, rules, and regulations, including withholding taxes at the source. Furthermore, the Optionee hereby agrees to indemnify the Company and/or its Affiliates and/or the Trustee and hold them harmless against and from any and all liability for any such taxes and any interest and penalties thereon, including without limitation, liabilities relating to the necessity to withhold, or to have withheld, any such taxes from any payment made to the Optionee.

(b) The Optionee will not be entitled to receive from the Company and/or the Trustee any Shares allocated or issued upon the exercise of the Option prior to the full payment of the Optionee’s tax liabilities arising from the grant of the Options and/or the issuance of the Shares upon the exercise of the Option. For the avoidance of doubt, neither the Company nor the Trustee shall be required to release any share certificate to the Optionee until all payments required to be made by the Optionee have been fully satisfied.

(c) With respect to Approved 102 Options, the Optionee hereby acknowledges that he or she is familiar with the provisions of Section 102 and the regulations and rules promulgated thereunder, including without limitations the type of Option granted hereunder and the tax implications applicable to such grant. If the Option is an Approved 102 Option, the Optionee accepts the provisions of the trust agreement signed between the Company and the Trustee, attached as Exhibit B hereto, and agrees to be bound by its terms.

7. Entire Agreement: Governing Law . The Plan, the Appendix and this Stock Option Agreement constitute the entire agreement of the parties with respect to the subject matter hereof and supersede in their entirety all prior undertakings and agreements of the Company and the Optionee with respect to the subject matter hereof, and the Notice and the Option Agreement may not be modified adversely to the Optionee’s interest except by means of a writing signed by the Company and the Optionee. Nothing in the Plan, the Appendix and this Option Agreement (except as expressly provided therein) is intended to confer any rights or remedies on any persons other than the parties. The Plan, the Appendix and this Option Agreement are to be construed in accordance with and governed by the internal laws of the State of Israel without giving effect to any choice of law rule that would cause the application of the laws of any jurisdiction other than the internal laws of the State of Israel to the rights

and duties of the parties. Should any provision of the Plan, the Appendix or this Option Agreement be determined by a court of law to be illegal or unenforceable, such provision shall be enforced to the fullest extent allowed by law and the other provisions shall nevertheless remain effective and shall remain enforceable.

8. Dispute Resolution. The provisions of this Section 8 shall be the exclusive means of resolving disputes arising out of or relating to the Plan, the Appendix and this Option Agreement. The Company, the Optionee, and the Optionee’s assignees (the “parties”) shall attempt in good faith to resolve any disputes arising out of or relating to the Plan, the Appendix and this Option Agreement by negotiation between individuals who have authority to settle the controversy. Negotiations shall be commenced by either party by notice of a written statement of the party’s position and the name and title of the individual who will represent the party. Within thirty (30) days of the written notification, the parties shall meet at a mutually acceptable time and place, and thereafter as often as they reasonably deem necessary, to resolve the dispute. If the dispute has not been resolved by negotiation, the parties agree that any suit, action, or proceeding arising out of or relating to the Plan, the Appendix or this Option Agreement shall be brought in the courts of Tel-Aviv, Israel and that the parties shall submit to the jurisdiction of such court. The parties irrevocably waive, to the fullest extent permitted by law, any objection the party may have to the laying of venue for any such suit, action or proceeding brought in such court. THE PARTIES ALSO EXPRESSLY WAIVE ANY RIGHT THEY HAVE OR MAY HAVE TO A JURY TRIAL OF ANY SUCH SUIT, ACTION OR PROCEEDING. If any one or more provisions of this Section 8 shall for any reason be held invalid or unenforceable, it is the specific intent of the parties that such provisions shall be modified to the minimum extent necessary to make it or its application valid and enforceable.

By your signature and the signature of the Company’s representative below, you and the Company agree that this Option is granted under and governed by the terms and conditions of the Plan, the Appendix and this Stock Option Agreement. Optionee has reviewed the Plan, the Appendix and this Stock Option Agreement in their entirety, has had an opportunity to obtain the advice of counsel prior to executing this Stock Option Agreement, and fully understands all provisions of the Plan, the Appendix and this Stock Option Agreement.


OPTIONEE:		DSP GROUP, INC.



By:		By:
	(Signature)		(Signature)

Address:		Title:

EXHIBIT A

DSP GROUP, INC.

1993 DIRECTOR STOCK OPTION PLAN

APPENDIX A - ISRAEL

EXERCISE NOTICE

DSP GROUP, INC.

3120 Scott Boulevard

Santa Clara, CA 95054

Attention: Stock Administration

1. Exercise of Option . Effective as of today, , , the undersigned, (“Purchaser”), hereby elects to purchase ( ) shares (the “Shares”) of the Common Stock of DSP GROUP, INC., a Delaware corporation (the “Company”), under and pursuant to the 1993 Director Stock Option Plan (the “Plan”), the Appendix A – Israel to the Plan (the “Appendix”) and the Stock Option Agreement dated (the “Option Agreement”). The purchase price per share for the Shares shall be ($ ), for an aggregate purchase price of $ , as required by the Option Agreement.

2. Delivery of Payment . Purchaser herewith delivers to the Company the full purchase price for the Shares. Purchaser hereby elects to pay the exercise price by the method marked below:

a. Cash

b. Check

c. Same day exercise and sale

3. Broker Instructions. In the event Purchaser elects to exercise options via the same day exercise and sale method, the Company is hereby authorized to instruct (the “Broker”) to accept the proceeds deriving from the sale of the Shares, and to take the following actions: (i) to deduct from the proceeds of the sale any Company expenses; (ii) to deduct from the proceeds any tax withholding requested by the Company and to request in writing from the Company a statement of the tax amounts to be withheld, if no request has been given by the Company; (iii) to deliver the above amounts so deducted to the Company; and (iv) to deliver the remaining proceeds to Purchaser as Purchaser shall direct the Broker.

These instructions shall be construed as authorizing the Broker and the Company to take any other actions reasonably necessary to effect the purposes hereof and the Broker and the Company may rely upon any statements and undertakings made herein by the undersigned, as if said statements and undertakings were made directly to the Broker and the Company.

Purchaser further acknowledges that Purchaser shall bear full liability for the payment of any taxes with respect to the Shares and the sale thereof and will, upon demand, indemnify and defend the Broker and the Company against any amounts which may be owing in this regard.

Purchaser further acknowledges that Purchaser shall bear sole responsibility for any commissions and fees relating to the performance of these instructions by the Broker or the Company, and any other banking activities and will, upon demand, indemnify and defend the Broker or the Company against any amounts which may be owing in this regard.

4. Representations of Purchaser . Purchaser acknowledges that Purchaser has received, read and understood the Plan, the Appendix and the Option Agreement, and agrees to abide by and be bound by their terms and conditions.

5. Rights as Stockholder . Until the issuance (as evidenced by the appropriate entry on the books of the Company or of a duly authorized transfer agent of the Company) of the stock certificate evidencing such Shares, no right to vote or receive dividends or any other rights as a Stockholder shall exist with respect to the Shares, notwithstanding the exercise of the Option. In the event Purchaser has not sold the Shares in a same day exercise and sale, a share certificate for the number of Shares so acquired shall be issued to the Purchaser as soon as practicable after exercise of the Option. No adjustment will be made for a dividend or other right for which the record date is prior to the date the stock certificate is issued, except as provided in the Plan.

6. Tax Consultation . Purchaser understands that Purchaser may suffer adverse tax consequences as a result of Purchaser’s purchase or disposition of the Shares. Purchaser represents that Purchaser has consulted with any tax consultants Purchaser deems advisable in connection with the purchase or disposition of the Shares and that Purchaser is not relying on the Company for any tax advice.

7. Governing Law; Severability . This Agreement is to be construed in accordance with and governed by the internal laws of the State of Israel without giving effect to any choice of law rule that would cause the application of the laws of any jurisdiction other than the internal laws of the State of Israel to the rights and duties of the parties. Should any provision of this Agreement be determined by a court of law to be illegal or unenforceable, such provision shall be enforced to the fullest extent allowed by law and the other provisions shall nevertheless remain effective and shall remain enforceable.

8. Dispute Resolution . The provisions of Section 8 of the Stock Option Agreement shall be the exclusive means of resolving disputes arising out of or relating to this Agreement.

9. Entire Agreement . The Plan, the Appendix and Option Agreement are incorporated herein by reference. This Agreement, the Plan, the Appendix and the Option Agreement constitute the entire agreement of the parties and supersede in their entirety all prior undertakings and agreements of the Company and Purchaser with respect to the subject matter hereof.


Submitted by:	Accepted by:

PURCHASER:	DSP GROUP, INC.:

	By:
(Signature)		(Signature)


		(Print Name and Title)

		3120 Scott Boulevard
		Santa Clara, CA 95054

Exhibit 10.5

DSP GROUP, INC.

1993 DIRECTOR STOCK OPTION PLAN

STOCK OPTION AGREEMENT

Unless otherwise defined herein, the terms defined in the 1993 Director Stock Option Plan (the “Plan”) shall have the same defined meanings in this Stock Option Agreement.

I. NOTICE OF STOCK OPTION GRANT

You have been granted an option to purchase Common Stock of DSP Group, Inc. (the “Company”), subject to the terms and conditions of the Plan and this Stock Option Agreement, as follows:


Date of Grant

Vesting Commencement Date

Exercise Price per Share		$

Total Number of Shares Granted

Total Exercise Price

Type of Option		[First Option] [Subsequent Option] (Nonstatutory)

Term/Expiration Date

II. AGREEMENT

1. Grant of [First] [Subsequent] Option . The Administrator hereby grants to the Optionee named in the Notice of Grant attached as Part I. of this Agreement (the “Optionee”), a nonstatutory option (the “Option”) to purchase a number of Shares, as set forth in the Notice of Grant, at the exercise price per share set forth in the Notice of Grant (the “Exercise Price”), subject to the terms and conditions of the Plan, which is incorporated herein by reference. Subject to Section 13(b) of the Plan, in the event of a conflict between the terms and conditions of the Plan and the terms and conditions of this Stock Option Agreement, the terms and conditions of the Plan shall prevail. The option granted hereunder is a [First] [Subsequent] Option, as defined in the Plan.

2. Exercise of Option .

3. Method of Payment . Payment of the aggregate Exercise Price shall be by any of the following, or a combination thereof, at the election of the Optionee:

a. Cash; or

b. Check; or

e. Any combination of the above methods.

4. Non-Transferability of Option . This Option may not be transferred in any manner otherwise than by will or by the laws of descent or distribution, and may be exercised during the lifetime of Optionee only by the Optionee. The terms of the Plan and this Stock Option Agreement shall be binding upon the executors, administrators, heirs, successors and assigns of the Optionee.

5. Term of Option . This Option may be exercised only within the term set out in the Notice of Grant, and may be exercised during such term only in accordance with the Plan and the terms of this Stock Option Agreement.

6. Tax Consequences . Some of the federal, California and other states tax consequences relating to this Option, as of the date of this Option, are set forth below. THIS SUMMARY IS NECESSARILY INCOMPLETE, AND THE TAX LAWS AND REGULATIONS ARE SUBJECT TO CHANGE. THE OPTIONEE SHOULD CONSULT A TAX ADVISER BEFORE EXERCISING THIS OPTION OR DISPOSING OF THE SHARES. SPECIAL RULES MAY APPLY IF SALE OF THE OPTIONEE’S SHARES AT A PROFIT MAY SUBJECT THE OPTIONEE TO SUIT UNDER SECTION 16(B) “INSIDER TRADING” RESTRICTIONS AS OF THE TIME THE OPTIONEE EXERCISES THE OPTION.

This Option will be treated for federal income tax purposes as a nonstatutory stock option (“NSO”). The Optionee may incur regular federal income tax and California and other states income tax liabilities upon exercise of a NSO. The Optionee will generally be treated as having received compensation income (taxable at ordinary income tax rates) equal to the excess, if any, of the fair market value of the Exercised Shares on the date of exercise over their aggregate Exercise Price.

By your signature and the signature of the Company’s representative below, you and the Company agree that this Option is granted under and governed by the terms and conditions of the Plan and this Stock Option Agreement. Optionee has reviewed the Plan and this Stock Option Agreement in their entirety, has had an opportunity to obtain the advice of counsel prior to executing this Stock Option Agreement, and fully understands all provisions of the Plan and this Stock Option Agreement. Optionee hereby agrees to accept as binding, conclusive and final all decisions or interpretations of the Administrator upon any questions relating to the Plan and this Stock Option Agreement.


OPTIONEE:	DSP GROUP, INC.

	By:
		(Signature)
Address:	Title:

CONSENT OF SPOUSE

The undersigned spouse of Optionee has read and hereby approves the terms and conditions of the Plan and this Stock Option Agreement. In consideration of the Company’s granting his or her spouse the right to purchase Shares as set forth in the Plan and this Stock Option Agreement, the undersigned hereby agrees to be irrevocably bound by the terms and conditions of the Plan and this Stock Option Agreement and further agrees that any community property interest shall be similarly bound. The undersigned hereby appoints the undersigned’s spouse as attorney-in-fact for the undersigned with respect to any amendment or exercise of rights under the Plan or this Stock Option Agreement.

Spouse of Optionee

EXHIBIT A

DSP GROUP, INC.

1993 DIRECTOR STOCK OPTION PLAN

EXERCISE NOTICE

DSP GROUP, INC.

3120 Scott Boulevard

Santa Clara, CA 95054

Attention: Stock Administration

1. Exercise of Option . Effective as of today, , , the undersigned, (“Purchaser”), hereby elects to purchase ( ) shares (the “Shares”) of the Common Stock of DSP GROUP, INC., a Delaware corporation (the “Company”), under and pursuant to the 1993 Director Stock Option Plan (the “Plan”), and the Stock Option Agreement dated (the “Option Agreement”). The purchase price per share for the Shares shall be ($ ), for an aggregate purchase price of $ , as required by the Option Agreement.

2. Delivery of Payment . Purchaser herewith delivers to the Company the full purchase price for the Shares. I hereby elect to pay the exercise price by the method marked below:

a. Cash

b. Check

c. Same day exercise and sale

3. Broker Instructions. In the event I have elected to exercise options via the same day exercise and sale method, you are hereby authorized to instruct (the “Broker”) to accept the proceeds deriving from the sale of the Shares, and to take the following actions: (i) to deduct from the proceeds of the sale any Company expenses; (ii) to deduct from the proceeds any tax withholding requested by the Company and to request in writing from the Company a statement of the tax amounts to be withheld, if no request has been given by the Company; (iii) to deliver the above amounts so deducted to the Company; and (iv) to deliver the remaining proceeds to me as I shall direct the Broker.

I further acknowledge that I shall bear full liability for the payment of any taxes with respect to the Shares and the sale thereof and will, upon demand, indemnify and defend the Broker and the Company against any amounts which may be owing in this regard.

I further acknowledge that I shall bear sole responsibility for any commissions and fees relating to the performance of these instructions by the Broker or the Company, and any other banking activities and will, upon demand, indemnify and defend the Broker or the Company against any amounts which may be owing in this regard.

4. Representations of Purchaser . Purchaser acknowledges that Purchaser has received, read and understood the Plan and the Option Agreement, and agrees to abide by and be bound by their terms and conditions.

7. Entire Agreement . The Plan and Option Agreement are incorporated herein by reference. This Agreement, the Plan and the Option Agreement constitute the entire agreement of the parties and supersede in their entirety all prior undertakings and agreements of the Company and Purchaser with respect to the subject matter hereof.


Submitted by:	Accepted by:

PURCHASER:	DSP GROUP, INC.:

	By:
(Signature)		(Signature)

		(Print Name and Title)

		3120 Scott Boulevard
		Santa Clara, CA 95054

Exhibit 31.1

CERTIFICATION

I, Eliyahu Ayalon, certify that:

1.	I have reviewed this quarterly report on Form 10-Q of DSP Group, Inc.;

2.	Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.	Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.	The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5.	The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: November 9, 2004

/s/ Eliyahu Ayalon

Eliyahu Ayalon

Chief Executive Officer

Exhibit 31.2

CERTIFICATION

I, Moshe Zelnik, certify that:

1.	I have reviewed this quarterly report on Form 10-Q of DSP Group, Inc.;

2.	Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.	Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.	The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

5.	The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: November 9, 2004

/s/ Moshe Zelnik

Moshe Zelnik

Chief Financial Officer

Exhibit 32.1

CERTIFICATION

In connection with the periodic report of DSP Group, Inc. (the “Company”) on Form 10-Q for the period ended September 30, 2004 as filed with the Securities and Exchange Commission (the “Report”), I, Eliyahu Ayalon, Chief Executive Officer of the Company, hereby certify as of the date hereof, solely for purposes of Title 18, Chapter 63, Section 1350 of the United States Code, that to the best of my knowledge:

(1)

the Report fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934, and

(2)

the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company at the dates and for the periods indicated.

This Certification has not been, and shall not be deemed, “filed” with the Securities and Exchange Commission.

Date: November 9, 2004

/s/ Eliyahu Ayalon

Eliyahu Ayalon

Chief Executive Officer

Exhibit 32.2

CERTIFICATION

In connection with the periodic report of DSP Group, Inc. (the “Company”) on Form 10-Q for the period ended September 30, 2004 as filed with the Securities and Exchange Commission (the “Report”), I, Moshe Zelnik, Chief Financial Officer of the Company, hereby certify as of the date hereof, solely for purposes of Title 18, Chapter 63, Section 1350 of the United States Code, that to the best of my knowledge:

(1)

the Report fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934, and

(2)

the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company at the dates and for the periods indicated.

This Certification has not been, and shall not be deemed, “filed” with the Securities and Exchange Commission.

Date: November 9, 2004

/s/ Moshe Zelnik

Moshe Zelnik

Chief Financial Officer

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents