PART I

Item 1. BUSINESS

Overview

We are a radio frequency (“RF”) semiconductor company providing RF product solutions worldwide to communications equipment companies and service providers. We design, develop and manufacture innovative, high performance products for both current and next generation wireless and wireline networks, and RF identification (“RFID”) systems. Our RF product solutions are comprised of advanced, highly functional RF semiconductors, components and integrated assemblies which address the radio frequency challenges of these various systems. We currently generate the majority of our revenue from our products utilized in wireless and wireline networks. Our revenue from our products used in RF identification systems represents a less significant portion of our current revenue however we believe they represent areas of future growth opportunity. The RF challenge is to create product designs that function within the unique parameters of different wireless system architectures. Our solution is comprised of design expertise, advanced device technology and manufacturability. Our commercial communications products are used by telecommunication and broadband cable equipment manufacturers supporting and facilitating mobile communications, enhanced voice services, data and image transport. Our objective is to be the leading supplier of innovative RF semiconductors products.

We have continued to augment our existing technology base and design capabilities with two recent acquisitions. On January 28, 2005 we completed our acquisition of Telenexus, Inc. (“Telenexus”). We believe the addition of Telenexus’ RFID products and technology will allow us to continue to enhance our RFID reader offerings to further capitalize on market opportunity. On June 18, 2004, we completed our acquisition of the wireless infrastructure business and associated assets from EiC Corporation, a California corporation and EiC Enterprises Limited (together “EiC”). We believe that the addition of EiC’s technical expertise further enhances WJ’s strategy of offering customers what we believe to be industry leading products for the wireless infrastructure market.

WJ Communications, Inc. (formerly Watkins-Johnson Company, “we,” “us,” “our” or the “Company”) was founded in 1957 in Palo Alto, California, and for many years we focused on RF microwave devices for defense electronics and space communications systems. Beginning in the 1990s, we began applying our RF design, semiconductor technology and integration capabilities to address the growing opportunities for commercial communications products. We believe that our history of designing high quality, reliable products and our long-standing relationships with industry-leading customers is an important competitive advantage. We were originally incorporated in California and reincorporated in Delaware in August 2000.

Our principal executive offices are located at 401 River Oaks Parkway, San Jose, California 95134, and our telephone number at that location is (408) 577-6200. Our Internet address is www.wj.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, amendments to those reports and other Securities and Exchange Commission, or SEC, filings are available free of charge through our website as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the SEC. The information contained on our website is not intended to be part of this report. Our common stock is listed on the Nasdaq National Market and traded under the symbol “WJCI”.

Industry Background

Industry overview

We believe several important trends provide long-term growth opportunities for RF technology in markets such as wireless communications, RFID and broadband cable. Market trends that drive the growth in demand for high-performance RF products include:

· Growth in the number of wireless subscribers and an increase in consumer demand for advanced data services. The worldwide wireless communications industry has grown considerably in recent years and continues to grow, with the number of subscribers expected to grow from 1.3 billion in 2003 to 1.7 billion in 2007 according to IDC, representing a 7% compound annual growth rate. At the same time, mobile subscribers are increasingly demanding data services in addition to traditional voice telephony services. To meet this demand, network operators are building new and upgrading existing mobile networks to offer greater network capacity and speed to deliver voice and data services. These next generation wireless networks require new equipment based on more advanced RF technology.

· Potential broad deployment of RFID technology. RFID offers the potential for substantial productivity gains and operational cost savings because it enables real-time knowledge of greater amounts of unique product data than can be delivered by conventional technology, such as product type, date of manufacture, serial number and expiration date. The technology has been successfully used in several applications to date, such as Exxon Mobil’s Speedpass™, and several recent announcements indicate a growing desire of companies to implement RFID technology, including Wal Mart’s public announcement that it’s 100 top suppliers must be RFID compliant in 2005 and a Department of Defense statement that its suppliers must use RFID tags by early 2005. According to Venture Development Corporation, the RFID market is forecasted to grow from $965 million in 2002 to $2.7 billion in 2007, representing a 23% compound annual growth rate. We are targeting the ultra high frequency (“UHF”) reader segment of that market.

· Demand for high performance broadband cable network services. In recent years, many cable network operators have begun to upgrade their network infrastructure to support high-speed data services, a broad selection of digital television channels and voice telephony services. To support these enhanced services, cable network operators are upgrading their network infrastructure with equipment that utilizes high frequency RF technologies.

Network Infrastructure

Consumers and businesses are continually seeking improved connectivity, mobility, functionality, reliability and bandwidth from voice and data networks. Increased deployment and use of wireless communications systems and the rise of cable and wireless Internet applications has also placed additional demands on network infrastructure.

Wireless communications and broadband cable service providers continue to make investments in network infrastructure to expand capacity and offer a broader range of services to support the changing needs of end users while reducing their operating costs. In addition, wireless network operators and service providers have announced their plans for deployment of next generation wireless services and networks, referred to in the industry as 2.5G and 3G networks. These networks will offer subscribers increased speeds, additional application capabilities, and broader compatible coverage across geographies. To meet these objectives, network operators are building new and upgrading existing mobile networks to offer greater network capacity and speed to deliver voice and data services. These next generation wireless networks require new equipment based on more advanced RF semiconductor technology. In broadband cable networks, operators have begun to upgrade their network infrastructure to support high-speed data services,

a broad selection of digital television channels, video-on-demand and voice telephony services. To support these enhanced services, cable network operators are upgrading their network infrastructure with equipment that utilizes high frequency RF technologies.

Original equipment manufacturers (“OEMs”) must develop systems to meet the requirements of communications service providers. In meeting these requirements, OEMs face significant market and product performance pressures including cost reduction, higher performance, greater reliability and shorter time to market. OEMs are adopting new approaches in designing systems to deliver the performance and feature improvements that service providers require. In a typical communications system, the principal functional blocks are the RF subsystem, which receives, amplifies and transmits signals, the signal processor, which encodes and decodes digitized signals, and the antenna. Since the RF subsystem receives the signal, interfaces with the signal processor, and amplifies and transmits the signal, a system’s performance and signal quality are significantly affected by the RF subsystem. Some OEMs do not have the internal resources to address every aspect of a system’s RF performance. To lower their production costs and shorten product development cycles, OEMs are seeking innovative RF components from third-party suppliers. We believe that there is a substantial market opportunity for a third-party supplier of high performance RF components who can meet the needs for flexibility, performance and value required by OEMs.

RF components are generally technically sensitive devices that demand circuit design expertise and sophisticated process technology. A process technology is a method of manufacturing semiconductor devices and circuits using a given wafer material. Many RF component suppliers have made significant investments in their own wafer fabrication facilities (“fabs”) which are typically based on a single process technology. As a result, RF component suppliers with wafer fabs generally focus most of their attention on developing products using their own process technology even if another process may be more appropriate for a given application. To adopt one of these other process technologies, these component suppliers would have to migrate their current facility to the other technologies, make significant capital investments in new wafer fabrication equipment or would have to develop relationships with merchant wafer fabs. Because all of these steps are expensive and time consuming, most RF component suppliers resist changing process technologies. As a result, it is difficult for a single RF component supplier to supply a broad range of products that meet all the requirement of the major OEMs, thus allowing multiple suppliers targeting different segments of the markets.

Radio Frequency Identification (RFID)

Radio frequency identification, or RFID, is a generic term for technologies that use radio waves to automatically identify individual items. In general, the system consists of an RFID tag, which contains the identification of the item tagged, and an RFID reader, which sends out a radio wave signal to read the information contained on the tag. The RFID tag is made up of a microchip with an antenna, and it can be either passive or active. Passive RFID tags contain no internal power source such as a battery. To read a passive RFID tag, the reader sends out electromagnetic waves. Passive RFID tags draw power from these electromagnetic waves and use it to power the microchip’s circuits. The microchip modulates the waves that the tag reflects back to the reader and the reader converts the returned waves into digital data. The digital data is then passed on to a host computer that can make use of the data. Active RFID tags operate more or less in the same manner except that the tags have a battery; this internal power supply in the tag allows for active response to the reader as well as active data manipulation on the tag.

Profitable and effective commercial RFID systems have been in operation for over a decade. The current market is driven by traditional applications such as security/access control, automobile immobilization, toll collection, and transportation. Many other applications are in the early adoption phase, including pallet tracking, point of sale commerce, baggage handling. There are notable obstacles to overcome before significant growth can be seen, including but not limited to, acceptable industry and

application standards, cost, end user education, frequency regulations, power restrictions, the weakness of indirect channel support and the highly fragmented competitive environment.

In addition to a high number of trial applications, there have also been many real implementations across several industries. For example, numerous libraries, labs, hospitals, warehouses, retailers, commercial laundries, and automobile manufacturers implemented RFID for applications such as item, material and asset management. This penetration into vertical industries occurs as a growing number of systems integrators and software companies who serve these industries continue to form relationships with RFID hardware vendors. RFID hardware manufactures are also welcoming service providers who specialize in warehouse management, logistics services, asset management, and industrial automation into their partner programs.

Going forward, the supply chain will begin to drive the RFID market. For example, Wal-Mart Stores Inc. (NYSE: WMT), Gillette Co (NYSE: G) and the United States Department of Defense mandates for their respective suppliers to deliver product RFID tagged at the case and pallet level have helped spur the industry to move beyond experimentation to implementation. We believe that the full Realization of the Transportation Recall Enhancement, Accountability, and Documentation Act mandated by the United States Congress in 2000 could also create opportunity for RFID readers. The next level in the supply chain will be item level tagging leading to the need for a high volume of shelf readers so that real time inventory tracking and shrinkage reduction can be put into place. In our view, the natural evolution for RFID will be into cell phones and other portable devices for point of sale applications.

The RF Challenge

Radio frequency (“RF”) semiconductor technology presents different engineering challenges than standard semiconductor design. In general, digital semiconductors are created from standard semiconductor circuit designs that have predictable performance. This permits an automated design process. Each RF component, however, has distinctly different characteristics that influence overall system performance in complex ways. Instead of having stable inputs and outputs, the RF circuit characteristics can drift based on process variations, temperature, power supply and other variables. As a result, performance characteristics are unique for each device, and the RF engineer must evaluate and develop new designs on a continuous basis for each system performance level and air interface standard. In addition to being skilled in semiconductor circuit design, the RF circuit designer must have a thorough understanding of signal processing principles, must understand the totality of the system for which the device is intended and must be able to create designs that function within the unique parameters of different wireless system architectures.

The knowledge and skills required to design and to manufacture RF semiconductors, components and integrated modules are unique and can take many years to develop. Manufacturers seek companies with the technical skills and engineering resources to design, manufacture and integrate RF semiconductors and the other advanced products required by current and future generations of wireless and cable communications equipment.

The WJ Communications Solution

With the ability to design and manufacture RF semiconductors, components, and integrated RF modules, and interface these assemblies with other network elements, we enable both current and next generation wireless networks, RFID systems and broadband cable worldwide. Our core technology lies within our advanced RF semiconductor designs.

Our RF expertise covers a broad range of frequencies used in advanced communications networks today. Our capabilities are comprised of the following key elements:

· RF Design Expertise. We have been designing RF and microwave products for more than 45 years and have developed significant RF design expertise. Our team of 84 highly qualified and talented engineering and technical employees is capable of applying this expertise to a variety of RF products. These products are optimized to achieve high performance with minimum cost.

· Advanced Device Technology. We have substantial expertise in designing and manufacturing highly linear semiconductor products that amplify and transform signals with minimal distortion and interference.

· Manufacturability. Our ability to rapidly convert new technologies and designs into completed RF semiconductors, integrated assemblies, and highly functional components products results from our flexible manufacturing operations and our manufacturing engineering expertise.

Business Strategy

Our objective is to be the leading supplier of innovative RF semiconductor products. To meet this goal, we intend to:

· Leverage Our Technology Leadership and Our Design and Integration Expertise to Grow with Growing Markets. We intend to target multiple growth markets such as RFID, power amplifiers and WiMAX and expand our addressable market opportunities in wireless communications and broadband cable. We believe that as data throughput requirements expand in wireless networks the ability to meet the RF requirements becomes increasingly important and the market for RF products will grow accordingly. We intend to apply our RF design expertise to develop additional leading-edge products in each of the rapidly growing areas of the communications markets, focusing on the markets for RF semiconductors, modules and components. Due to the commonality of RF requirements in broadband cable and wireless communications networks, we have the flexibility to allocate our design and engineering resources to any or all of these markets and intend to use this flexibility to take advantage of market opportunities as they arise.

· Maintain and Develop Strong Collaborative Customer Relationships with Industry Leaders. We believe our reputation for product quality, technical performance, customer responsiveness, on-time delivery and cost competitiveness will help us to continue to maintain and develop a loyal customer base. We collaborate with many of our customers to design and develop new products for them as they develop new products. We plan to maintain our current, and develop new, customer relationships with industry leaders within wireless and cable communications markets.

· Acquire and Develop New Technologies. We intend to continue to augment our existing technology base and design capabilities by acquiring complementary technologies, design capabilities, manufacturing processes and product offerings for broadband cable applications. In June 2004 we acquired the wireless infrastructure business of EiC Corporation and EiC Enterprises Limited and in January 2005 we acquired Telenexus, Inc. which designs, develops, manufactures and markets RFID reader products for a broad range of industries and markets. In addition, we intend to continue to focus our research and development efforts on emerging communications and RF technologies.

Products and Technology

We are committed to being a leader and innovator of RF products and believe that we are positioned to provide a broad portfolio of RF technology products. Our RF products are comprised primarily of semiconductors including amplifiers, mixers, RF integrated circuits, transistors, chipsets and multi-chip

modules (“MCMs”), and RFID readers and reader modules. Our MCMs integrate multiple RF semiconductors, process technologies and functions in a single package allowing us to significantly reduce cost, power consumption and circuit board space. Our ability to design our semiconductors in multiple process technologies enables us to address a variety of end-markets and applications.

The following table summarizes the sales from our significant product lines:

	Year Ended
	December 31, 2005			December 31, 2004			December 31, 2003
Semiconductor and RFID (RF products)		$	31,201		$	29,808		$	20,246
Wireless Integrated Assemblies and Fiber Optics		396			2,528			6,319
Total		$	31,597		$	32,336		$	26,565

In the second quarter of 2003 we sold our Thin-Film product line, included in Semiconductor and RFID, to M/A-COM, a unit of Tyco Electronics. Our Thin-Film product line contributed $855,000 to our semiconductor sales in 2003. The Wireless Integrated Assemblies and Fiber Optic businesses are at end-of-life, and we expect very modest contribution to sales from Wireless Integrated Assemblies and no contribution from Fiber Optic products.

Semiconductor Products and Process Technologies

Our semiconductor products include a broad array of high performance semiconductors that we manufacture for our own use as well as for sale to others. The primary markets for our semiconductor products are the wireless and broadband cable infrastructure markets.

Our semiconductor products are comprised primarily of amplifiers, mixers, multi-chip modules and transistors. Amplifiers and transistors increase the level of signals while mixers translate a signal from one frequency to another. The strength of our semiconductor technology lies in our ability to design and in the case of our gallium arsenide (“GaAs”) semiconductor products, manufacture highly linear products. High linearity is one of the most critical performance parameters for broadband cable and wireless networks and represents a semiconductors’ ability to amplify and transform signals with minimal distortion and interference.

We have expertise in designing and manufacturing RF components in multiple process technologies. Some of these processes have been built in our own manufacturing operations and in other cases we have our products manufactured for us by an outside foundry.

The following mature processes are running in our wafer fabrication facility. These processes support our current product portfolio in production. These technologies are also used actively in new product design now and will be for the next four to five years .

· Gallium arsenide metal semiconductor field effect transistor (GaAs MESFET)

· Gallium arsenide heterostructure field effect transistor (GaAs HFET)

· Indium gallium phosphide heterojunction bipolar transistor (InGaP HBT)

We also design products with state-of-the-art integrated circuit designs by using processes from outside foundries. Products have been released to market based on technologies from these foundries and more new products are being designed using these foundries. As foundries upgrade their process technologies, we expect that we will continue our design work with the latest process.

· Silicon On Insulator (SOI)

· Integrated combination of silicon-germanium heterostructure bipolar transistor and complementary metal oxide semiconductor (SiGe BiCMOS)

· Silicon complementary metal oxide semiconductor transistor (CMOS),

Finally, there are emerging process technologies that we have identified as being suitable for future amplifier products. These emerging technologies are focused around advanced InGaP HBT processes that will allow us to expand into higher power amplifier products that operate at higher supply voltages. We are in production based on the 12 Volt version of the InGaP HBT process. We are qualifying our 28 Volt InGap HBT process for a series of our new power amplifier products.

RFID Reader Products

Our radio frequency identification (“RFID”) products are primarily UHF RFID readers. During 2003 we began to utilize our core RF design expertise and RF semiconductor integration IP to address the market’s need for low cost RFID readers capable of working in real world environments. In September 2003, we introduced an Auto-ID Center Class 1 EPC compliant reader operating in the 900MHz ISM band achieving significant improvement in reader performance with a substantial reduction in cost and form factor. By the end of 2003 we began production deliveries of this product and have completed development on a Class 1 EPC compliant reader operating in the worldwide 2.4GHz band. During 2004, we introduced our MPR5000 and MPR6000 multi-protocol readers operating in the 900 MHz ISM band in the industry standard PCMCIA form factor. In 2005 we completed our acquisition of Telenexus, Inc. (“Telenexus”). We believe the addition of Telenexus’ RFID products and technology will allow us to continue to enhance our RFID reader offerings to further capitalize on market opportunity. For example, during 2005, we developed the Apollo I four-port fixed reader, a Smart Reader with a Linux based operating system and a thin-client Class 3 reader. Also during 2005, we introduced our MPR7000, a 1.0 Watt PCMCIA Type II RFID Reader Card.

Wireless Communications Integrated Assembly Products

Our wireless integrated assembly products are primarily used in wireless infrastructure equipment, such as cellular base stations, which provide a combination of voice and data services to mobile users. These products include base station RF front ends, diagnostic and support equipment and repeaters. Base station RF front ends consist of filters and frequency converters, and are used in virtually every communications system to translate signals from one frequency to another.

These products have reached the end of their product life cycle and are considered as legacy products which will not be a significant factor in our long term business. Aside from potential and infrequent “life time buys,” our focus will predominantly be repair and maintenance of the existing product base.

Customers

We sell our products principally to our distributor and original equipment manufacturers, including their manufacturing subcontractors. We believe that we have strong relationships with market leaders in all of our target markets. A sample of our revenue-producing customers includes:

Andrew Corporation	LG Electronics, Inc.	Richardson Electronics Ltd.
Celestica	Lucent Technologies, Inc.	Samsung Electronics Co. Ltd.
Ericsson	Motorola	Siemens
Flextronics	Nokia Networks	Symbol Technologies, Inc.
Global Electronics Corporation	Nortel Networks	UNIRF System Co., Ltd.
Huawei Technologies	Powerwave Technologies	Withus Co., Ltd.
Intermec, Inc.	RF Net Co. Ltd.	ZTE Corporation

We depend on a limited number of key customers for a majority of our sales. In 2005, Richardson Electronics, our sole worldwide distributor of our complete line of RF semiconductor products, and Celestica each accounted for more than 10% of our sales and in aggregate accounted for approximately 58% of our sales. In 2004, Richardson Electronics and Celestica each accounted for more than 10% of our sales and in aggregate accounted for approximately 63% of our sales. In 2003, Richardson Electronics and Lucent Technologies each accounted for more than 10% of our sales and in aggregate accounted for approximately 70% of our sales. We expect that our key customers will continue to account for a substantial portion of our sales in 2006 and in the foreseeable future. These customers and their respective contributions to our net revenue have varied and will likely continue to vary from period to period. We typically sell products pursuant to purchase orders that customers can generally cancel or defer on short notice without incurring a significant penalty, and currently do not have agreements with any of our key customers that contain long-term commitments to purchase specified volumes of our products.

Sales, Marketing and Customer Support

· Direct Sales We have a dedicated team of direct sales people who are responsible for maintaining relationships with our key customers and generating new business with both existing and potential customers. We cultivate strong, direct relationships with our key customers through major account teams that are led by our sales professionals and are comprised of engineers and product managers. These teams are designed to address the specific product needs of our key customers.

· Distributor In June 2002, we entered into a sole worldwide distributorship agreement with Richardson Electronics, Ltd., a global provider of engineered products, to resell our products through catalog, e-commerce and direct channels. This agreement expanded our previous relationship and includes provisions for joint marketing and promotional activities such as advertising in trade publications and the planning and execution of technical tours/demonstrations and trade shows, including such expenses as rental of space and/or equipment, travel and posters. We directly compensate vendors for the cost of these specifically identified goods or services or may reimburse Richardson Electronics, Ltd. if they incurred the cost of such specifically identified goods or services on our behalf the value of which is substantiated by invoicing from vendors. Our cost for these activities is recorded in selling and administrative expense as advertising.

· Manufacturer Sales Representatives Our worldwide network of twenty-four independent manufacturer sales representatives is responsible for assisting our direct sales force in calling on potential customers as well as maintaining relationships with non-major accounts.

· Applications Engineering Our products are highly technical and our customers frequently consult with us to select a component for a given application, determine product performance under specified conditions unique to their system, or test a product for new applications. To meet the needs of our customers, we provide support in all stages of the sales process, from concept definition and product selection to post-sale support. These services are provided by our applications engineering organization, which works closely with our sales organization in all pre- and post-sale activities. We intend to continue to invest in expanding our applications engineering organization to assist our customers.

· International Sales Our sales outside the United States were 44%, 35% and 32% of our total sales in 2005, 2004 and 2003, respectively. We believe Asia is one of the fastest growing technology markets. In 2005 we opened our Shenzhen office in China and we recently added a director of Asia Sales and appointed country managers in China and Korea.

Manufacturing

Our facility in Milpitas, California produces some of our gallium arsenide semiconductor products. At the same facility, we also produced our thin-film products until our second quarter of 2003. Considerable manufacturing capacity exists for our gallium arsenide semiconductors. Our gallium arsenide products are packaged in Singapore, The Philippines, Malaysia, and Taiwan at vendor facilities. We utilize external wafer foundries for our SiGe and some of the MESFET and InGap HBT semiconductor products. On March 8, 2006 we announced we had formed a strategic foundry relationship with Global Communication Semiconductors, Inc. to second-source our GaAs and InGaP HBT wafers.

Our San Jose, California facility produces our wireless communications and RFID products. We contract with external surface mount manufacturers for high volume manufacturing, using both turnkey and consignment material arrangements depending on the characteristics of the assembly. We have used a number of capable surface mount manufacturers. Once the surface mount assembly operations are completed, the products are shipped to our facilities for testing and final configuration.

We depend on single or limited source suppliers for the components and materials used in many of our products, including our SiGe processed wafers, 5Volt and 12Volt InGap HBT processed wafers, gallium arsenide wafers, packaging, electronic components and antennas. Although we rely on limited or sole source suppliers for other components and materials, there are typically alternative sources of supply available for them. If in the future we face difficulties obtaining these components and materials from any of our limited or sole source suppliers, we may face a delay in the shipment of products which are manufactured using these components and materials while we identify and qualify an alternative source of supply, if available. As a result of these delays, we may fail to satisfy customer orders and our sales may decline while we look for a suitable alternative supplier.

We are committed to quality of the management systems governing the manufacture of our products and our systems are ISO 9001 (revision 2000) certified. The International Organization for Standardization (“ISO”) is a network of the national standards institutes of 148 countries including the United States of America. The ISO 9000 family of standards is primarily concerned with “quality management,” meaning the systems the organization utilizes to fulfill: the customer’s quality requirements, and applicable regulatory requirements, while aiming to enhance customer satisfaction, and achieve continual improvement of its performance in pursuit of these objectives. The ISO 9001: 2000 is approved as an American National Standard by the American Society for Quality. Our systems are regularly assessed by independent certifying bodies, through routine quality system audits, for adherence to ISO 9001 standards.

Research and Development

Our future success depends on our ability to develop new designs, technologies and product enhancements. We have assembled a core team of experienced engineers and technologists to accomplish these objectives. These employees are involved in advancing our core technologies, as well as applying these core technologies to our product development activities in our target markets. We have made, and will continue to make, a substantial investment in research and development activities. Research and development costs, which are expensed when incurred, were $18.1 million, $17.2 million and $16.9 million for the years 2005, 2004 and 2003, respectively.

Intellectual Property

The protection of our intellectual property is critical to our success. We rely on patent, copyright, trademark and trade secret laws, as well as confidentiality procedures and contractual provisions, to protect our proprietary rights. We believe that one of our competitive strengths is our core competence in engineering, manufacturing and understanding our customers and markets, and we take aggressive steps to protect that knowledge. We have been active in securing patents and entering into non-disclosure and

confidentiality agreements to protect our proprietary technologies and know-how resulting from our ongoing research and development.

We seek patent protection for our unique developments in circuit designs, processes and algorithms. We have 22 United States patents and 16 foreign patents. We currently have a number of patent applications pending in the United States Patent and Trademark Office and throughout the world, including 22 patent applications filed in the United States in 2005. Our existing United States patents will expire between June 2007 and October 2022. We have chosen to pursue foreign patent protection only in selected foreign countries. Our failure to pursue foreign protection in certain countries and the fact that patent rights may be unavailable or limited in some foreign countries could make it easier for our competitors to utilize our intellectual property. We cannot assure you that any patent will be issued as a result of our pending applications or any future applications or that, if issued, these patents will be sufficient to protect our technology. In addition, we cannot assure you that any existing or future United States or foreign patents will not be challenged, invalidated or circumvented, or that any patent granted will provide us with adequate protection or any competitive advantages.

We license various technologies from third parties that we have integrated into our products. We have a non-exclusive, non-transferable, perpetual license to use particular thin-film technology and transferable, non-exclusive, perpetual licenses to use particular gallium arsenide technology, and technology used in the field of commercial, or non-military, RF communications. Although our business does not depend on any of the licenses to a material extent, our failure to maintain these licenses could harm our business.

We generally enter into non-disclosure agreements with our vendors, customers and licensees. Our employees are generally required to enter into agreements providing for the maintenance of confidentiality and the assignment of rights to inventions made by them while in our employ. We generally control access to the distribution of documentation and other information concerning our intellectual property. We also have entered into non-disclosure agreements to protect our confidential information delivered to third parties, in connection with possible strategic partnerships and for other purposes.

We have entered into license agreements in connection with some of our recent business dispositions with respect to some of our intellectual property used in these sold businesses. We cannot assure you that the other parties to these license agreements will honor the terms of the agreements or aggressively prevent the misappropriation or infringement of our intellectual property. Further, under these license agreements, some of our intellectual property may be licensed to one or more of our competitors.

The telecommunications industry is characterized by the vigorous protection and pursuit of intellectual property rights. We cannot assure you that actions alleging infringement by us of third-party intellectual property, misappropriation or misuse by us of third-party trade secrets or the invalidity of the patents held by us will not be asserted or prosecuted against us, or that any assertions of infringement, misappropriation or misuse or prosecutions seeking to establish the invalidity of our patents will not harm our competitive position or reputation or result in significant monetary expenditures.

Employees

We believe that one of our most important assets is our base of well-trained and experienced employees. As of December 31, 2005, we had 204 employees, consisting of:

· 18 executive and administrative employees;

· 21 sales and marketing employees;

· 81 manufacturing, facilities and operations employees; and

· 84 engineering and technical employees.

Our employees have an average of over seven years tenure with us. Many of our engineering and technical staff have been with us for even longer. We believe that many of our engineers, as a result of their tenure and their defense electronics background, are among the most experienced high frequency engineers in the United States. None of our employees is covered by collective bargaining agreements or represented by labor unions, and we have never experienced a work stoppage. We believe our employee relations are good.

Backlog

Our backlog is comprised of standard purchase orders and annual contracts for the delivery of products. For our annual contracts, our major customers provide us with rolling sales forecasts on at least a monthly basis. These forecasts are subject to changes, including changes as a result of changes in market conditions, and could fluctuate significantly from quarter to quarter. At December 31, 2005, our backlog was $6.7 million, compared to $5.3 million at the end of December 31, 2004. We include in our backlog all accepted product purchase orders for which delivery has been specified within 90 days, including orders from distributors. We do not recognize revenue from sales through our distributors until the distributor has sold our product to the end customer. Product orders in our backlog are subject to changes in delivery schedules or quantities or to cancellation at the option of the purchaser without significant penalty. Our backlog may vary significantly from time to time depending upon the level of capacity available to satisfy unfilled orders. Accordingly, although useful for scheduling production, we do not believe that backlog as of any particular date is necessarily indicative of our 2006 results.

Competition

The markets for our products are extremely competitive and are characterized by rapid technological change, new product development, product obsolescence and evolving industry standards. We compete primarily on the basis of product performance and design, reliability, quality, level of integration, delivery, price, customer support, reputation and the availability and breadth of product offerings. In each of the markets we serve, we compete primarily with other suppliers of high performance RF components. We also compete with current and potential communications equipment manufacturers who manufacture RF components internally such as Ericsson, Lucent, Motorola and Nortel Networks. We expect increased competition from existing competitors and from a number of companies that may enter the RF component market, as well as future competition from companies that may offer new or emerging technologies. Some of our competitors are large public companies that have significantly greater financial, technical, marketing and other resources than us. As a result, these competitors may be able to devote greater resources to the development, promotion, sale and support of their products. Furthermore, those of our competitors that have large market capitalization or cash reserves may be better positioned than we are to acquire other companies in order to gain new technologies or products that may displace our product lines. Many of our competitors operate their own fabrication facilities and have longer operating histories and presence in key markets, greater name recognition, larger customer bases and significantly greater financial, sales and marketing, manufacturing, distribution, technical and other resources than we do. As a result, these competitors may be able to adapt more quickly to new or emerging technologies and changes in customer requirements or to devote greater resources to the promotion and sale of their products. Current and potential competitors have established or may establish financial or strategic relationships among themselves or with existing or potential customers, resellers or other third parties. Accordingly, it is possible that new competitors or alliances among competitors could emerge and rapidly acquire significant market share. In addition, competitors may develop technologies that more effectively address our markets with products that offer enhanced features, lower power requirements or lower cost. Increased competition could result in pricing pressures, decreased gross margins and loss of market share and may materially and adversely affect our business, financial condition and results of operations.

Acquisitions

We have completed two acquisitions in connection with the implementation of our business strategy to acquire and develop new and complementary technologies.

On January 28, 2005 we completed our acquisition of Telenexus, Inc. Pursuant to an Agreement and Plan of Merger, dated January 19, 2005, by and between us, WJ Newco, LLC (the “WJ Sub”), Telenexus and Richard J. Swanson, Wilfred K. Lau, David Fried, Kurt Christensen and Mark Sutton. Telenexus was merged with and into the WJ Sub effective on January 29, 2005. The WJ Sub was the survivor in the merger and is our wholly-owned subsidiary. Telenexus designs, develops, manufactures and markets radio frequency identification reader products for a broad range of industries and markets. By virtue of the merger, we purchased through the WJ Sub all of the assets necessary for the conduct of the RFID business of Telenexus, consisting primarily of, and including, but not limited to RFID modules, baseband processing algorithm technology, applications software and realizations of several reader product designs. The consideration we paid on the closing date in connection with the merger consisted of cash in the amount of $3.0 million, which was paid out of our cash reserves on the closing date, and 2,333,333 shares of our common stock valued at $8.2 million at the closing date. Including acquisition costs of $230,000, the aggregate purchase price for the net assets of Telenexus totaled $11.4 million.

On June 18, 2004, we completed our acquisition of the wireless infrastructure business and associated assets from EiC Corporation, a California corporation and EiC Enterprises Limited (together “EiC”). The aggregate purchase price was $13.3 million which included consideration to EiC in the form of payments of cash of $10.0 million and the issuance of 737,000 shares of our common stock valued at $2.5 million, as well as acquisition related costs we incurred of $1.2 million and $152,000 of estimated registration statement related expenses reduced by a $576,000 benefit from the termination settlement of the associated supply agreement with EiC recognized during our quarter ended December 31, 2004.

Compliance with Environmental, Health and Safety Regulations

We are committed to achieving high standards of environmental quality and product safety, and strive to provide a safe and healthy workplace for our employees, contractors and the communities in which we do business. We have developed environmental, health and safety policies for our business, and internal processes focused on minimizing and properly managing any hazardous materials used in our facilities and products.

The manufacture, assembly and testing of our products requires the use of hazardous materials that are subject to a broad array of environmental, health and safety laws and regulations. As we continue to use advanced process technologies, the materials, technologies and products themselves become increasingly complex. Our evaluations of new materials for use in research and development, manufacturing, and assembly and test take into account environmental, health and safety considerations. Many new materials being evaluated for use may be subject to existing or future laws and regulations. Failure to comply with any of the applicable laws or regulations could result in fines, suspension of production, alteration of fabrication and assembly processes, curtailment of operations or sales, and legal liability. Our failure to properly manage the use, transportation, emission, discharge, storage, recycling or disposal of hazardous materials could subject us to future liabilities. Existing or future laws and regulations could require us to procure pollution abatement or remediation equipment, modify product designs, or incur other expenses. In addition, restrictions on the use of certain materials in our facilities or products in the future could have a material adverse effect on our operations. Compliance with these complex laws and regulations, as well as internal voluntary programs, is integrated into our manufacturing and assembly and test processes.

Our former Scotts Valley and Palo Alto sites have significant environmental liabilities for which in July 1999 we entered into and funded fixed price remediation contracts and obtained cost-overrun and

unknown pollution conditions insurance coverage. There can be no assurance that this insurance will be sufficient to cover all liabilities related to these two sites.

The Scotts Valley site is a federal Superfund site. Chlorinated solvent and other contamination was identified at the site in the early 1980s, and by the late 1980s we had installed a groundwater extraction and treatment system. In 1991, we entered into a consent decree with the United States Environmental Protection Agency providing for remediation of the site. In July 1999, we signed a remediation agreement with an environmental consulting firm, ARCADIS Geraghty & Miller. Pursuant to this remediation agreement, we paid $3.0 million in exchange for which ARCADIS agreed to perform the work necessary to assure satisfactory completion of our obligations under the consent decree. The agreement also contains a cost overrun guaranty from ARCADIS up to a total project cost of $15.0 million. In addition, the agreement included procurement of a ten-year, claims-made insurance policy to cover overruns of up to $10.0 million from Reliance Insurance Company, along with a ten-year, claims made $10-million policy to cover various unknown pollution conditions at the site.

The Palo Alto site is a state Superfund site and is within a larger, regional state Superfund site. As with the Scotts Valley site, contamination was discovered in the 1980s, and groundwater extraction and treatment systems have been operating for several years at both the site and the regional site. In July 1999, we entered into a remediation agreement with an environmental consulting firm, SECOR. Pursuant to this remediation agreement, we paid $2.4 million in exchange for which SECOR agreed to perform the work necessary to assure satisfactory completion of our obligations under the applicable remediation orders. The payment included the premium for a 30-year, claims-made insurance policy to cover cost overruns up to $10.0 million from AIG, along with a ten-year claims-made $10.0 million insurance policy to cover various unknown pollution conditions at the site.

With respect to our remaining current or former production facilities, to date either no contamination of significance has been identified or reported to us or the regulatory agency involved has granted closure with respect to the identified contamination. Nevertheless, we may face environmental liabilities related to these sites in the future which could harm our business.

Item 1a. RISK FACTORS

You should carefully consider the risks described below before making an investment decision in our securities. These risk factors are effective as of the date of this Annual Report on Form 10-K and shall be deemed to be modified or superseded to the extent that a statement contained in our future filings modifies or replaces such statement. The forward-looking statements in this Annual Report on Form 10-K involve risks and uncertainties and actual results may differ materially from the results we discuss in the forward-looking statements. If any of the following risks actually occur, our business, financial condition or results of operations could be materially adversely affected. In that case, the trading price of our stock could decline, and you may lose all or part of your investment. The most significant risks and uncertainties known to us that we believe make an investment in our stock speculative or risky are set forth in this section. This section does not include those risks and uncertainties that could apply to any issuer or any offering.

We have a history of losses, we may incur future losses, and if we are unable to achieve profitability our business will suffer and our stock price may decline.

We have not recorded operating income since 1999, our operating losses have been increasing and we may not be able to achieve revenue or earnings growth or obtain sufficient revenue to sustain profitability. In 2005 our sales were $31.6 million and we incurred an operating loss of $22.1 million compared to sales of $32.3 million and an operating loss of $17.3 million for 2004. In addition, our sales for 2003 were $26.6 million and we incurred an operating loss of $16.7 million. Our accumulated deficit was $174.2 million at December 31, 2005.

We expect that reduced end-customer demand will, and other factors could, adversely affect our operating results in the near term, and we anticipate incurring additional losses in the future. Other factors that could negatively impact our results include, but are not limited to:

· production overcapacity in the industry, which could reduce the price of our products adversely affecting our sales and margins;

· rescheduling, reduction or cancellation of significant customer orders, which could cause us to lose sales that we had anticipated;

· any loss of a key customer;

· the ability of our customers to manage their inventories, which if not properly managed could cause our customers to reschedule, reduce or cancel significant orders or return our products; and

· political and economic instability, foreign conflicts involving or the impact of regional and global infectious illnesses (such as outbreaks of SARS and bird flu) in the countries of our vendors, manufacturers, subcontractors and customers, particularly in the countries of China, South Korea, Malaysia and The Philippines.

We may incur losses for the foreseeable future, particularly if our revenues do not increase substantially or if our expenses increase faster than our revenues. In order to return to profitability, we must achieve substantial revenue growth, and we currently face an environment of uncertain demand in the markets our products address.

We operate in the highly cyclical semiconductor industry which has experienced significant fluctuations in demand.

The semiconductor industry is highly cyclical and has historically experienced significant fluctuations in demand for products. The industry has experienced significant downturns, often in connection with, or in anticipation of, maturing product cycles and declines in general economic conditions. These downturns have been characterized by diminished product demand of end-customers, production overcapacity, high

inventory levels and accelerated erosion of average selling prices. We have experienced these conditions in our business in the past and may experience such downturns in the future. Future downturns in the semiconductor industry could seriously impact our revenues and harm our business, financial condition and results of operations.

We depend on Richardson Electronics, Ltd. for distribution of our RF semiconductor products and the loss of this relationship could materially reduce our sales.

Richardson Electronics, Ltd. is the sole worldwide distributor of our complete line of RF semiconductor products. This sole distributor is our largest semiconductor customer, and our sales to Richardson Electronics, Ltd. represent 49%, 56% and 61% of our semiconductor sales (45%, 52% and 47% of total sales) in 2005, 2004 and 2003, respectively. In 2005 our revenue from Richardson Electronics was adversely effected by a change in the application of our revenue recognition policy to when our distributors have sold the product to the end customer which change in application resulted in a $4.0 million revenue deferral in our second quarter of 2005. We cannot assure you that this exclusive relationship will improve sales of our semiconductor products or that it is the most effective method of distribution. If Richardson Electronics, Ltd. fails to successfully market and sell our products, our semiconductor sales could materially decline. Our agreement with this distributor does not require it to purchase our products and is terminable at any time. If this distribution relationship is discontinued, our RF semiconductor sales could decline significantly.

We depend upon a small number of customers that account for a high percentage of our sales and the loss of, or a reduction in orders from, a significant customer could result in a reduction of sales.

We depend on a small number of customers for a majority of our sales. We currently have two customers, Richardson Electronics, Ltd. and Celestica, Inc., which each accounted for more than 10% of our sales and in aggregate accounted for 58% of our sales in 2005. Sales to Richardson Electronics, Ltd. accounted for 45%, 52% and 47% in 2005, 2004 and 2003, respectively. Sales to Celestica accounted for 13% of our sales in 2005 and 12% and 5% in 2004 and 2003, respectively. Sales to Lucent Technologies accounted for 1%, 7% and 23% of our sales in 2005, 2004 and 2003, respectively.

The decrease in our sales to Richardson Electronics, Ltd. during 2005 was related primarily to our change in the application of our revenue recognition policy to when our distributors have sold the product to the end customer which change in application resulted in a $4.0 million revenue deferral in our second quarter of 2005. The increase in our sales to Richardson Electronics, Ltd. during 2004 is primarily related to our new product introductions which have had a greater adoption rate amongst our smaller customers, particularly those in countries outside the United States of America. Both market segments are serviced through the distributor. The increase in our sales to Richardson Electronics, Ltd. during 2003 is primarily related to our entering into a sole worldwide distributorship arrangement with them during mid-2002. The increase in our sales to Celestica during 2005, 2004 and 2003 is related to an increasing business practice of original equipment manufacturers to outsource a greater percentage of their manufacturing. The decrease in our sales to Lucent Technologies represents the decrease in the sales of our wireless integrated assembly products as these products have reached the end of their product life cycle as well as Lucent Technologies outsourcing a greater percentage of their manufacturing.

In addition, most of our sales result from purchase orders or from contracts that can be cancelled on short-term notice. Moreover, it is possible that our customers may develop their own products internally or purchase products from our competitors. Also, events that impact our customers, for example wireless carrier consolidation, can adversely affect our sales. We expect that our key customers will continue to account for a substantial portion of our revenue in 2006. The loss of, or a reduction in orders from, a significant customer for any reason could cause our sales to decrease.

The new markets we are targeting may not grow as forecasted, and we may not be a successful participant in those markets.

Our growth strategy is based in part on our success in penetrating new radio frequency identification (“RFID”) markets. These markets currently are not a material source of revenue for us, and we cannot assure you that our new products will succeed. In addition to the risks generally associated with new product development and introduction, these products are subject to the particular risks described below.

The growth of the RFID market will depend on, among other things, the ability of suppliers to meet size, portability, cost and power consumption objectives, the ability of industry participants to agree on appropriate technology standards and the willingness of end users to invest in the required equipment and information systems. Even if the market does grow as forecasted, our ability to successfully participate in the RFID market will depend upon, among other things, our timely development and marketing of appropriate products, attracting the most advantageous industry partnerships, securing any necessary additional intellectual property and forming customer relationships. Therefore, we may not be a successful participant in these markets.

We may not be able to successfully integrate those businesses we have acquired or may acquire in the future, which could harm our business, financial condition and results of operations.

We acquired the wireless infrastructure business and associated assets of EiC and we acquired Telenexus, Inc. which designs develops manufactures and markets radio frequency identification reader products. We believe these acquisitions complement and expand our product portfolio, and we may continue to acquire businesses in the future as part of our growth strategy. Integrating completed acquisitions into our existing operations involves numerous risks including the following:

· diversion of management’s attention;

· potential loss of key personnel;

· ability of the acquired business to maintain its pre-acquisition revenues and growth rates;

· ability of the acquired business to be financially successful or provide desired results; and

· ability to develop and introduce new products.

We may not be able to successfully integrate our acquisitions which could harm our business, financial condition and results of operations.

Third party intellectual property claims could harm our business.

We occasionally receive communications from third parties alleging infringement of patent and other intellectual property rights. While we are not subject to any current claims that we believe could be material, there can be no assurance that material claims will not arise in the future. While all of our revenue is derived from products containing our proprietary intellectual property, approximately 9% and 5% of our revenue for 2005 and 2004, respectively, is derived from newly developed technologies which could have a higher risk of infringement claims. We intend to vigorously protect our proprietary intellectual property rights with respect to all of our products. However, we cannot assure you that claims can be amicably disposed of, and it is possible that litigation could ensue. Litigation could result in substantial costs to us and diversion of our resources. If we fail to obtain a necessary license or if we do not prevail in patent or other intellectual property litigation, we could be required to discontinue selling the affected products, to seek to develop non-infringing technologies, which may not be feasible, and to pay monetary damages, any of which could harm our business.

Our quarterly operating results may fluctuate significantly. As a result, we may fail to meet the expectations of securities analysts and investors, which could cause our stock price to decline.

Our quarterly revenues and operating results have fluctuated significantly in the past and are expected to vary from quarter to quarter due to a number of the factors described in this “Risk Factors” section and in our public filings, many of which are not within our control. If our operating results do not meet our publicly stated guidance or the expectations of securities analysts or investors, our stock price may decline. For example, in early 2003 and as recently as during our third quarter ended September 26, 2004, we publicly announced revised lowered expectations of financial results for certain periods. Subsequent to such announcements, the trading price of our common stock declined significantly.

As we continue to develop new products utilizing existing and new process technologies, we will likely increase our utilization of third parties for the manufacture of our products.

As we continue to develop new products utilizing existing and new process technologies, we will obtain an increasing portion of our wafer requirements from outside wafer fabrication facilities, known as foundries. There are significant risks associated with our reliance on third-party foundries, including:

· the lack of ensured wafer supply, potential wafer shortages and higher wafer prices;

· limited control over product delivery schedules, quality assurance and control, manufacturing yields and production costs; and

· the unavailability of, or delays in obtaining, access to key fabrication process technologies.

The foundries we use may experience financial difficulties or suffer damage or destruction to their facilities. If these events or any other disruption of wafer fabrication capacity occur, we may not have a second manufacturing source immediately available. We may therefore experience difficulties or delays in securing an adequate supply of our products, which could impair our ability to meet our customers’ needs and have a material adverse effect on our operating results. In the event of these types of delays, we cannot assure you that the required alternate capacity, particularly wafer production capacity, would be available on a timely basis or at all. Even if alternate wafer production capacity is available, we may not be able to obtain it on favorable terms, which could result in a loss of customers. We may be unable to obtain sufficient manufacturing capacity to meet demand, either at our own facilities or through foundry or similar arrangements with others.

In addition, the highly complex and technologically demanding nature of semiconductor manufacturing has caused foundries to experience from time to time lower than anticipated manufacturing yields, particularly in connection with the introduction of new products and the installation and start-up of new process technologies. Lower than anticipated manufacturing yields may affect our ability to fulfill our customers’ demands for our products on a timely and cost-effective basis.

We cannot be certain that we will be able to maintain our good relationships with our existing foundries. In addition, we cannot be certain that we will be able to form relationships with other foundries as favorable as our current ones. Moreover, transferring from our internal fabrication facility or our existing foundries to another foundry, could require a significant amount of time and loss of revenue, and we cannot assure you that we could make a smooth and timely transition. When we choose to use a new foundry, it typically takes several months to complete the qualification process before we can begin shipping products from the new foundry. If foundries are unable or unwilling to continue to supply us with these semiconductor products in required time frames and volumes or at commercially acceptable costs, our business may be harmed.

If we are unable to develop and introduce new semiconductors successfully, and in a cost-effective and timely manner or to achieve market acceptance of our new semiconductors, our operating results would be adversely affected.

The future success of our semiconductor business depends on our ability to develop new semiconductor products for existing and new markets, introduce these products in a cost-effective and timely manner and convince leading equipment manufacturers to select these products for design into their own new products. Our quarterly results in the past have been, and are expected in the future to continue to be, dependent on the introduction of new products and the timely completion and delivery of those products to customers. The development of new semiconductor devices is highly complex, and from time to time we have experienced delays in completing the development and introduction of new products and lower than anticipated manufacturing yields in the early production of such products. Our ability to develop and deliver new semiconductor products successfully will depend on various factors, including our ability to:

· accurately predict market requirements and evolving industry standards;

· accurately define new products;

· timely complete and introduce new product designs;

· timely qualify and obtain industry interoperability certification of our products and the products of our customers into which our products will be incorporated;

· obtain sufficient foundry capacity;

· achieve high manufacturing yields;

· shift our products to smaller geometry process technologies to achieve lower cost and higher levels of design integration; and

· gain market acceptance of our products and our customers’ products.

If we are not able to develop and introduce new products successfully and in a cost-effective and timely manner, our business, financial condition and results of operations would be materially and adversely affected.

Our new semiconductor products generally are incorporated into our customers’ products at the design stage. We often incur significant expenditures for the development of a new product without any assurance that an equipment manufacturer will select our product for design into its own product. The value of our semiconductors largely depends on the commercial success of our customers’ products and the extent to which those products accommodate components manufactured by our competitors. We cannot assure you that we will continue to achieve design wins or that equipment that incorporates our products will be commercially successful.

The amount and timing of revenue from newly designed semiconductors is often uncertain.

We announce from time to time new semiconductor products and design wins for new and existing semiconductors. Achieving a design win with a customer does not create a binding commitment from that customer to purchase our products. Rather, a design win is solely an expression of interest by potential customers to purchase our products and is not supported by binding commitments of any nature. Accordingly, a customer may choose at any time to discontinue using our products in their designs or product development efforts. Even if our products are chosen to be incorporated into our customer’s products, we still may not realize significant revenues from that customer if their products are not commercially successful. A design win may not generate revenue if the customer’s product is rejected by

their end market. Typically, most new products or design wins have very little impact on near-term revenue. It may take well over a year before a new product or design win generates revenue.

Once a manufacturer of communications equipment has designed a supplier’s semiconductor into its products, the manufacturer may be reluctant to change its source of semiconductors due to the significant costs associated with qualifying a new supplier and potentially redesigning its product. Accordingly, our failure to achieve design wins with equipment manufacturers, which have chosen a competitor’s semiconductor, could create barriers to future sales opportunities with these manufacturers.

Our semiconductor products typically have lengthy sales cycles, and we may ultimately be unable to recover our investment in new products.

After we have developed and delivered a semiconductor product to a customer, the customer will usually test and evaluate our product prior to designing its own equipment to incorporate our product. Our customer may need three to six months or longer to test, evaluate and adopt our semiconductors and an additional three to nine months or more to begin volume production of equipment that incorporates our semiconductors. Moreover, in light of the ongoing economic slow down in the telecommunications sector, it may take significantly longer than three to nine months before customers commence volume production of equipment incorporating some of our semiconductors. Due to this lengthy sales cycle, we may experience significant delays from the time we increase our expenses for research and development, sales and marketing efforts and make investments in inventory until the time that we generate revenue from these products. It is possible that we may never generate any revenue from these products after incurring such expenditures. Even if a customer selects our semiconductors to incorporate into its equipment, we have no assurances that the customer will ultimately market and sell its equipment or that such efforts by our customer will be successful. The delays inherent in our lengthy sales cycle increase the risk that a customer will decide to cancel or change its product plans. Such a cancellation or change in plans by a customer could cause us to lose sales that we had anticipated. In addition, our business, financial condition and results of operations could be materially and adversely affected if a significant customer curtails, reduces or delays orders during our sales cycle or chooses not to release equipment that contains our products.

The resources devoted to product research and development and sales and marketing may not generate material revenue for us, and from time to time, we may need to write off excess and obsolete inventory. If we incur significant marketing and inventory expenses in the future that we are not able to recover, and we are not able to compensate for those expenses, our operating results could be adversely affected. In addition, if we sell our products at reduced prices in anticipation of cost reductions and we still have higher cost products in inventory, our operating results would be harmed.

If we are unable to respond to the rapid technological changes taking place in our industry, our existing products could become obsolete and we could face difficulties making future sales.

The markets in which we compete are characterized by rapidly changing technologies, evolving industry standards and frequent improvements in products and services. If the technologies supported by our products become obsolete or fail to gain widespread acceptance, as a result of a change in industry standards or otherwise, we could face difficulties making future sales.

We must continue to make significant investments in research and development to seek to develop product enhancements, new designs and technologies on a cost effective basis. If we are unable to develop and/or gain access to and introduce new products or enhancements in a timely and cost effective manner in response to changing market conditions or customer requirements, or if our new products do not achieve market acceptance, our sales could decline. Additionally, initial lower margins are typically experienced with new products under development.

Our existing and potential customers operate in an intensely competitive environment, and our success will depend on the success of our customers.

The companies in our target markets face an extremely competitive environment. Some of the products we design and sell are customized to work with specific customers’ systems. If the companies with whom we establish business relations are not successful in building their systems, promoting their products, including new revenue-generating services, receiving requisite approvals and accomplishing the many other requirements for the success of their businesses, our growth will be limited. Furthermore, our customers may have difficulty obtaining parts from other suppliers causing these customers to cancel or delay orders for our products. In addition, we have limited ability to foresee the competitive success of our customers and to plan accordingly.

If the wireless communications and broadband cable markets fail to grow, or they decline, our sales may not grow or may decline.

Our future growth depends on the success of the wireless communications and broadband cable markets. The rate at which these markets will grow is difficult to predict. These markets may fail to grow or decline for many reasons, including:

· insufficient consumer demand for wireless products or broadband cable or services;

· the inability of the various communications service providers to access adequate capital to build their networks;

· inefficiency and poor performance of wireless communications or broadband cable services compared to other forms of broadband access; and

· real or perceived security or health risks associated with wireless communications.

If the markets for our products in wireless communications or broadband cable decline, fail to grow, or grow more slowly than we anticipate, the use of our products may be reduced and our sales could suffer.

If we or our outsourced manufacturers fail to accurately forecast component and material requirements, we could incur additional costs or experience product delays.

We use rolling forecasts based on anticipated product orders to determine our component requirements. It is very important that we accurately predict both the demand for our products and the lead times required to obtain the necessary products and/or components and materials. Lead times for components and materials that we, or our outsourced manufacturers, order can vary significantly and depend on factors such as specific supplier requirements, the size of the order, contract terms and current market demand for the components. To the extent that we rely on outsourced manufacturers, many of these factors will be outside of our direct managerial control. For substantial increases in production levels, our outsourced manufacturers and some suppliers may need six months or more lead time. As a result, we may be required to make financial commitments in the form of purchase commitments. We lack visibility into the finished goods inventories of our customers and the end-users. This lack of visibility impacts our ability to accurately forecast our requirements. If we overestimate our component, material and outsourced manufactured requirements, we may have excess inventory, which would increase our costs. An additional risk for potential excess inventory results from our volume purchase commitments with certain material suppliers, which can only be reduced in certain circumstances. Additionally, if we underestimate our component, material, and outsourced manufactured requirements, we may have inadequate inventory, which could interrupt and delay delivery of our products to our customers. Any of these occurrences would negatively impact our sales and profitability. We have incurred, and may in the future incur, charges related to excess and obsolete inventory. These charges amounted to $975,000, $670,000 and $251,000 in 2005, 2004 and 2003, respectively. While these charges may be partially offset by subsequent sales of

previously written-down inventory, there can be no assurance that any such sales will be significant. As we broaden our product lines we must outsource the manufacturing of or purchase a wider variety of components. In addition, new product lines contain a greater degree of uncertainty due to a lack of visibility of customer acceptance and potential competition. Both of these factors will contribute a higher level of inventory risk in our near future.

We depend on, and will likely increase our use of, outsourced manufacturers and single or limited source suppliers which makes us susceptible to shortages or price fluctuations that could adversely affect our operating results.

We currently purchase several key components and materials used in our products from single or limited source suppliers. These products amounted to 15%, 5% and 5% of our revenue in 2005, 2004 and 2003, respectively. Although we do not currently have any suppliers that are material to our business, in the event one of our sole source suppliers or outsourced manufacturers are unable to deliver us products or unwilling to sell us components or materials, it could harm our business. It could take us as long as six to 12 months to replace our single or limited source suppliers and there can be no assurance that we would be successful. Additionally, we or our outsourced manufacturers may fail to obtain required products and components in a timely manner in the future. We may also experience difficulty identifying alternative sources of supply for the components used in our products or products we obtain through outsourcing. We would experience delays if we were required to test and evaluate products of potential alternative suppliers or products we obtain through outsourcing. Furthermore, financial or other difficulties faced by our outsourced manufacturers, or suppliers or significant changes in demand for the components or materials they use in the products and/or supply to us could limit the availability of those products, components or materials to us. Thus far we have not experienced any material delays related to such suppliers, but we cannot assure you that this will continue to be the situation. To the extent that our dependence on outsourcing continues to increase in the future, our corresponding risks will be greater.

We rely on the significant experience and specialized expertise of our senior management in our industry and must retain and attract qualified engineers and other highly skilled personnel in a highly competitive job environment to maintain and grow our business.

Our performance is substantially dependent on the continued services and on the performance of our senior management and our highly qualified team of engineers, who have many years of experience and specialized expertise in our business. We have recently undergone changes in our senior management. Our performance also depends on our ability to retain and motivate our other executive officers and key employees. The loss of the services of any of our executive officers or of a number of our engineers could harm our ability to maintain and build our business. We have no “key man” life insurance policies.

Our future success also depends on our ability to identify, attract, hire, train, retain and motivate highly skilled technical, managerial, sales, marketing and customer service personnel. If we fail to attract, integrate and retain the necessary personnel, our ability to maintain and build our business could suffer significantly. Additionally, California State law can create unique difficulties for a California based company attempting to enforce covenants not to compete with employees, which could be a factor in our future ability to retain key management and employees in a competitive environment.

Our business is subject to the risks of product returns, product liability and product defects.

Products as complex as ours frequently contain undetected errors or defects, especially when first introduced or when new versions are released. The occurrence of errors could result in product returns from and reduced product shipments to our customers. In addition, any failure by our products to properly perform could result in claims against us by our customers. Such failure also could result in the loss of or delay in market acceptance of our products or harm our reputation. Due to the recent introduction of some of our products, we have limited experience with the problems that could arise with these products. If

problems occur or become significant, it could result in a reduction in our revenues and increased costs related to inventory write-offs, warranty claims and other expenses which could have a material and adverse affect on our financial condition.

Our purchase agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims. However, the limitation of liability provision contained in these agreements may not be effective as a result of federal, state or local laws or ordinances or unfavorable judicial decisions in the United States or other countries. Although we maintain $22.0 million of insurance to protect against claims associated with the use of our products, our insurance coverage may not adequately cover all claims asserted against us. In addition, even ultimately unsuccessful claims could result in costly litigation, divert our management’s time and resources and damage our customer relationships.

We use a number of specialized technologies, some of which are patented, to design, develop and manufacture our products. Infringement of our intellectual property rights could hurt our competitive position, harm our reputation and negatively impact our future profitability.

We regard the protection of our copyrights, patents, service marks, trademarks, trade dress and trade secrets as critical to our future success and rely on a combination of copyright, patent, trademark and trade secret law, as well as on confidentiality procedures and contractual provisions, to protect our proprietary rights. We seek patent protection for our unique developments in circuit designs, processes and algorithms. Adequate protection of our intellectual property rights may not be available in every country where our products and services are made available. We intend, as a general policy, to enter into confidentiality and invention assignment agreements with all of our employees and contractors, as well as into nondisclosure agreements with parties with which we conduct business, to limit access to and disclosure of our proprietary information; however, we have not done so on a uniform basis. As a result, we may not have adequate remedies to preserve our trade secrets or prevent third parties from using our technology without authorization. We cannot assure you that all future employees, contractors and business partners will agree to these contracts, or that, even if agreed to, these contractual arrangements or the other steps we have taken to protect our intellectual property will prove sufficient to prevent misappropriation of our technology or to deter independent third-party development of similar technologies. If we are unable to execute these agreements or take other steps to prevent misappropriation of our technology or to deter independent development of similar technologies, our competitive and financial position and reputation could suffer, and we could be forced to make significant expenditures.

We regularly file patent applications with the U.S. Patent and Trademark Office and in selected foreign countries covering particular aspects of our technology and intend to prosecute such applications to the fullest extent of the law. Based upon our assessment of our current and future technology, we may decide to file additional patent applications in the future, and may decide to abandon current patent applications. We cannot assure you that any patent application we have filed or will file will result in an issued patent, or, if patents are issued to us, that such patents will provide us with any competitive advantages and will not be challenged by third parties or invalidated by the U.S. Patent and Trademark Office or foreign patent office. Any failure to protect our existing patents or to secure new patents may limit our ability to protect the intellectual property rights that such patents or patent applications were intended to cover. Furthermore, the patents of others may impair our ability to do business.

We have several registered trademarks and service marks, in the United States and abroad, and are in the process of registering others in the United States. Nevertheless, we cannot assure you that the U.S. Patent and Trademark Office will grant us these registrations. Should we decide to apply to register additional trademarks or service marks in foreign countries, there is no guarantee that we will be able to secure such registrations. The inability to register or decision not to register in certain foreign countries

and adequately protect our trademarks and service marks could harm our competitive position, harm our reputation and negatively impact our future profitability.

We must gain access to improved process technologies.

For our semiconductor products, our future success will depend upon our ability to continue to gain access to new and/or improved process technologies in order to adapt to emerging industry standards or competitive market conditions. In the future, we may be required to transition one or more of our products to process technologies with smaller geometries, other materials or higher speed in order to reduce costs and/or improve product performance. We may not be able to gain access to new process technologies in a timely or affordable manner. In addition, products based on these technologies may not achieve market acceptance.

Due to our relationships with foreign vendors, manufacturers, customers and subcontractors, we are subject to international operational, financial and political risks.

We expect to continue to rely on vendors, manufacturers and subcontractors located in China, Malaysia, Singapore, South Korea, Taiwan and The Philippines. Additionally, we utilize vendors located in such countries in our semiconductor business to source gallium arsenide (“GaAs”) wafers as raw material in our semiconductor fabrication, to fabricate certain products, to assemble certain products and to package the majority of our semiconductor die in plastic or ceramic. Accordingly, we will be subject to risks and challenges such as:

· compliance with a wide variety of foreign laws and regulations:

· changes in laws and regulations relating to the import or export of semiconductor products;

· legal uncertainties regarding taxes, tariffs, quotas, export controls, export licenses and other trade barriers;

· political and economic instability, foreign conflicts involving or the impact of regional and global infectious illnesses (such as outbreaks of SARS and bird flu) in the countries of these vendors, manufacturers and subcontractors causing delays in our ability to obtain our product;

· reduced protection for intellectual property rights in some countries; and

· fluctuations in freight rates and transportation disruptions.

Political and economic instability and changes in governmental regulations in these areas as well as the United States could affect the ability of our overseas vendors to supply materials or services. Any interruption or delay in the supply of our required components, products, materials or services, or our inability to obtain these components, materials, products or services from alternate sources at acceptable prices and within a reasonable amount of time, could impair our ability to meet scheduled product deliveries to our customers and could cause customers to cancel orders.

There are inherent risks associated with sales to our foreign customers.

We sell a significant portion of our product to customers outside of the United States. Sales to customers outside of the United States accounted for approximately 44%, 35% and 32% of our sales in 2005, 2004 and 2003, respectively. We expect that sales to customers outside of the United States will continue to account for a significant portion of our sales. Although all of our foreign sales are denominated in U.S. dollars, such sales are subject to certain risks, including, among others, changes in regulatory requirements, the imposition of tariffs and other trade barriers, the existence of political, legal and economic instability in foreign markets, language and cultural barriers, seasonal reductions in business

activities, our ability to receive timely payment and collect our accounts receivable, currency fluctuations, and potentially adverse tax consequences, which could adversely affect our business and financial results.

We face intense competition, and, if we do not compete effectively in our markets, we will lose sales and have lower margins.

The semiconductor industry is intensely competitive in each of the markets we serve and is characterized by:

· rapidly changing technology;

· swift product obsolescence;

· manufacturing yield problems;

· price erosion; and

· limited supplies of components and materials.

Our end markets are rapidly evolving and intensely competitive, and we expect competition to intensify further in the future. Many of our current and potential competitors have substantially greater technical, financial, marketing, distribution and other resources than we have. Price competition is intense and the market prices and margins of products frequently decline after competitors begin making similar products. A number of our competitors may have greater name recognition and market acceptance of their products and technologies. Furthermore, our competitors, or the competitors of our customers, may develop new technologies, enhancements of existing products or new products that offer superior price or performance features. These new products or technologies could render obsolete our products or the systems of our customers into which our products are integrated. If we fail to successfully compete in our markets, our business and operating results would be materially and adversely affected.

Our growth depends in part on future acquisitions and investments in new businesses, products or technologies that involve numerous risks, including the use of cash and diversion of management’s attention.

As part of our growth plans, we may make acquisitions of and investments in new businesses, products and technologies or we may acquire operations that expand our manufacturing capabilities. If we identify an acquisition candidate, we may not be able to successfully negotiate or finance the acquisition. Even if we are successful, we may not be able to integrate the acquired businesses, products or technologies into our existing business and products. As a result of the rapid pace of technological change, we may misgauge the long-term potential of the acquired business or technology or the acquisition may not be complementary to our existing business. Furthermore, potential acquisitions and investments, whether or not consummated, may divert our management’s attention and require considerable cash outlays at the expense of our existing operations. In addition, to complete future acquisitions, we may issue equity securities, incur debt, assume contingent liabilities or have amortization expenses and write-downs of acquired assets, which could affect our profitability.

Changes in the regulatory and market dynamics environment of the communications industry may reduce the demand for our products.

The deregulation of the telecommunications industry has resulted in an increased number of service providers. Such increase, coupled with the expanding use of the Internet and data networking by businesses and consumers, has resulted in the rapid growth of the communications industry. This has led and will likely continue to lead to intense competition, short product life cycles, and, to some extent, regulatory uncertainty in and outside the United States. The course of the development of the communications industry is difficult to predict. For example, the delays in governmental approval

processes that our customers are subject to, such as the issuance of site permits and the auction of frequency spectrum, have in the past caused, and may in the future cause, the cancellation, postponement or rescheduling of the installation of communications systems by our customers. A reduction in network infrastructure expenditures could negatively affect the sale of our products. Moreover, in the short term, deregulation may result in a delay or a reduction in the procurement cycle because of the general uncertainty involved with the transition period of businesses.

If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results or prevent fraud which could subject us to regulatory sanctions, harm our business and operating results and cause the trading price of our stock to decline.

Effective internal controls required under Section 404 of the Sarbanes-Oxley Act of 2002 are necessary for us to provide reliable financial reports and effectively prevent fraud. If we cannot provide reliable financial reports or prevent fraud, our business, reputation and operating results could be harmed. We have in the past discovered, and may in the future discover, areas of our internal controls that need improvement. For example, a “material weakness” was identified in our quarter ended December 31, 2005, which means that there was “a significant deficiency, or a combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.” The material weakness was in the operating effectiveness of the controls over the determination of excess and obsolete inventory and the related valuation adjustments resulting in an audit adjustment to reduce inventory and increase cost of goods sold. The error occurred in our fourth quarter of 2005 and was corrected in the same period. This material weakness arose from our failure to consider all current business conditions in determining the salability of our current inventory. We cannot be certain that the measures we have taken or intend to take will ensure that we implement and maintain adequate controls over our financial processes and reporting in the future. Any failure to implement required new or improved controls, or difficulties encountered in their implementation, could subject us to regulatory sanctions, harm our business and operating results or cause us to fail to meet our reporting obligations. Inferior internal controls could also harm our reputation and cause investors to lose confidence in our reported financial information, which could have a negative impact on the trading price of our stock.

Our future profitability could suffer from known or unknown liabilities that we retained when we sold parts of our company.

In the recent past, we completed the divestiture of all but our current business. In the transactions in which we sold our other businesses, we generally retained liability arising from events occurring prior to the sale. Some of these liabilities were or have since become known to us, such as the environmental condition of the production facilities we sold. We may have underestimated the scope of these liabilities, and we may become aware of additional liabilities associated with the following in the future:

· ownership of the intellectual property we have sold;

· the potential infringement by our sold businesses of the intellectual property of others;

· the regulatory compliance of our sold defense business;

· export control compliance with respect to our defense products purchased by the United States and foreign governments; and

· product defect claims with respect to products manufactured by our sold businesses before they were sold.

If these and any other unknown liabilities and obligations exceed our expectations and established reserves, our future profitability could suffer and our capital needs could increase.

If we fail to comply with environmental regulations we could be subject to substantial fines, we could be required to suspend production, alter manufacturing processes or cease operations.

Two of our former production facilities at Scotts Valley and Palo Alto have significant environmental liabilities for which we have entered into and funded fixed price remediation agreements and obtained cost-overrun and unknown pollution insurance coverage.

The Scotts Valley site is a federal Superfund site. Chlorinated solvent and other contamination was identified at the site in the early 1980s, and by the late 1980s we had installed a groundwater extraction and treatment system. In 1991, we entered into a consent decree with the United States Environmental Protection Agency providing for remediation of the site. In July 1999, we signed a remediation agreement with an environmental consulting firm, ARCADIS Geraghty & Miller. Pursuant to this remediation agreement, we paid $3.0 million in exchange for which ARCADIS agreed to perform the work necessary to assure satisfactory completion of our obligations under the consent decree. The agreement also contains a cost overrun guaranty from ARCADIS up to a total project cost of $15.0 million. In addition, the agreement included procurement of a ten-year, claims-made insurance policy to cover overruns of up to $10.0 million from American International Specialty, along with a ten-year, claims made $10.0 million policy to cover various unknown pollution conditions at the site.

We cannot assure you that this insurance will be sufficient to cover all liabilities related to these two sites. In addition, we are subject to a variety of federal, state and local governmental regulations relating to the storage, discharge, handling, emission, generation, manufacture and disposal of toxic or other hazardous substances used to manufacture our products. In the past, we have been subject to periodic environmental reviews and audits, which have resulted in minor fines. If we fail to comply with these regulations, substantial fines could be imposed on us, and we could be required to suspend production, alter manufacturing processes or cease operations any of which could have a material negative effect on our sales, income and business operations.

If RF emissions pose a health risk, the demand for our products may decline.

Recent news reports have asserted that some radio frequency emissions from wireless handsets may be linked to various health concerns, including cancer, and may interfere with various electronic medical devices, including hearing aids and pacemakers. If it were determined or perceived that RF emissions from wireless communications equipment create a health risk, the market for our wireless customers’ products and, consequently, the demand for our products could decline significantly.

We may need to raise additional capital in the future through the issuance of additional equity or convertible debt securities or by borrowing money, and additional funds may not be available on terms acceptable to us.

We believe that the cash, cash equivalents and investments on hand, the cash we expect to generate from operations and borrowings under our line of credit will be sufficient to meet our liquidity and capital spending requirements for at least the next twelve months. However, it is possible that we may need to raise additional funds to fund our activities during and/or beyond that time. We could raise these funds by

selling more stock to the public or to selected investors, or by borrowing money. In addition, even though we may not need additional funds, we may still elect to sell additional equity securities or obtain credit facilities for other reasons. We may not be able to obtain additional funds on favorable terms, or at all. If adequate funds are not available, we may be required to curtail our operations significantly or to obtain funds through arrangements with strategic partners or others that may require us to relinquish rights to certain technologies or potential markets. If we raise additional funds by issuing additional equity or convertible debt securities, the ownership percentages of existing stockholders would be reduced. In addition, the equity or debt securities that we issue may have rights, preferences or privileges senior to those of the holders of our common stock.

It is possible that our future capital requirements may vary materially from those now planned. The amount of capital that we will need in the future will depend on many factors, including:

· whether we operate on a positive cash flow basis;

· the market acceptance of our products;

· the levels of promotion and advertising that will be required to launch our products and achieve and maintain a competitive position in the marketplace;

· volume price discounts;

· our business, product, capital expenditure and research and development plans and product and technology roadmaps;

· the levels of inventory and accounts receivable that we maintain;

· capital improvements to new and existing facilities;

· technological advances;

· our competitors’ response to our products; and

· our relationships with suppliers and customers.

In addition, we may require additional capital to accommodate planned growth, hiring, infrastructure and facility needs or to consummate acquisitions of other businesses, products or technologies.

Our facilities are concentrated in an area susceptible to earthquakes.

Our facilities are concentrated in an area where there is a risk of significant earthquake activity. Substantially all of the production equipment that currently accounts for our sales, as well as planned additional production equipment, is or will be located in a known earthquake zone. We cannot predict the extent of the damage that our facilities and equipment would suffer in the event of an earthquake or how such damage would affect our business. We do not maintain earthquake insurance.

Risks Related to Our Stock

Sales of substantial amounts of our common stock by our largest stockholder in connection with shares we have issued in recent acquisitions and others could adversely affect the market price of our common stock.

We are required to register for resale up to 25,492,044 shares of common stock for resale by Fox Paine Capital Fund, L.P., FPC Investors, LP, WJ Coinvestment Fund I, LLC, WJ Coinvestment Fund III, LLC and WJ Coinvestment Fund IV, LLC (together the “FP Entities”) pursuant to an agreement providing for registration rights. The Fox Paine Entities are collectively our largest stockholder. As of December 31, 2005, the Fox Paine Entities beneficially owned 39.2% of our common stock which represents approximately 25.5 million of our 65.0 million outstanding shares of common stock. To date, we

have issued an aggregate of 2,442,882 shares of our common stock in connection with our recent EiC and Telenexus acquisitions of which there are an aggregate of 627,451 shares being held in escrow which will be released if there are no indemnification claims. We may be required to pay further compensation in the EiC acquisition of up to $14.0 million in cash (10%) and shares (90%) if specific revenue and gross margin targets are achieved by March 31, 2005 and March 31, 2006, and in the Telenexus acquisition, up to $2.5 million in cash and 833,333 shares if certain revenue targets are achieved by July 28, 2006. If the targets are attained and we elect to pay in shares of common stock, the number of additional shares issued in connection with these transactions could be significant depending on the average closing price of our stock on Nasdaq during the 10 day period prior to the end of the earnout period. If, for example, the average closing price is $3.50 per share and the full targets are met in 2006, we would be obligated to issue 2,633,333 shares unless we otherwise elect to pay in cash. With respect to the EiC transaction, we have calculated that the revenue and the gross margin targets were not met for the nine month period ending March 31, 2005, which was provided to EiC on May 31, 2005. EiC subsequently notified us that it disagrees with our conclusions that the revenue and gross margin targets were not met for the nine month period ending March 31, 2005. While we believe EiC’s assertions are without merit and we have notified EiC of such, there can be no assurance as to the eventual outcome of this matter. Our stock is not heavily traded and our stock prices can fluctuate significantly. As such, sales of substantial amounts of our common stock into the public market by the Fox Paine Entities, or selling stockholders in connection with the EiC and Telenexus acquisitions or others, or perceptions that significant sales could occur, could adversely affect the market price of our common stock.

Furthermore, future sales of substantial amounts of common stock by our officers, directors and other stockholders, including any sales under a Rule 10b5-1 sales plan, in the public market or otherwise or the awareness that a large number of shares is available for sale, could adversely affect the market price of our common stock. In addition to the adverse effect a price decline would have on holders of our common stock, that decline would impede our ability to raise capital through the issuance of additional shares of common stock or other equity or convertible debt securities.

In addition to the adverse effect a price decline would have on holders of our common stock, a price decline in our common stock could impede our ability to raise capital through the issuance of additional shares of common stock or other equity or convertible debt securities. A price decline in our common stock below the Nasdaq minimum bid requirements due to substantial sales of our common stock could result in our common stock being delisted from the Nasdaq National Market. Delisting could in turn reduce the liquidity of our common stock and inhibit or preclude our ability to raise capital.

If our common stock ceases to be listed for trading on the NASDAQ National Market, it may harm our stock price and make it more difficult to sell shares.

Our common stock is listed on the NASDAQ National Market and their marketplace rules for continued listing require, among other things, that the bid price for our common stock not fall below $1.00 per share for a period of 30 consecutive trading days. In late October 2005 the bid price for our common stock was below $1.00 per share for five consecutive trading days and as recently as April 2003 the bid price for our common stock was been below $1.00 per share for thirty consecutive trading days. Although we have been able to regain compliance in the past, because of the volatility in our common stock price, there can be no assurance that we will be able to maintain compliance in the future. If, in the future, our minimum bid price is again below $1.00 for 30 consecutive trading days, under the current NASDAQ National Market rules we will have a period of 180 days to attain compliance by meeting the minimum bid price requirement for 10 consecutive days during the compliance period.

If our common stock ceases to be listed for trading on the NASDAQ National Market, we expect that our common stock would be traded on the NASD’s Over-the-Counter Bulletin Board (OTC-BB) unless NASDAQ grants an additional grace period for transfer to the NASDAQ Capital Market (formerly known

as the NASDAQ SmallCap Market), which also has a similar $1.00 minimum bid requirement. In addition, our stock could then potentially be subject to the Securities and Exchange Commission’s “penny stock” rules, which place additional disclosure requirements on broker-dealers. These additional disclosure requirements may harm your ability to sell shares if it causes a decline in the ability or willingness of broker-dealers to sell our common stock. We also expect that the level of trading activity of our common stock would decline if it is no longer listed on the NASDAQ National Market or NASDAQ Capital Market. As such, if our common stock ceases to be listed for trading on the NASDAQ National Market or NASDAQ Capital Market for any reason, it may harm our stock price, increase the volatility of our stock price and make it more difficult to sell your shares of our common stock.

On January 10, 2006, we received a letter from the staff of the Listings Qualification Department of the Nasdaq Stock Market, Inc. (“Nasdaq”) dated January 10, 2006, notifying the Company that as a result of the Board of Directors vacancy created by the resignation of Jan Loeber as a director and member of the Company’s Audit Committee on December 31, 2005, the Company does not comply with Nasdaq’s Marketplace Rule 4350(d)(2), which requires the company to have an audit committee of at least three independent directors as defined by Nasdaq’s rules. Consistent with Marketplace Rule 4350(d)(4), the Company has a cure period until the earlier of December 31, 2006 or the Company’s next annual meeting of stockholders to fill the vacancy and regain compliance.

Our largest stockholder has the ability to take action that may adversely affect our business, our stock price and our ability to raise capital.

As of December 31, 2005, Fox Paine & Company, LLC (“Fox Paine”) is the indirect beneficial owner of 39.2% of our outstanding share capital. As a result, Fox Paine has and will continue to have significant influence over the outcome of matters requiring stockholder approval, including:

· election of all our directors and the directors of our subsidiaries;

· amending our charter or by-laws; and

· agreeing to or preventing mergers, consolidations or the sale of all or substantially all our assets or our subsidiaries’ assets.

Fox Paine’s significant ownership interest could also delay, prevent or cause a change in control relating to us which could adversely affect the market price of our common stock.

Fox Paine’s significant ownership interest could also subject us to a class action lawsuit which could result in substantial costs and divert our management’s attention and financial resources from more productive uses. Fox Paine, on September 18, 2002, made a proposal to acquire all of the shares held by unaffiliated stockholders, which was subsequently withdrawn on March 27, 2003. Prior to Fox Paine’s withdrawal of such proposal, four lawsuits, three of which were purported class action lawsuits, were filed against us and Fox Paine in connection with such proposal. Among other things, these lawsuits sought an injunction against the consummation of the proposal and an award of unspecified compensatory damages. These lawsuits were voluntarily dismissed after Fox Paine’s withdrawal of such proposal without any consideration being required to be paid to the plaintiff’s and each party was obligated to bear its own attorney’s fees, costs and expenses. We can make no assurance, however, that Fox Paine will not at some point in the future make another proposal regarding us and, if so, what the terms and outcome of such proposal might be. If Fox Paine were in the future to make a proposal involving us then, depending on the terms of such proposal, the resulting transaction could result in litigation which could adversely affect our business or our stock price.

In addition, Fox Paine receives management fees from us which could influence their decisions regarding us. Under our management agreement with Fox Paine, we are obligated to pay Fox Paine a fee in the amount of 1% of the prior year’s income before interest expense, interest income, income taxes,

depreciation and amortization and equity in earnings (losses) of minority investments, calculated without regard to the fee. Due to our losses incurred, we have not been required to pay management fees to Fox Paine since 2001.

Fox Paine may in the future make significant investments in other communications companies. Some of these companies may be our competitors. Fox Paine and its affiliates are not obligated to advise us of any investment or business opportunities of which they are aware, and they are not restricted or prohibited from competing with us.

The sale of a substantial number of shares of our common stock by Fox Paine or the perception that such sale could occur, could negatively affect the market price of our common stock and could also materially impair our future ability to raise capital through an offering of securities. In addition, the sale of a substantial number of shares of our common stock by Fox Paine could result in the loss of Fox Paine’s services to us as well as the services of members of Fox Paine on our board of directors which could adversely effect our business.

Our stock price is highly volatile.

The market price of our common stock has fluctuated substantially in the past and is likely to continue to be highly volatile and subject to wide fluctuations. Since our initial public offering in August, 2000, through December 31, 2005, our common stock has traded at prices as low as $0.560 and as high as $59.875 per share. These fluctuations have occurred and may continue to occur in response to various factors, many of which we cannot control, including:

· shares sold by the selling stockholders;

· quarter-to-quarter variations in our operating results;

· announcements of technological innovations or new products by our competitors, customers or us;

· general conditions in the semiconductor industry and telecommunications and data communications equipment markets;

· changes in earnings estimates or investment recommendations by analysts;

· changes in investor perceptions; or

· changes in expectations relating to our products, plans and strategic position or those of our competitors or customers.

In addition, the market prices of securities on the NASDAQ National Market and that of our customers and competitors have been especially volatile. This volatility has significantly affected the market prices of securities for reasons frequently unrelated to the operating performance of the specific companies. Accordingly, you may not be able to resell your shares of common stock at or above the price you paid. In the past, companies that have experienced volatility in the market price of their securities have been the subject of securities class action litigation. If we were the object of a securities class action litigation, it could result in substantial losses and divert management’s attention and resources from other matters.

We do not expect to pay any dividends for the foreseeable future.

Although we had cash, cash equivalents and short-term investments of approximately $30.2 million at December 31, 2005, we do not anticipate that we will pay any dividends to holders of our common stock in the foreseeable future. Accordingly, investors must rely on sales of their common stock after price appreciation, which may never occur, as the only way to realize any future gains on their investment. Investors seeking cash dividends should not invest in our common stock.

Item 1b. UNRESOLVED STAFF COMMENTS

Not applicable.

Item 2. PROPERTIES

We have three leased sites: a building in Milpitas, California with over 35,000 square feet, at a base monthly rent of $40,738, two buildings in San Jose, California totaling over 124,000 square feet and leased space in Richardson, Texas for 10,754 square feet, at a base monthly rent of $12,322. The San Jose facility consists of two buildings: a larger building of approximately 82,000 square feet and a smaller building of approximately 42,000 square feet. Both buildings are leased for ten years. The larger building has a base monthly rent of $192,645 as of December 31, 2005, which increases by 4% over each succeeding twelve month period. The smaller building has a base monthly rent of $110,552 as of December 31, 2005 which will also increase by 4% over each succeeding twelve month period. The Fremont facility we acquired as a part of the EiC transaction in June 2004 was shut down during the first quarter of 2005 after we relocated the manufacturing capacity and associated personnel to our facility in Milpitas and completed our obligations under this sublease agreement.

In September 2001, we decided to abandon the smaller building at our San Jose facility based on revised anticipated demand for our products and market conditions and as of December 31, 2005, we have signed three tenants to cover approximately 76% of such excess leased space. In September 2002, we decided to abandon a portion of the larger building at our San Jose facility based on revised anticipated demand for our products and market conditions. This excess space is located on the first floor of our current corporate headquarters and originally housed a portion of our optics and integrated assemblies manufacturing operations. We are actively seeking tenants to occupy the excess leased space.

We believe that our present facilities are in good condition and suitable for our operations. We also believe that we have excess capacity, which more than meets our anticipated requirements for the foreseeable future.

Item 3. LEGAL PROCEEDINGS

We currently are involved in litigation and regulatory proceedings incidental to the conduct of our business and expect that we will be involved in other litigation and regulatory proceedings from time to time. While we currently believe that any adverse outcome of such pending matters will not materially affect our business or financial condition, there can be no assurance that this will ultimately be the case.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matters submitted to a vote of security holders in the fourth quarter of 2005.

PART II

Item 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Price Range of Common Stock

Our common stock is listed on the Nasdaq National Market and traded under the symbol “WJCI”. The following table sets forth, for the periods indicated the high and low sales prices as reported on the Nasdaq National Market for WJ Communications, Inc. common stock.

	High	Low
First Quarter (through March 28, 2004)	7.500	3.100
Second Quarter (through June 27, 2004)	4.540	2.250
Third Quarter (through September 26, 2004)	3.850	2.070
Fourth Quarter (through December 31, 2004)	4.300	1.710
First Quarter (through April 3, 2005)	3.680	2.180
Second Quarter (through July 3, 2005)	2.450	1.680
Third Quarter (through October 2, 2005)	1.870	1.180
Fourth Quarter (through December 31, 2005)	1.950	0.880

As of December 31, 2005, there were approximately 267 stockholders of record of our common stock according to our transfer agent.

Issuer Purchases of Equity Securities

We did not repurchase any shares of our common stock in the fourth quarter of 2005.

Dividend Policy

We did not pay any dividends in 2005 and 2004. We do not intend to pay cash dividends on our common stock for the foreseeable future. Instead, we intend to retain all earnings for use in the operation and expansion of our business. Our board of directors will make any future determination of the payment of dividends based upon various factors then existing, including, but not limited to, our financial condition, operating results and current and anticipated cash needs. In addition, covenants in our revolving credit facility limit our ability to declare and pay cash dividends on our common stock.

Recent Sales of Unregistered Securities

Except as previously reported in our Form 8-K filed with the Securities and Exchange Commission on February 3, 2005 in connection with the Telenexus acquisition, we did not sell any of our securities that were not registered under the Securities Act during 2005.

Equity Compensation Plan Information

Equity Compensation Table. The following table sets forth information as of December 31, 2005, with respect WJ Communication’s equity compensation plans.

Plan Category	Number of Shares of Common Stock to be Issued Upon Exercise of Outstanding Options and Rights			Weighted-Average Exercise Price of Outstanding Options			Number of Shares of Common Stock Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Shares Reflected in the First Column)
Equity Compensation Plans Approved by Stockholders(1)		8,355,559	(2)		$	1.765		4,785,886	(3)
Equity Compensation Plans Not Approved by Stockholders(4)		1,011,200			$	2.779		948,456

(1) The equity compensation plans approved by stockholders are the 2000 Stock Incentive Plan and the amended and restated 2000 Non-Employee Director Stock Compensation Plan.

(2) Of these shares 270,000 options were outstanding under the amended and restated 2000 Non-Employee Director Stock Compensation Plan and 8,085,559 were outstanding under the 2000 Employee Stock Incentive Plan.

(3) Of these shares 4,619,542 shares are available for issuance under the 2000 Stock Incentive Plan and 166,344 shares are available for issuance under the amended and restated 2000 Non-Employee Director Plan.

(4) The equity compensation plan not approved by stockholders is the 2001 Employee Stock Incentive Plan. Key provisions of the plan are:

· The plan was adopted by the board of directors on May 23, 2001 and was effective on that date. The plan will terminate on May 23, 2011, however, awards outstanding at that time will not be affected or impaired by the plan’s termination;

· Participation is limited to our employees or affiliates who are not directors or officers of the Company or any of its affiliates at the time a particular award is made;

· Stock options granted may include incentive stock options, restricted stock, nonqualified stock options and stock appreciation rights or any combination thereof;

· The plan shall be administered by the Board or any committee that has been designated by the board;

· The term of each stock option may in no event be more than 10 years; and

· Upon a change of control transaction as described in the plan, the committee may, in its sole discretion, do one or more of the following;

· shorten the period during which stock options are exercisable, provided they remain exercisable for at least 30 days after the date notice of the shortening is given to the participants;

· accelerate any vesting schedule to which a stock option or restricted stock award is subject;

· arrange to have the surviving or successor entity or any parent entity thereof assume the restricted stock awards and the stock options or grant replacement options with appropriate adjustments in the exercise prices and adjustments in the number and kind of securities issuable upon exercise or adjustments so that the stock options or their replacements represent

the right to purchase the shares of stock, securities or other property, including cash, as may be issuable or payable as a result of the change of control transaction with respect to or in exchange for the number of shares of common stock purchasable and receivable upon exercise of the stock options had such exercise occurred in full prior to the change of control transaction; or

· cancel stock options or unvested stock awards upon payment to the participants in cash, with respect to each stock option or restricted stock award to the extent then exercisable or vested, including, if applicable, any stock options or restricted stock awards as to which the vesting schedule has been accelerated by decision of the compensation committee because of the change of control transaction, of an amount that is the equivalent of the excess of the fair market value of the common stock at the effective time of the change of control transaction over, in the case of stock options, the exercise price of the stock option.

Item 6. SELECTED CONSOLIDATED FINANCIAL DATA

The following selected consolidated financial data should be read in conjunction with the consolidated financial statements and notes thereto and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial data included elsewhere in this report. The statements of operations data for the years ended December 31, 2005, 2004, and 2003 and the selected balance sheet data as of December 31, 2005 and 2004 are derived from our audited consolidated financial statements which are included elsewhere in this annual report on Form 10-K. The statements of operations data for the years ended December 31, 2002 and 2001 and the selected consolidated balance sheet data as of December 31, 2003, 2002 and 2001 are derived from our audited consolidated financial statements which are not included in this annual report on Form 10-K. The historical results are not necessarily indicative of results to be expected for any future period.

	Year Ended December 31,
	2005			2004			2003			2002			2001
	(in thousands, except per share data)
Consolidated Statements of Operations Data:
Sales, net	$	31,597		$	32,336		$	26,565		$	40,156		$	62,220
Cost of goods sold	16,906			15,278			15,495			28,892			58,932
Gross profit	14,691			17,058			11,070			11,264			3,288
Operating expenses:
Research and development	18,070			17,238			16,882			17,882			17,325
Selling and administrative	15,295			12,503			10,251			11,167			14,160
Acquired in-process research and development(1)	3,400			8,500			—			—			—
Recapitalization merger(2)	—			—			680			509			—
Restructuring charges (reversals)(3)	—			(3,845		)	(54		)	34,233			9,797
Total operating expenses	36,765			34,396			27,759			63,791			41,282
Loss from operations	(22,074		)	(17,338		)	(16,689		)	(52,527		)	(37,994		)
Interest income	1,048			682			755			1,218			3,015
Interest expense	(96		)	(104		)	(117		)	(142		)	(238		)
Other income—net	14			5			1,094			16			693
Gain on dispositions of real property(4)	—			—			—			—			325
Loss before income taxes	(21,108		)	(16,755		)	(14,957		)	(51,435		)	(34,199		)
Income tax benefit	120			7,674			647			—			12,528
Net loss	$	(20,988	)	$	(9,081	)	$	(14,310	)	$	(51,435	)	$	(21,671	)
Basic and diluted net loss per share	$	(0.33	)	$	(0.15	)	$	(0.25	)	$	(0.91	)	$	(0.39	)
Shares used to calculate loss from continuing operations per share—basic and diluted	64,162			60,397			56,835			56,291			55,629

	December 31,
	2005		2004		2003		2002		2001
	(in thousands)
Selected Consolidated Balance Sheet Data:
Cash and cash equivalents	$	14,169	$	24,392	$	10,900	$	43,524	$	25,216
Short-term investments	16,052		18,732		49,232		21,221		30,457
Working capital	28,362		46,724		58,748		71,431		84,822
Total assets	61,644		69,733		79,820		95,548		127,016
Total debt	—		—		—		—		—
Capital leases, net of current portion	—		—		14		—		—
Total stockholders’ equity	31,117		41,297		36,239		49,618		99,722

1) During 2005, $3.4 million of the purchase price for the acquisition of Telenexus, Inc. was allocated to acquired in-process research and development expense (“IPRD”).

During 2004, $8.5 million of the purchase price for the acquisition of the wireless infrastructure business and associated assets from EiC was allocated to IPRD.

For further discussion, see Management’s Discussion and Analysis of Financial Condition and the Results of Operations under the caption “Acquired In-process Research and Development Expenses” included elsewhere in this Form 10-K.

2) Our 2003 and 2002 recapitalization merger and other expense is a non-recurring expenditure comprised of expenses incurred by the special committee to our Board of Directors to review a proposal from an affiliate, Fox Paine & Company LLC to acquire all of the shares of the Company’s common stock held by unaffiliated stockholders. In 2003, Fox Paine & Company LLC withdrew its proposal.

3) During the second quarter of 2004, the Company delayed the closure of its internal wafer fabrication facility (“fab”) for a minimum of three months to assess the integration of the EiC acquisition into its existing operations which resulted in an approximate $430,000 reduction in its lease loss accrual. During the third quarter of 2004, the Company decided to not close its fab as the Company believed at that time that integrating the newly acquired fab from EiC with its pre-existing fab will offer the Company certain benefits over outsourcing the pre-existing fab. As such, the Company reversed the remainder of this lease loss accrual of $3.6 million. Also during the third quarter of 2004, the Company revised its lease loss assumptions for its other facilities based on reductions in sublease occupancy rates and current facility costs. As such the Company accrued $161,000 of additional lease loss. During 2003, we revised our lease loss accrual downward for the four month additional operation of our wafer fab and reduced facility costs at our other two abandoned facilities. This credit was largely offset by an additional lease loss accrual for reductions in estimated sublease occupancy and market rates and disposal of our remaining unsold assets held for sale. We also reversed a portion of our severance accrual for one employee slated to be terminated but instead retained for another position. Our 2002 restructuring charge reflects further consolidation and abandonment of leased space and associated impairment of tenant improvements, severance costs, an asset impairment charge and the initiation of a program to sell excess manufacturing equipment resulting from the prolonged downturn in the telecommunications industry, especially related to our fiber optics products. The 2002 restructuring charge also includes an additional charge for the leased facility we abandoned in 2001 based on our downward revised assumptions regarding sublease occupancy rates and market rates due to an overall deteriorating real estate market and difficulties encountered in subleasing the available space. Also during 2002, we recorded a restructuring charge related to our decision in December 2002 to completely outsource our internal wafer fabrication. Our 2001 restructuring charge reflects our decision to abandon a leased facility based on revised anticipated

demand for our products and current market conditions. For further discussion of our restructuring charges, see Note 14 to the consolidated financial statements included elsewhere in this Form 10-K.

4) Our 2001 gain on dispositions of real property is related to the release of escrow funds related to our sale of leasehold interests in our Palo Alto site which was partially offset by residual expenses from the sale of the property.

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND THE RESULTS OF OPERATIONS

Special Notice Regarding Forward-Looking Statements. The following discussion and analysis contains forward-looking statements including financial projections, statements as to the plans and objectives of management for future operations, and statements as to our future economic performance, financial condition or results of operations. These forward-looking statements are not historical facts but rather are based on current expectations, estimates, projections about our industry, our beliefs and our assumptions. Words such as “may,” “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks” and “estimates” and variations of these words and similar expressions are intended to identify forward-looking statements. Our actual results may differ materially from those projected in these forward-looking statements as a result of a number of factors, including, but not limited to, those factors described in “Risk Factors” above. Readers of this report are cautioned not to place undue reliance on these forward-looking statements.

The following discussion should be read in conjunction with our consolidated financial statements and related disclosures included elsewhere in this annual report on Form 10-K. Except for historic actual results reported, the following discussion may contain predictions, estimates and other forward-looking statements that involve a number of risks and uncertainties. See “Special Notice Regarding Forward-looking Statements” above and “Risk Factors” above for a discussion of certain factors that could cause future actual results to differ from those described in the following discussion.

Overview

We are a radio frequency (“RF”) semiconductor company providing RF product solutions worldwide to communications equipment companies and service providers. We design, develop and manufacture innovative, high performance products for both current and next generation wireless and wireline networks, and RF identification systems. Our RF product solutions are comprised of advanced, highly functional RF semiconductors, components and integrated assemblies which address the radio frequency challenges of these various systems. We currently generate the majority of our revenue from our products utilized in wireless and wireline networks. Our revenue from our products used in RFID represents a less significant portion of our current revenue however we believe they represent areas of future growth opportunity. The RF challenge is to create product designs that function within the unique parameters of different wireless system architectures. Our solution is comprised of design expertise, advanced device technology and manufacturability. Our commercial communications products are used by telecommunication and broadband cable equipment manufacturers supporting and facilitating mobile communications, enhanced voice services, data and image transport. Our objective is to be the leading supplier of innovative RF semiconductors products.

WJ Communications, Inc. (formerly Watkins-Johnson Company, “we,” “us,” “our” or the “Company”) was founded in 1957 in Palo Alto, California, and for many years we focused on RF microwave devices for defense electronics and space communications systems. Beginning in the 1990s, we began applying our RF design, semiconductor technology and integration capabilities to address the growing opportunities for commercial communications products. We believe that our track record of designing high quality, reliable products and our long-standing relationships with industry-leading

customers are important competitive advantages. We were originally incorporated in California and reincorporated in Delaware in August 2000.

Our principal executive offices are located at 401 River Oaks Parkway, California 95134, and our telephone number at that location is (408) 577-6200. Our Internet address is www.wj.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, amendments to those reports and other Securities and Exchange Commission, or SEC, filings are available free of charge through our website as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the SEC. The information contained on our website is not intended to be part of this report. Our common stock is listed on the Nasdaq National Market and traded under the symbol “WJCI”.

Acquisitions

We have completed two acquisitions in connection with the implementation of our business strategy to acquire and develop new and complementary technologies.

On January 28, 2005 we completed our acquisition of Telenexus, Inc. (“Telenexus”). Pursuant to an Agreement and Plan of Merger, dated January 19, 2005, by and between us, WJ Newco, LLC (the “WJ Sub”), Telenexus and Richard J. Swanson, Wilfred K. Lau, David Fried, Kurt Christensen and Mark Sutton (the “Shareholders”). Telenexus was merged with and into the WJ Sub effective on January 29, 2005. The WJ Sub was the survivor in the merger and is our wholly-owned subsidiary. Telenexus designs, develops, manufactures and markets radio frequency identification (“RFID”) reader products for a broad range of industries and markets. By virtue of the merger, we purchased through the WJ Sub all of the assets necessary for the conduct of the RFID business of Telenexus, consisting primarily of, and including, but not limited to RFID modules, baseband processing algorithm technology, applications software and realizations of several reader product designs. The consideration we paid on the closing date in connection with the merger consisted of cash in the amount of $3.0 million, which was paid out of our cash reserves on the closing date, and 2,333,333 shares of our common stock valued at $8.2 million at the closing date. Including acquisition costs of $230,000, the aggregate purchase price for the net assets of Telenexus totaled $11.4 million. Of the closing consideration, cash in the amount of $500,000 and 333,333 shares of our common stock are being held in escrow with respect to any indemnification matter under the merger agreement. The outstanding cash balance of the escrow account less any properly noticed unpaid or contested amounts was to be distributed within two days after October 28, 2005. We released the full amount of the cash balance of the escrow account on October 31, 2005. The 333,333 shares in the escrow account less any shares for any properly noticed unpaid or contested amounts will be distributed within five days after July 28, 2006. The fair value of our common stock was determined based on the average closing price per share of our common stock over a 5-day period beginning two trading days before and ending two trading days after the amended terms of the acquisition were agreed to and announced (January 31, 2005). In addition to the closing consideration, the sellers may be entitled to further compensation of up to up to $2.5 million in cash and up to 833,333 shares of our common stock if we achieve certain revenue targets by July 28, 2006. Any change in the fair value of the net assets of Telenexus or any additional consideration to the Shareholders will change the amount of the purchase price allocable to goodwill. The acquisition was accounted for using the purchase method of accounting in accordance with SFAS No. 141, Business Combinations (“SFAS No. 141”).

connection with the acquisition, $1.5 million in cash and 294,118 shares of common stock were held in escrow as security against certain financial contingencies. On March 30, 2005, we made a claim against the escrow account for unpaid invoices issued under the supply agreement. We received those funds on May 4, 2005. The uncontested amount was released to EiC on April 5, 2005 per the escrow agreement and the residual balance of the $1.5 million was released to EiC on May 4, 2005. The 294,118 shares in the escrow account less any shares for any properly noticed unpaid or contested amounts will be distributed within five days after March 31, 2006. On November 23, 2004 we filed a registration statement registering for resale by the seller of up to 442,882 shares of our common stock issued in the acquisition.

In addition to the closing consideration, EiC was originally entitled to further consideration of up to $7.0 million and $7.0 million in cash and shares of our common stock if certain revenue and gross margin targets were achieved by March 31, 2005 and March 31, 2006, respectively. We have determined that the revenue and gross margin targets were not met for the nine month period ending March 31, 2005. EiC subsequently notified us that it disagrees with our conclusion that the revenue and gross margin targets were not met for the nine month period ending March 31, 2005. While we believe EiC’s assertions are without merit and has notified EiC of such, there can be no assurances as to the eventual outcome of this matter.

If we achieve certain revenue targets by March 31, 2006, we will be obligated to pay EiC the remaining contingent consideration of up to $7.0 million, ninety percent (90%) in our common stock and ten percent (10%) in cash. The number of shares of our common stock to be delivered is to be determined by dividing the value in dollars of the portion payable in our common stock by the average closing price of our common stock, as quoted on the NASDAQ National Market, during the ten consecutive trading days ending one trading day before the end of the period covered by the payment, provided, however, that in the event that the calculation of the average closing price results in a price per share for the first payment that would be less than $5.00 or for the second payment that would be less than $6.00, then we, at our option, in our sole discretion, may elect to make the payment part or all in cash and the balance, if any, in shares of our common stock. If EiC receives such consideration, the amounts will be recorded as an increase to goodwill. As of March 20, 2006 we have not yet determined if the revenue targets were met for the year ending March 31, 2006. We will not be able to make our determination until after we have completed our internal control procedures after our quarter end on April 2, 2006. The fair value of our common stock was determined based on the average closing price per share of our common stock over a 5-day period beginning two trading days before and ending two trading days after the amended terms of the acquisition were agreed to and announced (June 21, 2004). The acquisition was accounted for using the purchase method of accounting in accordance with SFAS No. 141, Business Combinations (“SFAS No. 141”).

Sales

We sell our products to a broad group of communications original equipment manufacturers (“OEMs”) and their suppliers and subcontractors. Our major customers provide forecasted demand on at least a monthly basis, which assists us in managing our inventory requirements. These forecasts, however, are subject to changes, including changes as a result of market conditions, and could fluctuate from quarter to quarter.

We depend on a small number of customers for a majority of our sales. Sales to our customers which individually account for more than 10% of our total annual sales were, in aggregate, 58%, 63% and 70% of our sales for the years ended December 31, 2005, 2004 and 2003, respectively. For the identity of our customers who contributed greater than 10% of our total sales for each of the preceding three years and the annual amount of those sales, see Note 16 to the consolidated financial statements included elsewhere in this Form 10-K. We have diversified our customer base over the last few years and intend to further diversify our customer base and product offering in the future. However, we anticipate that we will

continue to sell a majority of our products to a relatively small group of customers. In addition, most of our sales result from purchase orders or contracts that can be cancelled on short-term notice. Delays in manufacturing or supply procurement or other factors, including general market slow downs, have caused and could potentially continue to cause cancellation, reduction or delay in orders by or in shipments to a significant customer. If the markets for our products decline, fail to grow, or grow more slowly than we anticipate, the use of our products may be reduced with a significant negative impact on our sales, earnings, inventory valuations and cash flow.

Revenues from product sales are recognized when all of the following conditions are met: the product has been shipped and title has passed to the customer, we have the right to invoice the customer at a fixed price, the collection of the receivable is reasonably assured and there are no significant obligations remaining. Generally, title passes upon shipment of our products. Certain contracts are under a consignment arrangement under which title to our products does not pass until the customer utilizes these products in its production processes. As a consequence, we recognize revenue on these contracts only when the customer notifies us of product consumption.

We may enter into fixed price development contracts with customers. Revenue under development agreements is recognized when applicable contractual non-refundable milestones have been met, including deliverables, and in any case, does not exceed the amount that would be recognized using the percentage-of-completion accounting method based on the actual physical completion of work performed and the ratio of costs incurred to total estimated costs to complete the contract. Losses on contracts are recognized when determined. Revisions in estimates are reflected in the period in which the conditions become known.

Generally, the selling prices of our products tend to decrease over time as a result of increased volumes or general competitive pressures and in general we expect that prices will continue to decline as a result of volume increases or these competitive pressures.

Cost of Goods Sold

Our cost of goods sold consists primarily of:

· direct material costs of product components;

· production wages, taxes and benefits;

· costs of assembly and test by third party contract manufacturers;

· wafer costs from third-party semiconductor foundries;

· labor contracted on a temporary basis;

· supplies consumed in the manufacturing process;

· depreciation and amortization of manufacturing and test equipment and leasehold improvements;

· lease expense for our manufacturing facilities;

· allocated occupancy costs;

· scrapped material used in the production process; and

· write-downs of excess and obsolete inventory.

We recognize cost of goods sold upon recognition of revenue. We recognize losses on contracts, including purchase order commitments, when identified. We have not recognized any such losses during 2005, 2004 or 2003.

Operating Expenses

Our operating expenses are classified into two general categories: research and development, and selling and administrative. We classify all charges to these two categories based on the nature of the expenditures. Although each of these two categories includes expenses that are unique to the category type, there are commonly recurring expenditures that are typically included in these categories, such as wages, fringe benefit costs, depreciation and allocated overhead.

Research and Development

Research and development expense represents wages, supplies and allocated overhead costs to design, develop and improve products and processes. These costs are expensed as incurred. We generate revenues from development contracts with customers that have enabled us to accelerate our own product development efforts. Such development revenues have only partially funded our product development activities, and we generally retain ownership of the products developed under these arrangements. As a result, we classify all development costs related to these contracts as research and development expenses.

Selling and Administrative

Selling and administrative expense consists primarily of wages, travel and facility costs incurred by and other expenses allocated to our selling and administrative departments. Selling and administrative expense also includes manufacturer representatives and distributor sales commissions, trade show and advertising expenses and fees and expenses of legal, accounting, and other professional consultants.

Recapitalization Merger

In September 2002 we announced the receipt of a proposal from an affiliate, Fox Paine & Company LLC (“Fox Paine”) to acquire all of the shares of the Company’s common stock held by unaffiliated stockholders (the “Acquisition Proposal”). On March 27, 2003, Fox Paine withdrew its Acquisition Proposal. Our 2003 recapitalization merger and other expense is a non-recurring expenditure comprised of expenses incurred by the special committee to our Board of Directors to review the proposal from an affiliate, Fox Paine & Company LLC to acquire all of the shares of our common stock held by unaffiliated stockholders for $1.10 per share in cash. These expenses include legal and financial consulting fees as well as compensation to the members of the special committee.

Restructuring Charge

Our 2001 restructuring charge reflects our decision to abandon a leased facility based on revised anticipated demand for our products and current market conditions. It is comprised of future lease payments net of anticipated sublease income, broker commissions and other facility costs, and an asset impairment charge on tenant improvements. In determining this estimate, we have made certain assumptions with regards to our ability to sublease the space and have reflected off-setting assumed sublease income in line with our best estimate based on the current market conditions. Our 2002 restructuring charge reflects further consolidation and abandonment of leased space and associated impairment of tenant improvements, severance costs, an asset impairment charge and the initiation of a program to sell excess manufacturing equipment resulting from the prolonged downturn in the telecommunications industry, especially related to our fiber optics products. The 2002 restructuring charge also includes an additional charge for the leased facility we abandoned in 2001 based on our downward revised assumptions regarding sublease occupancy rates and market rates due to an overall deteriorating real estate market and difficulties encountered in subleasing the available space. Also during 2002, we recorded a restructuring charge related to our decision in December 2002 to completely outsource our internal wafer fabrication (“fab”) within one year. As a result of the planned fab closure, we accrued

associated severance expenses, accrued the eventual abandonment of additional excess space for which we will have a remaining two year commitment and recorded an impairment on our internal wafer fabrication equipment and related leasehold improvements. During 2003, we revised our lease loss accrual downward for the four month additional operation of our wafer fab and reduced facility costs at our other two abandoned facilities. This reversal was largely offset by an additional lease loss accrual for reductions in estimated sublease occupancy and market rates and disposal of our remaining unsold assets held for sale. We also reversed a portion of our severance accrual for one employee slated to be terminated but instead retained for another position. During 2004, we reversed the lease loss associated with our fab and remaining severance accrual due to our assessment and subsequent decision to not close our fab as we believed at that time that integrating the newly acquired fab from EiC with our pre-existing fab will offer the Company certain benefits over outsourcing the pre-existing fab. This reversal was partially offset by a net increase in the lease loss accrual for our other leased facilities based on reductions in sublease occupancy rates and a net increase in facility operating costs.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On a continuous basis, we evaluate all our significant estimates including those related to doubtful accounts receivable, inventory valuation, impairment of long-lived assets, income taxes, restructuring including accruals for abandoned lease properties, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstance, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions and such differences could be material.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. See Note 2 to the consolidated financial statements included elsewhere in this Form 10-K for a detailed discussion of all our significant accounting policies.

Business Combinations

We allocate the purchase price of acquired companies to the tangible and intangible assets acquired and in-process research and development based on their estimated fair values. Such valuations require management to make significant estimations and assumptions, especially with respect to intangible assets.

Critical estimates in valuing certain intangible assets include but are not limited to: future expected cash flows from acquired developed technologies and patents, expected costs to develop the in-process research and development into commercially viable products and estimating cash flows from the projects when completed, customer contracts, customer lists, distribution agreements, also the brand awareness and the market position of the acquired products and assumptions about the period of time the brand will continue to be used in the combined company’s product portfolio. Management’s estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable.

Revenue Recognition

We recognize revenue in accordance with SEC Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition.” This SAB requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed or determinable; and (4) collectibility is reasonably assured. Determination of criteria (3) and (4) are based on management’s judgments regarding the fixed nature of the fee charged for products delivered and the collectibility of those fees.

Effective for our second quarter ended July 3, 2005, we changed the application of our revenue recognition policy regarding our distributors. We had previously recognized revenue upon shipment to our distributors less estimated reserves for distributor right of return, authorized price reductions for specific end-customer sales opportunities and price protection based on known events and historical trends. Effective for our second quarter ended July 3, 2005, we recognize revenue from our distribution channels when our distributors have sold the product to the end customer. Historically, we have received stock rotation requests from our distributors that were within the amounts estimated and contractually allowed with only one exception of an insignificant amount. However, the request for stock rotation during our second quarter ended July 3, 2005 was higher than the amount contractually allowed. Our management, with the concurrence of our Audit Committee, believes the increasing percentage of new products introduced by us makes it likely that stock rotation reserves will continue to be difficult to estimate based on historical patterns and contractual provisions. Based on this change in facts and circumstances and our management’s future expectations, we believe that we can no longer reasonably estimate the amount of future returns from our distributors as of July 3, 2005. Accordingly, recognition of revenue and associated cost of sales on shipments to distributors is deferred until the resale to the end customer. This change in application resulted in a $4.1 million revenue deferral in our second quarter of 2005. Although revenue is deferred until resale, title of products sold to distributors transfers upon shipment. Accordingly, shipments to distributors are reflected in the consolidated balance sheets as accounts receivable and a reduction of inventories at the time of shipment. Deferred revenue and the corresponding cost of sales on shipments to distributors are reflected in the consolidated balance sheet on a net basis as “Deferred margin on distributor inventory.” For further discussion, see Note 3 to the consolidated financial statements included elsewhere in this Form 10-K.

Through the quarter ended April 3, 2005, revenues from our distributors were recognized upon shipment based on the following factors: our sales price is fixed or determinable by contract at the time of shipment, payment terms are fixed at shipment and are consistent with terms granted to other customers, the distributor has full risk of physical loss, the distributor has separate economic substance, we have no obligation with respect to the resale of the distributor’s inventory, and we believed we could reasonably estimate the potential returns from our distributor based on their history and our visibility in the distributor’s success with its products and into the market place in general. In accordance with Financial Accounting Standards Board (“FASB”) Statement No. 48 “Revenue Recognition When Right of Return Exists”, we accrued a reserve based on our reasonable estimate of future returns based on historical trends and contractual limitations. Per contractual agreement, the distributor may return product three times per year under the following conditions: the total value of inventory returned shall not exceed an amount equal to 5% of the total value of the distributor’s stock on hand of our products as reported in the prior month’s inventory report, the inventory is returned no earlier than 6 months and no later than 24 months from the date of the original invoice date and the product’s packaging has not been opened or any alteration or modification has been performed on the part. Due to our change in application of our revenue recognition policy regarding our distributors, we no longer accrue a distributor stock rotation reserve. As of December 31, 2004 and 2003, our distributor stock rotation reserve was $338,000 and $196,000, respectively.

Beginning in September 2003, we entered into a program where the distributor would receive a credit if it sold specific product at a reduced price to specific end-customers pre-authorized by us. We maintain a log of all such pre-authorized price reductions which we accrue as a reduction to revenue in the period that the pre-authorization occurs per issue 4 of EITF 01-9 “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products).” As of December 31, 2005, 2004 and 2003, our Ship & Debit Allowance was $34,000, $5,000, and $29,000, respectively.

If we reduce the prices of our products as negotiated with the distributor, the distributor may receive a credit for the difference between the price paid by the distributor and the reduced price on applicable unsold products remaining in the distributor’s inventory on the effective date of the price reduction assuming that inventory is less than 24 months old as determined by the original invoice date. When we recognized revenue upon shipment to our distributors, we reserved for distributor price protection per issue 4 of EITF 01-9 based on specific identification of our initiated price reductions and the associated reported distributor inventory. There were no such price reductions in 2005, 2004 or 2003.

We may enter into contracts to perform research and development for others meeting the requirements of Statement of Financial Accounting Standards No. 68 “Research and Development Arrangements”. Revenue under these development agreements is recognized when applicable contractual non-refundable milestones have been met, including deliverables, and in any case, does not exceed the amount that would be recognized using the percentage-of-completion accounting method based on the actual physical completion of work performed and the ratio of costs incurred to total estimated costs to complete the contract in accordance with Accounting Research Bulletin 45 “Long-Term Construction Type Contracts” using the relevant guidance in the American Institute of Certified Public Accountants Statement of Position (“SOP”) 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. Given the duration and nature of these development contracts, we believe that recognizing revenue under the percentage completion method best represents the legal and economic results of contract performance on a timely basis. Losses on contracts are recognized when determined. Revisions in estimates are reflected in the period in which the conditions become known. These development contracts with customers have enabled us to accelerate our own product development efforts. Such development revenues have only partially funded our product development activities, and we generally retain ownership of the products developed under these arrangements. As a result, we classify all development costs related to these contracts as research and development expenses. The achievement of contractual milestones is evidenced by written documentation provided by the customer in accordance with the applicable terms and conditions of each contract. In any period, progress on the contract is based on input measures (direct labor dollars, direct material costs and direct outside processing costs) in the ratio of costs incurred to total estimated costs. Estimated costs to complete are provided by engineering personnel directly involved in the development program and are reviewed by management and finance personnel for reasonableness given the known facts and circumstances. A number of internal and external factors can affect our estimates, including labor rates, utilization and efficiency variances and specification and testing requirement changes. If different conditions were to prevail such that accurate estimates could not be made, then the use of the completed contract method would be required and the recognition of all revenue and costs would be deferred until the project was completed. Such a change could have a material impact on our results of operations. If we bill the customer prior to performing services under the development agreement, the amounts are recorded as deferred revenue. We recorded revenue of $832,000 under development agreements in 2005. We have no deferred revenue at December 31, 2005. No comparable amounts were included in 2004 or 2003.

Write-down of Excess and Obsolete Inventory

We write down our inventory for estimated obsolete or unmarketable inventory for the difference between the cost of inventory and the estimated market value based upon assumptions about future

demand and market conditions. Management specifically identifies obsolete products and analyzes historical usage, forecasted production generally based on a rolling twelve month demand forecast, current economic trends and historical write-offs when evaluating the valuation of our inventory. Due to rapidly changing customer forecasts and orders, additional write-downs of excess or obsolete inventory, while not currently expected, could be required in the future. In addition, the sale of previously written down inventory could result from significant unforeseen increases in customer demand.

Valuation of Intangible Assets and Goodwill

We periodically evaluate our intangible assets and goodwill in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” for indications of impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Intangible assets include goodwill and purchased technology. Factors we consider important that could trigger an impairment review include significant under-performance relative to historical or projected future operating results, significant changes in the manner of our use of the acquired assets or the strategy for our overall business, or significant negative industry or economic trends. If these criteria indicate that the value of the intangible asset may be impaired, an evaluation of the recoverability of the net carrying value of the asset over its remaining useful life is made. If this evaluation indicates that the intangible asset is not recoverable, the net carrying value of the related intangible asset will be reduced to fair value, and the remaining amortization period may be adjusted. Any such impairment charge could be significant and could have a material adverse effect on our reported financial statements if and when an impairment charge is recorded. If an impairment charge is recognized, the amortization related to intangible assets would decrease during the remainder of the fiscal year.

Income Taxes

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 5 “Accounting for Contingencies” we have established reserves for income tax contingencies. These reserves relate to various tax years subject to audit by tax authorities including our tax filings for 1996 to 2000. The reserves represent our best estimate of the probable amount for our liability of income taxes, interest and penalties. The actual liability could differ significantly from the amount of the reserve, which could have a material effect on our results of operations. The tax benefit for the year ended December 31, 2004 of $7.7 million resulted from a revision of our estimated income tax contingency liability due to our receipt of the final assessment from the Internal Revenue Service related to the audit of the Company’s 1996 through 2000 tax returns.

In addition, as part of the process of preparing our consolidated financial statements, we are required to estimate our income tax provision (benefit) in each of the jurisdictions in which we operate. This process involves us estimating our current income tax provision (benefit) together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet.

We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of our net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should we determine that we would not be able to realize all or part of our net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.

Restructuring

During fiscal 2002 and 2001, we recorded significant restructuring charges representing the direct costs of exiting certain product lines or businesses and the costs of downsizing our business. Such charges were established in accordance with Emerging Issues Task Force Issue 94-3 (“EITF 94-3”) “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)” and Staff Accounting Bulletin No. 100, “Restructuring and Impairment Charges.” These charges include abandoned leased properties comprised of future lease payments net of anticipated sublease income, broker commissions and other facility costs, and asset impairment charges on tenant improvements deemed no longer realizable. In determining these estimates, we make certain assumptions with regards to our ability to sublease the space and reflect offsetting assumed sublease income in line with our best estimate of current market conditions. Should there be a further significant change in market conditions, the ultimate losses on these could be higher and such amount could be material. During 2002, we recorded restructuring charges of $27.9 million related to restructuring activities initiated in 2002 and also recorded additional charges of $6.3 million related to restructuring activities initiated in 2001, primarily due to changes in estimated sublease income. During 2003, we revised our lease loss accrual downward for an estimated four months of additional operation of our wafer fab and reduced facility costs at our other two abandoned facilities. This reversal was largely offset by an additional lease loss accrual for reductions in estimated sublease occupancy and market rates. During 2004, we recorded a reversal of $4.0 million related to our assessment and subsequent decision to not close our internal wafer fabrication facility (“fab”) as we believed at that time that integrating the newly acquired fab from EiC with our pre-existing fab will offer the Company certain benefits over outsourcing the pre-existing fab. As such, we reversed $3.9 million of our lease loss accrual and $85,000 of our severance accrual. This credit was partially offset by an additional $161,000 lease loss accrual as we revised our lease loss assumptions for our facilities based on reductions in sublease occupancy rates and a net increase in facility operating costs.

The leased property abandonments have resulted in an average per year benefit of $3.1 million in reduced lease expense and $677,000 in reduced amortization of leasehold improvements which will continue through 2010. The leased property abandonments had no effect on our future cash flows. The collective asset impairments have resulted in an average per year benefit of $2.6 million in reduced depreciation expense of manufacturing equipment which will continue through 2007. The equipment deemed excess in 2002 was ultimately sold for $1.8 million. Otherwise, the asset impairments had no effect on our future cash flows. The workforce reductions have resulted in reduced wages and benefits of $2.7 million per year with a corresponding reduction in cash flows. In total the restructuring plans have benefited our results of operations on average as follows since 2002: $5.7 million reduction in cost of goods sold, $1.1 million reduction in research and development expense and $2.4 million reduction in selling and administrative expense. Except for changes in the sublease estimates noted above, actual results to date have been consistent, in all material respects, with our assumptions at the time of the restructuring charge.

Impairment of Long-Lived Assets

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we review long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Factors we consider that could trigger an impairment review include the following: significant underperformance relative to expected historical or projected future operating results; significant changes in the manner of our use of the acquired assets or the strategy for our overall business; significant negative industry or economic trends; or significant technological changes, which would render equipment and manufacturing processes obsolete. Recoverability of assets to be held and used is measured by a

comparison of the carrying amount of these assets to future undiscounted cash flows expected to be generated by these assets. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets.

Significant management judgment is required in the forecasting of future operating results which are used in the preparation of projected cash flows and should different conditions prevail, material write downs of our long-lived assets could occur.

Current Operations

The following table sets forth certain statements of operations data expressed as a percentage of sales for the periods indicated. As a result of our new products, changing market conditions and other factors, the historical percentages and comparisons set forth below may not reflect our expected future operations.

	Percentage of Sales
	Year Ended December 31,
	2005		2004		2003
Consolidated Statements of Operations Data:
Sales, net	100.0	%	100.0	%	100.0	%
Cost of goods sold	53.5		47.2		58.3
Gross profit	46.5		52.8		41.7
Operating expenses:
Research and development	57.2		53.3		63.5
Selling and administrative	48.4		38.7		38.6
Acquired in-process research & development	10.7		26.3		—
Recapitalization merger and other	—		—		2.6
Restructuring charge (reversals)	—		(11.9	)	(0.2	)
Total operating expenses	116.3		106.4		104.5
Loss from operations	(69.8	)	(53.6	)	(62.8	)
Interest income	3.3		2.1		2.8
Interest expense	(0.3	)	(0.3	)	(0.4	)
Other income—net	—		—		4.1
Loss before income taxes	(66.8	)	(51.8	)	(56.3	)
Income tax benefit	.4		23.7		2.4
Net loss	(66.4	)%	(28.1	)%	(53.9	)%

Comparison of Years Ended December 31, 2005, 2004 and 2003

Sales—We recognized $31.6 million, $32.3 million and $26.6 million in sales for the fiscal years ended December 31, 2005, 2004 and 2003, respectively. The increase in sales both periods reflects the increase in our semiconductor and radio frequency identification (“RFID”) sales mitigated by the declines in our wireless integrated assembly and fiber optic sales reflecting our strategic decision to focus our competitive advantage and dedicate our resources to the radio frequency (“RF”) semiconductor market.

Semiconductor and RFID sales during 2005 were $31.2 million, representing 99% of total sales which was a $1.4 million or 5% increase in comparison to the comparable 2004’s sales of $29.8 million (92% of total sales). Semiconductor and RFID sales during 2004 increased $9.6 million or 47% in comparison to 2003 sales of $20.2 million (76% of total sales). The increase in our semiconductor and RFID sales during 2005 primarily related to our increasing sales in Asia (particularly China, which increased 29% and Korea, which increased 196%), our expanded product offering due to our acquisition of the wireless infrastructure business from EiC Corporation (representing $3.8 million of our semiconductor and RFID sales in 2005 compared to $3.4 million in 2004 after the acquisition in June 2004) and an increase in our expanded

RFID product offering due to our acquisition of Telenexus representing $1.2 million of our sales in 2005. During 2005, we have experienced an approximate 4% decrease in the average selling price of our semiconductor products due to competitive pressure. The increase in our 2005 sales was partially offset by a change in the application of our revenue recognition policy from revenue recognition upon shipment to our distributors to revenue recognition when our distributors have sold the product to the end customer as discussed above under “Critical Accounting Policies and Estimates”.

This change in application resulted in a $4.1 million revenue deferral in our second quarter of 2005 which is reflected in year ended December 31, 2005. For further discussion, see Note 3 to the consolidated financial statements included elsewhere in this Form 10-K. The increase in our semiconductor and RFID sales during 2004 related to an increase in the volume of products sold due, in part, to our introduction of over 60 new products (including our MPR family of PCMCIA form factor UHF RFID readers and our power amplifier modules for PAS/PHS telecommunication networks in China), our expanded product offering due to our acquisition of the wireless infrastructure business from EiC Corporation (representing $3.4 million of our semiconductor and RFID sales in 2004) and our increasing sales in the United States (16% increase in 2004) and Asia (particularly China, which increased 106% in 2004). During 2004 our average selling price of our semiconductor products increased by approximately 9% due to new product introductions. Also in 2004, approximately $661,000 of our semiconductor and RFID sales resulted from sales of product to EiC under a supply agreement we entered into with them as part our acquisition of their wireless infrastructure business and associated assets. This supply agreement was substantially completed by December 31, 2004 and there will be no significant sales from these products in future periods. In 2003, approximately $855,000 of our semiconductor and RFID sales resulted from sales of our Thin-Film products. In May 2003 we sold our Thin-Film product line to M/A COM (a unit of Tyco Electronics).

Wireless integrated assembly and fiber optic sales for 2004 totaled $2.5 million, representing 8% of total sales and a decrease of $3.8 million or 60% from sales of $6.3 million (24% of total sales) in 2003. As these products have reached the end of their product life cycle, they only represented $396,000 of our sales in 2005. Lucent Technologies was the major customer for our wireless integrated assembly products. During 2003, they decided to design the next generation of this type of product themselves and build it through the use of contract manufacturers. During our third quarter ended September 28, 2003, they notified us that they would no longer purchase significant quantities of these products and might only purchase moderate quantities for their customers who may need to expand or maintain older telecommunications networks. The decline in our wireless integrated assembly sales over the last two years contributed to the decline in our sales to Europe. As these products have reached the end of their product life cycle, they will not be a significant factor in our long term business. Aside from potential and infrequent “life time buys,” our focus will predominantly be supporting the existing product base.

Based on the current business trends in the target markets our products address, we believe that our revenue for our first quarter of 2006 will be in the range of $11.5 to $12.0 million equalling or showing a slight increase from our recently completed fourth quarter. Based on the same trends, we currently believe that our revenue will be in the range of $44.0 to $46.0 million for 2006.

Cost of Goods Sold—Our cost of goods sold for 2005 was $16.9 million, an increase of $1.6 million or 11% as compared with cost of goods sold of $15.3 million in 2004. Our cost of goods sold for 2004 decreased by $217,000 or 1% as compared with cost of goods sold of $15.5 million in 2003. As a percentage of sales, our cost of goods sold increased to 54% in 2005 from 47% in 2004 which decreased from 58% in 2003. The 2005 increase in our cost of goods sold as a percentage of sales and in absolute dollars reflects an increased percentage of newer products in our product sales mix which have not yet achieved the volumes or yields of our more mature products. This decrease in our cost of goods sold as a percentage of sales in 2004 reflects the change in our product sales mix to a greater percentage of higher margin semiconductor products from relatively lower margin wireless assembly products. This reduction in direct costs was partially offset by increased indirect cost of goods sold of $573,000 for manufacturing supplies, $447,000 for equipment maintenance and $387,000 for increased manufacturing support staff all due to increased volume production including the product lines we acquired from EiC. In absolute dollars, the decrease in cost of goods sold reflects the factors previously noted.

We continue to experience unabsorbed overhead costs related to underutilization of our existing wafer fabrication facility. While prior restructuring programs have mitigated some of our unabsorbed overhead through the write down of excess facilities and equipment, we will still have fixed manufacturing costs that these efforts will not impact until we can further reduce excess capacity. We typically generate a lower gross margin on new product introductions which we expect to be a higher percentage of our sales mix going forward. Over time, we typically become more efficient relative to new products through learning and increased volumes as well as through improved yields. New product lines also contain a greater degree of inventory risk due to uncertainty regarding a lack of visibility and predictability of customer demand and potential competition.

Research and Development—Our 2005 research and development expense was $18.1 million, an increase of $832,000 or 5% as compared with our research and development expense of $17.2 million for 2004. Our research and development for 2004 increased by $356,000 or 2% as compared with research and development expense of $16.9 million in 2003. The increase in absolute dollars in 2005 is primarily related to the increased engineering staff and new product development related to the products we acquired from Telenexus and increased spending on design consulting services which was partially offset by a decrease in overall overhead. The increase in absolute dollars in 2004 is primarily related to the increased engineering staff and new product development efforts related to the products and processes we acquired from EiC and increased spending on design consulting services which was largely offset by a decrease in overall overhead. During 2005, research and development expenses were 57% as a percentage of sales which compares to 53% in 2004 and 64% in 2003. The increase in research and development expense as a percentage of sales from 2004 to 2005 reflects the factors noted above as well as the decrease in sales in the same period. The decrease in research and development expense as a percentage of sales from 2003 to 2004 is primarily related to our increase in sales. We generate revenues from development contracts with customers that have enabled us to accelerate our own product development efforts. Such development revenues have only partially funded our product development activities, and we generally retain ownership of the products developed under these arrangements. As a result, we classify all development costs related to these contracts as research and development expenses. We recorded revenue of $832,000 under such development agreements in 2005. Product research and development is essential to our future success and we expect to continue to make investments in new product development and engineering talent. In 2006 we will continue to focus our research efforts and resources on RF semiconductor development which target multiple growth markets such as RFID and WiMAX, adjacent markets such as power amplifiers while expanding our addressable market opportunities in wireless communications and broadband cable. We will also explore process capabilities of third party foundries and develop products under new process technologies such as SiGe BiCMOS. In absolute dollars, we expect our 2006 research and development expenditures to remain relatively constant with the prior year.

Selling and Administrative—Selling and administrative expense for 2005 was $15.3 million or 48% of sales, an increase of $2.8 million or 22% as compared with selling and administrative expense of $12.5 million or 39% of sales in 2004. During 2004 selling and administrative expense increased by $2.3 million or 22% as compared with selling and administrative expense of $10.3 million or 39% of sales in 2003. The increase in absolute dollars during 2005 related to a $1.2 million charge for a former CEO separation agreement, a $754,000 increase related to the acquired administrative operations of Telenexus, $445,000 of professional fees related to a potential strategic business combination which we decided not to consummate, a $412,000 increase in legal fees resulting from additional corporate governance requirements, $646,000 charge related to severance and a $398,000 increase in external sales representatives commission due to the increase in semiconductor sales over the prior year’s period. These increased costs were partially offset by a $267,000 decrease in bonus expense and a $156,000 decrease in insurance premiums. The increase in absolute dollars during 2004 is primarily related to a $560,000 increase in salaries and wages due to an increase in the number of sales and marketing personnel, $558,000 increase in severance due to a stock compensation charge resulting from the modification of two option agreements (extension of the option exercise period), a $484,000 increase in accounting fees resulting from additional corporate governance requirements, $267,000 increase in commission costs due to increased sales of our radio frequency (‘RF”) semiconductor products and a $141,000 increase in bonus expense. Additionally, during 2003, we benefited from a reduction in our Board of Directors’ compensation plan which was approved at our Annual Meeting of Stockholders held on July 15, 2003 and resulted in a reduction in accrued expenses of $238,000. Also, 2003 had benefited from the collection of $393,000 of receivables which had been reserved in a prior period. During 2004, we reserved $51,000 of receivables whose collection is doubtful. These increased costs were partially offset by a $347,000 reduction in our Directors and Officers and Liability insurance premiums and a $112,000 decrease in advertising and promotion costs. As a percentage of sales, the increase in selling and administrative expense from 2004 to 2005 reflects the factors noted above as well as the decrease in sales in the same period. Selling and administrative expenses remained flat from 2003 to 2004 as a percentage of sales. For our first quarter of 2006, we expect selling and administrative expenses to be higher than those incurred in our fourth quarter of 2005 primarily as a result of approximately $500,000 in professional service costs associated with a special project conducted on behalf of our audit committee and completed during that quarter with no material issues.

Acquired In-process Research and Development Expenses—During 2005, $3.4 million of the purchase price for the acquisition of Telenexus, Inc. was allocated to acquired in-process research and development expense (“IPRD”). Projects that qualify as in-process research and development represent those that have not yet reached technological feasibility and have no future alternative use. Technological feasibility is defined as being equivalent to a beta-phase working prototype in which there is minimal remaining risk relating to the development. The value assigned to IPRD charge comprises the following projects: multi-protocol readers ($1.3 million), Smart readers ($900,000) and Class 3 readers ($1.2 million). As of December 31, 2005, the estimated aggregate cost to complete these projects was $344,000, $1.2 million and $737,000, respectively which is expected to occur through our fourth quarter of 2006. The value of these projects was determined by estimating the discounted net cash flows from the sale of the products resulting from the completion of the projects, reduced by the portion of the revenue attributable to developed technology and the percentage of completion of the project. Actual results to date have been consistent, in all material respects, with our assumptions at the time of the acquisition. The assumptions consist primarily of expected completion dates for the IPRD projects, estimated costs to complete the projects, and revenue and expense projections for the products once they have entered the market. Our assumptions for the multi-protocol reader project at the time of the acquisition include an estimated completion date of the project in 2006 at a cost of approximately $938,000, estimated future revenue of $23.4 million over an estimated product life cycle of 7 years, and the following average financial metrics over the life of the product: gross margin of 40% during the first two years increasing to 55% by year five and remaining

constant throughout the remainder of the estimation periods, average operating expenses of 19% and a 41% tax rate. Our assumptions for the Smart reader project at the time of the acquisition include an estimated completion date of the project in 2006 at a cost of approximately $1.3 million, estimated future revenue of $31.3 million over an estimated product life cycle of 10 years, and the following average financial metrics over the life of the product: gross margin of 40% during the first two years increasing to 55% by year five and remaining constant throughout the remainder of the estimation periods, average operating expenses of 19% and a 41% tax rate. Our assumptions for the Class 3 reader project at the time of the acquisition include an estimated completion date of the project in 2006 at a cost of approximately $857,000, estimated future revenue of $21.6 million over an estimated product life cycle of 8 years, and the following average financial metrics over the life of the product: gross margin of 40% during the first two years increasing to 55% by year five and remaining constant throughout the remainder of the estimation periods, average operating expenses of 17% and a 41% tax rate. A discount rate of 25% was employed to determine the discounted net cash flow for all projects.

During 2004, $8.5 million of the purchase price for the acquisition of the wireless infrastructure business and associated assets from EiC was allocated to acquired in-process research and development expense (“IPRD”). Projects that qualify as in-process research and development represent those that have not yet reached technological feasibility and have no future alternative use. Technological feasibility is defined as being equivalent to a beta-phase working prototype in which there is no remaining risk relating to the development. The IPRD charge related to the EiC acquisition which was made up of two projects: 12V heterojunction bipolar transistor (“HBT”) power amplifiers and 28V HBT high power amplifiers which had an assigned value of $1.5 million and $7.5 million, respectively. As of December 31, 2004, we have completed both the 12V and 28V HBT high power amplifier process development projects. The value of these projects was determined by estimating the discounted net cash flows from the sale of the products resulting from the completion of the projects, reduced by the portion of the revenue attributable to developed technology and the percentage of completion of the project. Actual results to date have been consistent, in all material respects, with our assumptions at the time of the acquisition. The assumptions consist primarily of expected completion dates for the IPRD projects, estimated costs to complete the projects, and revenue and expense projections for the products once they have entered the market. Our assumptions for the 12V HBT project at the time of the acquisition include an estimated completion date of the project in early 2005 at a cost of approximately $223,000, estimated future revenue of $17.5 million over an estimated product life cycle of 7.5 years, and the following average financial metrics over the life of the product: gross margin of 50%, operating expenses of 23% and a 40% tax rate. A discount rate of 25% was employed to determine the discounted net cash flow. Our assumptions for the 28V HBT project at the time of the acquisition include an estimated completion date of the project in early 2005 at a cost of approximately $160,000, estimated future revenue of $189.6 million over an estimated product life cycle of 16.5 years, and the following average financial metrics over the life of the product: gross margin of 50%, operating expenses of 23% and a 40% tax rate. A discount rate of 25% was employed to determine the discounted net cash flow.

The nature of the efforts to develop the acquired in-process research and development into commercially viable products principally relates to the completion of all prototyping and testing activities that are necessary to establish that the product can meet its design specification including function, features and technical performance requirements. Therefore, the amount allocated to in-process research and development has been charged to operations.

Recapitalization Merger—We incurred recapitalization merger expense of $680,000 in 2003 related to our consideration of the proposed Fox Paine transaction. On September 19, 2002, we announced the receipt of a proposal from an affiliate, Fox Paine & Company LLC (“Fox Paine”) to acquire all of the shares of our common stock held by unaffiliated stockholders (the “Acquisition Proposal”). At that time, Fox Paine and its affiliates owned approximately 66% of our outstanding shares or 37.0 million shares of a

total of 55.9 million shares outstanding. Our Board of Directors formed a special committee composed of two independent directors not affiliated with Fox Paine (the “Special Committee”) to review the Acquisition Proposal. These expenses include legal and financial consulting fees as well as compensation to the members of the Special Committee. On March 27, 2003, Fox Paine withdrew its Acquisition Proposal.

Restructuring Charges—During 2004, we reversed the lease loss associated with our internal wafer fabrication facility (“fab”) and remaining severance accrual due to our assessment and subsequent decision to not close our fab as we believed at that time that integrating the newly acquired fab from EiC with our pre-existing fab will offer the Company certain benefits over outsourcing the pre-existing fab. This reversal was partially offset by a net increase in the lease loss accrual for our other leased facilities based on reductions in sublease occupancy rates and a net increase in facility operating costs.

In 2003, we revised our lease loss accrual downward for the four month additional operation of our wafer fab and reduced facility costs at our other two abandoned facilities. This reversal was largely offset by an additional lease loss accrual for reductions in estimated sublease occupancy and market rates and disposal of our remaining unsold assets held for sale. We also reversed a portion of our severance accrual for one employee slated to be terminated but instead retained for another position.

For 2002, we recorded a restructuring charge of $25.4 million reflecting consolidation and abandonment of leased space and associated impairment of tenant improvements, severance costs, an asset impairment charge and the initiation of a program to sell excess manufacturing equipment resulting from the prolonged downturn in the telecommunications industry, especially related to our fiber optics products. In the third quarter of 2002, we decided to abandon a portion of our leased facility based on revised anticipated demand for our products and current market conditions. This excess space, for which we had a remaining eight year commitment, is located on the first floor of our current corporate headquarters and originally housed a portion of our optics and integrated assemblies manufacturing operations. This decision resulted in a lease loss of $11.3 million, comprised of future lease payments net of anticipated sublease income, broker commissions and other facility costs, and an asset impairment charge of $3.2 million on tenant improvements deemed no longer realizable. In determining this estimate, we made certain assumptions with regards to our ability to sublease the space and reflected offsetting assumed sublease income in line with our best estimate of current market conditions. In addition, our management made a decision during the third quarter of 2002 to exit the fiber optics business after current contractual obligations had been satisfied. This decision resulted in a significant overcapacity of certain manufacturing equipment and we initiated a plan to sell this equipment before the end of the first quarter of 2003. Our excess manufacturing equipment resulted in a total charge of $3.9 million. Assets to be held for sale are measured at the lower of carrying amount or fair value less cost to sell. Management determined fair market value after consideration of several factors including the condition of the equipment, offers made by potential buyers of the equipment and the results of an independent third party appraisal. The majority of these impaired assets was sold in the fourth quarter of 2002. Also during the third quarter of 2002, our management identified manufacturing equipment exclusively supporting certain in-warranty optics and fixed wireless products as well as manufacturing equipment supporting final orders for certain other optics and fixed wireless products and determined that the estimated future cash flows did not support the carrying value of these assets. As such, the carrying value of these assets were written down to the estimated future cash flows that are directly associated with and that are expected to arise as a direct result of the use and eventual disposition of these assets, which management determined after consideration of several factors including the condition and management’s intended use of the equipment, offers made for similar equipment the Company intended to sell and the results of an independent third party appraisal. This action resulted in a $200,000 asset impairment charge. During 2002, we incurred severance expense of $507,000 related to a reduction of 50 employees.

Also during 2002, we recorded a restructuring charge of $8.8 million related to our decision in December 2002 to completely outsource our internal wafer fabrication. As a result of the planned closure

of our wafer fabrication facility, approximately 10% of the Company’s workforce (20 employees) would have been eliminated, which would have resulted in severance payments of $279,000. The closure of this facility would have resulted in additional excess space of approximately 35,000 square feet for which we had a remaining two year commitment at that time. This decision resulted in a lease loss of $4.3 million, comprised of future lease payments net of anticipated sublease income, broker commissions and other facility costs. In determining this estimate, we made certain assumptions with regards to our ability to sublease the space and reflected offsetting assumed sublease income in line with our best estimate of current market conditions. This decision triggered an impairment analysis under SFAS No. 144. Management measured the recoverability of these assets through a comparison of the carrying amount of these assets to future undiscounted cash flows expected to be generated by these assets over their remaining year of life. As such, the carrying value of these assets were written down to the estimated future cash flows that are directly associated with and that were expected to arise as a direct result of the use and eventual disposition of these assets. Management estimated the future cash flows using a traditional present value approach based on management’s assumptions regarding the intended use of these assets consistent with the Company’s budget and projections as well as the planned eventual disposition of the asset group through sale. Management estimated the disposition value of these assets after consideration of several factors including the condition and management’s intended use of the equipment, offers made for similar equipment the Company intended to sell and the results of an independent third party appraisal. Management employed a risk-free interest rate commensurate with the Company’s size, capital structure and stock volatility in relation to the overall market. This action resulted in a $4.2 million asset impairment charge.

For 2001, we recorded a restructuring charge of $9.8 million related to our decision to abandon an excess facility. In September 2001, we decided not to occupy a new leased facility based on revised anticipated demand for our products and current market conditions. This excess facility, for which we had a ten year commitment, is located adjacent to our current corporate headquarters and was originally developed to house additional administrative and corporate offices to accommodate planned expansion. This decision resulted in a pre-tax lease loss of $7.2 million, comprised of future lease payments net of anticipated sublease income, broker commissions and other facility costs, and a pre-tax asset impairment charge of $2.6 million on tenant improvements deemed no longer realizable. The 2002 restructuring charge also includes an additional charge for the leased facility we abandoned in 2001 based on our downward revised assumptions regarding sublease occupancy rates and market rates due to an overall deteriorating real estate market and difficulties subleasing our available space. In determining this estimate, we made certain assumptions with regards to our ability to sublease the space and reflected off-setting assumed sublease income in line with our best estimate of the current market conditions.

For further discussion, see Note 14 to the consolidated financial statements included elsewhere in this Form 10-K.

Interest Income—Interest income primarily represents interest earned on cash equivalents and short-term available-for-sale investments. In 2005 our interest income was $1.0 million, an increase of $366,000 or 54% as compared with interest income of $682,000 in 2004. This relative dollar increase in both comparative periods resulted from an increase in interest rates offsetting a decrease in average funds available for investment. Our interest income for 2004 of $682,000 had decreased $73,000 or 10% as compared with interest income of $755,000 in 2003. This decrease primarily resulted from decreased average amounts of funds available for investment.

Interest Expense—Our interest expense for 2005 was $96,000, a decrease of $8,000 or 8% as compared with interest expense of $104,000 in 2004 and a decrease of $13,000 or 11% as 2004 is compared with interest expense of $117,000 in 2003. Interest expense for all periods relates to fees associated with our revolving credit facility and outstanding letters of credit.

Other Income-Net—The other income realized in 2003 was primarily related to a $1.1 million gain we recorded related to the sale of our Thin-Film product line. The sale includes equipment, inventory, intellectual property, training and services for which we received total proceeds of $1.8 million. For further discussion, see Note 16 to the consolidated financial statements included elsewhere in this Form 10-K.

Income Tax Benefit—In 2005 we recorded a net tax benefit of $120,000 as the statute had expired on certain estimated federal tax exposures. The tax benefit for 2004 of $7.7 million resulted from a revision of our estimated income tax contingency liability due to our receipt of the final assessment from the Internal Revenue Service related to the audit of the Company’s 1996 through 2000 tax returns. In 2003, we recorded a tax benefit of $647,000 related to an income tax refund of $480,000 from the State of Maryland as the result of amending our 1999 state tax return and an adjustment to our tax contingency liability of $167,000 for additional federal income tax refund determined after finalizing our 2002 carryback claim filed in the first quarter of 2003 and miscellaneous tax payments. Beginning in 2002, it was determined that it was not more likely than not that any additional deferred tax assets would be realized through the application of carryforward claims.

Liquidity and Capital Resources

Cash, cash equivalents and short-term investments at December 31, 2005 were $30.2 million, a decrease of $12.9 million or 30% compared to the balance of $43.1 million at December 31, 2004.

On December 27, 2005, we entered into the fourth amendment (the “Amendment”) to our Amended and Restated Loan and Security Agreement between Comerica Bank and us dated September 23, 2003 and as amended June 13, 2005, July 12, 2005 and September 28, 2005. The effective date of the Amendment is December 22, 2005. Under the new terms, the revolving credit facility (“Revolving Facility”) provides for a maximum credit extension of $10.0 million, with a $5.0 million sub-limit to support letters of credit, a $250,000 sub-limit for foreign exchange transactions and a $200,000 sub-limit for corporate credit cards. The Revolving Facility matures on December 21, 2006. Interest rates on outstanding borrowings are periodically adjusted based on certain financial ratios and are initially set, at our option, at LIBOR plus 2.0% or Prime. The Revolving Facility requires us to maintain certain financial ratios and contains limitations on, among other things, our ability to incur indebtedness, pay dividends and make acquisitions without the bank’s permission. The Revolving Facility is secured by substantially all of our assets. We were in compliance with the covenants as of December 31, 2005. As of December 31, 2005 and December 31, 2004, there were no outstanding borrowings under the Revolving Facility. We have letters of credit of $3.2 million available as of December 31, 2005 against which no amounts have been drawn.

Net Cash Used by Operating Activities—Net cash used by operations was $(10.4) million, ($15.4) million and ($5.9) million in 2005, 2004 and 2003, respectively. Net loss in 2005, 2004 and 2003 was (21.0) million, ($9.1) million and ($14.3) million, respectively.

The most significant cash item impacting the difference between net loss and cash flows used in operations in 2005 was $223,000 used by working capital. The $223,000 used by working capital primarily relates to a $2.7 million decrease in restructuring liabilities which were partially offset by a $1.6 million increase in accruals and accounts payable and a $516,000 decrease in inventories. The $2.7 million decrease in restructuring liabilities primarily relates to payments against the remaining lease loss accrual. The $1.6 million increase in accruals and accounts payable relates primarily to the timing of payments within terms. Non-cash items included in net loss in 2005 included $3.1 million of depreciation and amortization, $3.4 million of IPRD related to our acquisition of Telenexus, Inc. and $3.2 million related to an increase in our deferred margin on distributor inventory due to our change in the application of our revenue recognition policy from revenue recognition upon shipment to our distributors to revenue recognition when our distributors have sold the product to the end customer during 2005. For further discussion, see Note 3 to the consolidated financial statements included elsewhere in this Form 10-K.

The most significant cash item impacting the difference between net loss and cash flows used in operations in 2004 was $7.6 million used in working capital. The $7.6 million used in working capital primarily relates to a $2.3 million increase in receivables, a $2.4 million decrease in restructuring liabilities, a $1.0 million increase in other assets and a decrease of $867,000 in income tax contingency liability. Our receivables increased $2.3 million due to increased shipments during the fourth quarter of 2004. The $2.4 million decrease in restructuring liabilities primarily relates to payments against the remaining lease loss accrual. The increase in other assets of $1.0 million is primarily due to a $576,000 accrual of a settlement related to the termination of the supply agreement with EiC (see Note 5 to the consolidated financial statements included elsewhere in this Form 10-K) and a $560,000 increase in accrued interest receivable related to our investments. The decrease of $867,000 in income taxes payable relates to payments resulting from an audit of our 1996 through 2000 returns. Non-cash items included in net loss in 2004 included $2.8 million of depreciation and amortization, $8.5 million of IPRD related to our acquisition of the wireless infrastructure business and associated assets from EiC and $7.7 million related to a decrease in our income tax contingency liability. The $7.7 million decrease in our income tax contingency liability resulted from a revised estimate related to the audit of our 1996 through 2000 tax returns. The $7.7 million decrease in our tax contingency liability resulted from a revised estimate of our tax contingency liability related to the audit of our 1996 through 2000 tax returns as a result of our receipt of the final assessment from the Internal Revenue Service.

The most significant cash items impacting the difference between net loss and cash flows used in operations in 2003 were $949,000 used in working capital and $6.0 million provided by the realization of deferred tax assets. The $949,000 used in working capital primarily relates to a $2.2 million decrease in restructuring liabilities, which was offset by a $1.5 million decrease in inventories. The $1.5 million decrease in inventories relates to the decrease in our sales from $40.2 million in 2002 to $26.6 million in 2003. The $6.0 million provided by the realization of deferred tax assets relates to the receipt of an income tax refund generated by the carryback of our 2002 net operating loss. Starting in the second quarter of 2003, we provided more favorable payment terms to significant customers in order to remain competitive in the current business environment. As a result, our average payment terms have increased from 30 days to 60 days, which has had a negative impact to our working capital. Non-cash items included in net loss in 2004 included $4.4 million of depreciation and amortization.

Net Cash Provided (Used) by Investing Activities—Net cash provided (used) by investing activities was ($1.5) million, $18.2 million and ($27.3) million in 2005, 2004 and 2003, respectively. In 2005, we used $34.9 million to purchase short-term investments, $3.2 million to acquire Telenexus, Inc. including associated acquisition costs and $1.5 million to purchase equipment which was partially offset by $37.6 million in proceeds we realized from the sale and maturities of our short-term investments. In 2004, we realized $89.2 million in proceeds from the sale of short term investments which was partially offset by $59.3 million used to purchase short-term investments, $10.7 million of acquisition and costs related to the EiC transaction (see Note 5 to the consolidated financial statements included elsewhere in this Form 10-K) and $878,000 to invest in property, plant and equipment. In 2003, we used $92.6 million to purchase short-term investments and $841,000 to invest in property, plant and equipment which was partially offset by $64.6 million provided by our sale of short-term investments and $1.6 million proceeds from the sale of our Thin-Film product line (see Note 16 to the consolidated financial statements included elsewhere in this Form 10-K). During 2006, we expect to invest approximately $2.0 to $3.0 million in capital expenditures. We have funded our capital expenditures from cash, cash equivalents and short-term investments and expect to continue to do so throughout 2006.

In conjunction with our recent acquisitions, we may be required to pay further compensation in the EiC acquisition of up to $7.0 million in cash (10%) and shares (90%) if specific revenue targets are achieved by March 31, 2006 and in the Telenexus acquisition, of up to $2.5 million in cash and up to

833,333 shares if certain revenue targets are achieved by July 28, 2006. We expect to fund these payments, if earned, from our cash, cash equivalents and short-term investments, cash flows and borrowings to the extent available. As of March 20, 2006 we have not yet determined if the revenue targets were met for the year ending March 31, 2006. We will not be able to make our determination until after we have completed our internal control procedures after our quarter end on April 2, 2006.

Net Cash Provided by Financing Activities—Net cash provided by financing activities totaled $1.7 million, $10.7 million and $617,000 in 2005, 2004 and 2003, respectively. In 2005, we received net proceeds of approximately $1.9 million from the sale of our common stock to employees through our employee stock purchase and option plans which was partially offset by $201,000 representing 117,439 shares of our common stock withheld from our former CEO to cover the income tax withholding on his receipt of 328,500 shares of restricted stock in connection with a severance agreement and $49,000 representing shares withheld from other employees. In 2004, we received net proceeds of $10.2 million related to our secondary public offering of 2 million newly issued shares of our common stock and $1.5 million from the sale of our common stock to employees through our employee stock purchase and option plans which was partially offset by $920,000 of cash used to repurchase our common stock under our current stock repurchase program (see Note 10 to the consolidated financial statements included elsewhere in the Form 10-K). In 2003, we received net cash of $3.5 million from the sale of our common stock to employees through our option plans which was partially offset by $2.8 million of cash used to repurchase our common stock under our stock repurchase program (see Note 10 to the consolidated financial statements included elsewhere in the Form 10-K).

Based on our current plans and business conditions, we believe that our existing cash, cash equivalents and short-term investments together with available borrowings under our line of credit will be sufficient to meet our liquidity and capital spending requirements for at least the next twelve months. Thereafter, we will utilize our cash, cash flows and borrowings to the extent available and, if desirable or necessary, we may seek to raise additional capital through the sale of debt or equity. There can be no assurances, however, that future borrowings and capital resources will be available on favorable terms or at all. Our cash flows are highly dependent on demand for our products, timing of orders and shipments with key customers and our ability to manage our working capital, especially inventory and accounts receivable, as well as controlling our production and operating costs in line with our revenue.

Contractual Obligations

The following table summarizes our contractual obligations at December 31, 2005 and the effect those obligations are expected to have on our liquidity and cash flow in future periods (in thousands):

	Payments due by Period
	Less than			More than
Contractual obligations	Total			1 year			1-3 years			3-5 years			5 years
Capital lease obligations		$	—		$	—		$	—		$	—		$	—
Operating lease obligations(1)		20,968			4,589			13,120			3,259			—
Purchase obligations(2)		3,644			3,569			75			—			—
Other long-term liabilities(3)		—			—			—			—			—
Total(4)		$	24,612		$	8,158		$	13,195		$	3,259		$

(1) We lease our three facilities, including our executive offices in San Jose, California, under lease agreements that expire at various dates through 2011. Total future lease obligations as of December 31, 2005, were $21.0 million, of which $13.0 million was recorded as a liability for certain facilities that were included in our restructuring accrual (current and long-term).

(2) Purchase obligations are primarily orders for raw material, processed silicon wafers and assembly and test services. While the purchase orders are generally cancelable without penalty, certain vendor agreements provide for percentage-based cancellation fees or minimum restocking charges based on the nature of the product or service. We expect to receive and pay for these materials and services within the next six months.

(3) The only component of Other Long-Term Liabilities that requires us to make cash payments is a restructuring accrual of $10.5 million relating to the future operating lease payments on certain facilities that were included in our restructuring plans (See Note 14 to the consolidated financial statements included elsewhere in this Form 10-K). We will make these payments through 2011. We included these amounts in the operating lease total in the table above. Excluding payments under the operating lease component included in the restructuring accrual, the other components of Other Long-Term Liabilities do not contractually require us to make cash payments and primarily consist of estimated operating costs on restructured facilities, deferred rent and estimated environmental costs.

(4) The table above does not include contractual obligations related to our acquisition in June 2004 of the wireless infrastructure business and associated assets from EiC Corporation or our acquisition in January 2005 of Telenexus, Inc. as the additional consideration is contingent on certain future identifiable events which have not occurred as of December 31, 2005. EiC may be entitled to further consideration of up to $7.0 million in cash and shares of our common stock if certain revenue targets are achieved by March 31, 2006. We shall pay EiC this additional consideration, if earned, ninety percent (90%) in our common stock and ten percent (10%) in cash. Thus, if earned, $700,000 would be payable in less than one year As of March 20, 2006 we have not yet determined if the revenue targets were met for the year ending March 31, 2006. We will not be able to make our determination until after we have completed our internal control procedures after our quarter end on April 2, 2006. The sellers of Telenexus, Inc. may be entitled to further compensation of up to $2.5 million in cash and up to 833,333 shares of our common stock if we achieve certain revenue targets by July 28, 2006. Thus, if earned, $2.5 million would be payable in one to three years. Certain employment agreements which may require us to pay out termination benefits upon future identifiable events are also excluded from the table above as no events have occurred as of December 31, 2005 which make the payment probable.

For purposes of the table above, obligations for the purchase of goods or services are defined as agreements that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Our purchase orders are based on our current manufacturing needs and are typically fulfilled by our vendors within short time horizons. We have additional purchase orders (not included in the table above) that represent authorizations to purchase rather than binding agreements. We do not have significant agreements for the purchase of raw materials or other goods specifying minimum quantities or set prices that exceed our expected requirements.

The expected timing of payment of the obligations discussed above is estimated based on current information. Timing of payments and actual amounts paid may be different depending on the time of receipt of goods or services or changes to agreed-upon amounts for some obligations.

Off-Balance Sheet Arrangements

We do not have any special purpose entities or off-balance sheet financing arrangements except for operating leases as discussed in Note 12 to the consolidated financial statements included elsewhere in this Form 10-K.

Other Matters

Recent Accounting Pronouncements—On December 16, 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”). SFAS 123R eliminates the alternative of applying the intrinsic value measurement provisions of Opinion 25 to stock compensation awards issued to employees. Rather, the new standard requires enterprises to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide services in exchange for the award, known as the requisite service period (usually the vesting period).

We adopted SFAS 123R in January 2006 and currently do not expect to restate prior periods to conform to the new accounting standard as we will use the Modified Prospective Application Method. Under this method SFAS 123R is applied to new awards and to awards modified, repurchased or cancelled after the effective date. Additionally, compensation cost for the portion of awards for which the requisite service has not been rendered (such as unvested options) that are outstanding as of the date of adoption shall be recognized as the remaining requisite services are rendered. The compensation cost relating to unvested awards at the date of adoption shall be based on the grant-date fair value of those awards as calculated for pro forma disclosures under the original SFAS 123 adjusted for estimated forfeitures. See Note 2 to the consolidated financial statements included elsewhere in this Form 10-K under the caption “STOCK-BASED COMPENSATION” for information related to the pro forma effect on reported net income and net earnings per share of applying the fair value provisions of the SFAS 123. The balance of unearned stock-based compensation to be expensed in the period 2006 through 2010 related to share-based awards unvested at December 31, 2005, as previously calculated under the disclosure-only requirements of SFAS 123, is approximately $2.7 million. If there are any modifications or cancellations of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. To the extent that we grant additional future stock option and other share-base awards, our future stock-based compensation expense will be increased by the additional unearned compensation resulting from those additional grants. The fair value of these grants is not included in the amount above, as the impact of these grants cannot be predicted at this time because it will depend on the number of share-based payments granted and the then current fair values. We are currently in the process of determining our estimated forfeiture rate for purposes of adopting SFAS 123R and we estimate that our forfeiture rate will be between 10% and 25%, which will result in a reduction to the foregoing annual amoritization amounts.

In May 2005, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 154, “Accounting Changes and Error Corrections-a replacement of APB Opinion No. 20 and FASB Statement No. 3” (“SFAS 154”). This Statement replaces APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for and reporting of a change in accounting principle. This Statement applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed.

requires that the new accounting principle be applied to the balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable and that a corresponding adjustment be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period rather than being reported in an income statement. When it is impracticable to determine the cumulative effect of applying a change in accounting principle to all prior periods, this Statement requires that the new accounting principle be applied as if it were adopted prospectively from the earliest date practicable. This Statement shall be effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We adopted SFAS 154 in January 2006 and currently do not anticipate that it will have a significant effect on our financial statements or disclosures.

In June 2005, the FASB’s Emerging Issues Task Force reached a consensus on Issue No. 05-6, “Determining the Amortization Period for Leasehold Improvements” (“EITF 05-6”). The guidance requires that leasehold improvements acquired in a business combination or purchased subsequent to the inception of a lease be amortized over the lesser of the useful life of the assets or a term that includes renewals that are reasonably assured at the date of the business combination or purchase. The guidance is effective for interim periods beginning after June 29, 2005. We adopted EITF 05-6 in July 2005 and currently do not anticipate that it will have a significant effect on our financial statements or disclosures.

Environmental Matters—Of our former production facilities, two have known environmental liabilities of significance, the Scotts Valley site and the Palo Alto site. Prior to the recapitalization merger, we entered into and funded fixed price remediation contracts, as well as cost overrun and unknown pollution conditions liability coverage, with respect to both these sites. For a more detailed description, see “Business—Environmental Matters.”

Litigation—We currently are involved in litigation and regulatory proceedings incidental to the conduct of our business and expect that we will be involved in other litigation and regulatory proceedings from time to time. While we currently believe that any adverse outcome of such pending matters will not materially affect our business or financial condition, there can be no assurance that this will ultimately be the case.

Item 7a. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS

The following discussion about our market risk disclosures involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. We are exposed to market risk related to changes in interest rates. We do not use derivative financial instruments for speculative or trading purposes.

Cash, Cash Equivalents and Investments—Cash and cash equivalents consist of municipal bond funds and commercial paper acquired with remaining maturity periods of 90 days or less and are stated at cost plus accrued interest which approximates market value. Short-term investments consist primarily of high-grade debt securities (A rating or better) with maturity greater than 90 days from the date of acquisition and are classified as available-for-sale. Short-term investments classified as available-for-sale are reported at fair market value with unrealized gains or losses excluded from earnings and reported as a separate component of stockholders’ equity, net of tax, until realized. These available-for-sale securities are subject to interest rate risk and will rise or fall in value if market interest rates change. They are also subject to short-term market risk. We have the ability to hold our fixed income investments until maturity, and therefore we would not expect our operating results or cash flows to be affected to any significant degree by the effect of a sudden change in market interest rates on our investment portfolio.

The following table provides information about our investment portfolio and constitutes a “forward-looking statement.” For investment securities, the table presents principal cash flows and related weighted average interest rates by expected maturity dates.

				Weighted
	Expected Maturity			Average Interest
Expected Maturity Dates	Amounts			Rate
	(in thousands)
Cash equivalents:
2006		$	11,774		3.83	%
Short-term investments:
2006		16,052			4.00	%
Fair value at December 31, 2005		$	27,826

REPORT OF MANAGEMENT

Our management is responsible for establishing and maintaining adequate internal control over financial reporting to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

Management assessed our internal control over financial reporting as of December 31, 2005, the end of our fiscal year. Management based its assessment on criteria established in “Internal Control—Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Management’s assessment included evaluation of such elements as the design and operating effectiveness of key financial reporting controls, process documentation, accounting policies and our overall control environment. This assessment is supported by testing and monitoring is performed by or under the supervision of our internal accounting and finance organization.

Because of its inherent limitations, internal controls over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Based on our assessment, management has concluded that our internal control over financial reporting was not effective as of December 31, 2005 to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with generally accepted accounting principles due solely to the following material weakness (the results of management’s assessment were reviewed with the Audit Committee):

A material weakness in the operating effectiveness of the controls over the determination of excess and obsolete inventory and the related valuation adjustments resulting in an audit adjustment to reduce inventory and increase cost of goods sold. The error occurred in our fourth quarter of 2005 and was corrected in the same period. The correction is reflected in our consolidated financial statements included in this Form 10-K. This material weakness arose from our failure to consider all current business conditions in determining the salability of our current inventory.

Our independent registered public accounting firm, Deloitte & Touche LLP, has issued an attestation report on management’s assessment of our internal control over financial reporting, which is included in this Item 8 of this Annual Report on Form 10-K.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of
WJ Communications, Inc.

We have audited management’s assessment, included in the accompanying Report of Management, that WJ Communications, Inc. and subsidiaries (the “Company”) did not maintain effective internal control over financial reporting as of December 31, 2005, because of the effect of the material weakness identified in management’s assessment based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

A material weakness is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weakness has been identified and included in management’s assessment:

to consider all current business conditions in determining the salability of its current inventory. Accordingly, management has determined that this deficiency constituted a material weakness.

In our opinion, management’s assessment that the Company did not maintain effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, the Company has not maintained effective internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedule as of and for the year ended December 31, 2005 of the Company and our report dated March 30, 2006 expressed an unqualified opinion on those financial statements and financial statement schedule.

/s/ DELOITTE & TOUCHE LLP
San Jose, California
March 30, 2006

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of
WJ Communications, Inc.

We have audited the accompanying consolidated balance sheets of WJ Communications, Inc. and subsidiaries (the “Company”) as of December 31, 2005 and 2004, and the related consolidated statements of operations, comprehensive loss, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of WJ Communications, Inc. and subsidiaries at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 30, 2006, expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an adverse opinion on the effectiveness of the Company’s internal control over financial reporting because of a material weakness.

/s/ DELOITTE & TOUCHE LLP
San Jose, California
March 30, 2006

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share amounts)

	December 31,
	2005			2004
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	14,169		$	24,392
Short-term investments	16,052			18,732
Receivables (net of allowances of $122 and $496, respectively)	7,135			6,841
Inventories	4,826			5,148
Other	2,632			3,183
Total current assets	44,814			58,296
PROPERTY, PLANT AND EQUIPMENT, net	7,919			9,679
Goodwill (Note 6)	6,806			1,368
Intangible assets, net (Note 6)	1,884			180
Other assets	221			210
	$	61,644		$	69,733
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable	$	4,220		$	2,633
Accrued liabilities	1,047			1,348
Accrued professional services	740			797
Accrued payroll and profit sharing	2,024			1,498
Income tax contingency liability	1,818			1,946
Deferred margin on distributor inventory (Note 3)	3,217			—
Restructuring accrual (Note 14)	3,386			3,350
Total current liabilities	16,452			11,572
OTHER LONG-TERM OBLIGATIONS (Notes 9 and 14)	14,075			16,864
COMMITMENTS AND CONTINGENCIES (Notes 9 and 12)
STOCKHOLDERS’ EQUITY:
Preferred stock, $0.01 par value—10,000,000 shares authorized, no shares issued and outstanding	—			—
Common stock, $0.01 par value—100,000,000 shares authorized, 67,455,845 and 62,936,760 shares issued and outstanding in 2005 and 2004, respectively	675			629
Treasury stock—1,922,063 shares in 2005 and 1,769,772 shares in 2004	(19		)	(18		)
Additional paid-in capital	205,320			194,262
Accumulated deficit	(174,187		)	(153,199		)
Other comprehensive loss	(9		)	(12		)
Deferred stock compensation	(663		)	(365		)
Total stockholders’ equity	31,117			41,297
	$	61,644		$	69,733

See notes to consolidated financial statements.

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)

	Year Ended
	December 31,				December 31,				December 31,
	2005				2004				2003
Sales, net		$	31,597			$	32,336			$	26,565
Cost of goods sold		16,906				15,278				15,495
Gross profit		14,691				17,058				11,070
Operating expenses:
Research and development		18,070				17,238				16,882
Selling and administrative		15,295				12,503				10,251
Acquired in-process research & development		3,400				8,500				—
Recapitalization merger		—				—				680
Restructuring reversals (Note 14)		—				(3,845		)		(54		)
Total operating expenses		36,765				34,396				27,759
Loss from operations		(22,074		)		(17,338		)		(16,689		)
Interest income		1,048				682				755
Interest expense		(96		)		(104		)		(117		)
Other income—net		14				5				1,094
Loss before income taxes		(21,108		)		(16,755		)		(14,957		)
Income tax benefit		120				7,674				647
Net loss		$	(20,988	)		$	(9,081	)		$	(14,310	)
Basic and diluted net loss per share		$	(0.33	)		$	(0.15	)		$	(0.25	)
Basic and diluted average shares		64,162				60,397				56,835

See notes to consolidated financial statements.

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(In thousands, except share amounts)

											Additional
	Common Stock				Treasury Stock						Paid-in
	Shares	Dollars			Shares		Dollars				Capital
Balance, December 31, 2002	56,358,519		$	564	—			$	—		$	179,172
Net loss	—		—		—			—			—
Common stock issued	153,973		2		—			—			102
Exercise of stock options	2,534,724		24		—			—			3,435
Deferred stock compensation	—		—		—			—			287
Repurchases of common stock	—		—		(1,340,719	)		(13		)	(2,778		)
Amortization of deferred stock compensation	—		—		—			—			—
Elimination of deferred compensation related to stock options forfeited	—		—		—			—			(55		)
Unrealized holding gains on securities—net of taxes of $5	—		—		—			—			—
Balance, December 31, 2003	59,047,216		590		(1,340,719	)		(13		)	180,163
Net loss.	—		—		—			—			—
Common stock issued.	2,955,437		30		—			—			12,942
Exercise of stock options	934,107		9		—			—			1,180
Deferred stock compensation.	—		—		—			—			298
Repurchases of common stock	—		—		(429,053	)		(5		)	(915		)
Amortization of deferred stock compensation	—		—		—			—			—
Compensation charge due to option date extension	—		—		—			—			594
Unrealized holding gains on securities—net of taxes of $8	—		—		—			—			—
Balance, December 31, 2004	62,936,760		629		(1,769,772	)		(18		)	194,262
Net loss	—		—		—			—			—
Common stock issued	3,141,143		32		—			—			9,953
Exercise of stock options	1,377,942		14		—			—			1,441
Shares repurchased for tax withholding on employee stock transactions	—		—		(152,291	)		(1		)	(249		)
Amortization of deferred stock compensation	—		—		—			—			—
Elimination of deferred compensation related to stock options forfeited	—		—		—			—			(87		)
Unrealized holding gains on securities—net of taxes of $2	—		—		—			—			—
Balance, December 31, 2005	67,455,845		$	675	(1,922,063	)		$	(19	)	$	205,320

See notes to consolidated financial statements.

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (continued)
(In thousands, except share amounts)

	Accumulated Deficit				Other Comprehensive Loss				Deferred Stock Compensation				Total Stockholders’ Equity
Balance, December 31, 2002		$	(129,808	)		$	(18	)		$	(292	)		$	49,618
Net loss		(14,310		)		—				—				(14,310		)
Common stock issued		—				—				—				104
Exercise of stock options		—				—				—				3,459
Deferred stock compensation		—				—				(287		)		—
Repurchases of common stock		—				—				—				(2,791		)
Amortization of deferred stock compensation		—				—				149				149
Elimination of deferred compensation related to stock options forfeited		—				—				55				—
Unrealized holding gains on securities—net of taxes of $5		—				10				—				10
Balance, December 31, 2003		(144,118		)		(8		)		(375		)		36,239
Net loss		(9,081		)		—				—				(9,081		)
Common stock issued		—				—				—				12,972
Exercise of stock options		—				—				—				1,189
Deferred stock compensation		—				—				(298		)		—
Repurchases of common stock		—				—				—				(920		)
Amortization of deferred stock compensation		—				—				308				308
Compensation charge due to option date extension		—				—				—				594
Unrealized holding gains on securities—net of taxes of $8		—				(4		)		—				(4		)
Balance, December 31, 2004		(153,199		)		(12		)		(365		)		41,297
Net loss		(20,988		)		—				—				(20,988		)
Common stock issued		—				—				(1,302		)		8,683
Exercise of stock options		—				—				—				1,455
Shares repurchased for tax withholding on employee stock transactions		—				—				—				(250		)
Amortization of deferred stock compensation		—				—				917				917
Elimination of deferred compensation related to stock options forfeited		—				—				87				—
Unrealized holding gains on securities—net of taxes of $2		—				3				—				3
Balance, December 31, 2005		$	(174,187	)		$	(9	)		$	(663	)		$	31,117

See notes to consolidated financial statements.

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

	Year Ended
	December 31, 2005				December 31, 2004				December 31, 2003
OPERATING ACTIVITIES:
Net loss		$	(20,988	)		$	(9,081	)		$	(14,310	)
Adjustments to reconcile net loss to net cash used by operating activities:
Non-cash restructuring charges (reversals)		54				(3,804		)		(69		)
Depreciation and amortization		3,117				2,825				4,374
Acquired in-process research and development		3,400				8,500				—
Amortization of premiums on short-term investments		161				485				106
Net (gain) loss on disposal of property, plant & equipment		25				(4		)		91
Net gain on sale of product line		—				—				(1,084		)
Deferred income taxes		—				—				6,036
Stock based compensation		920				902				253
Amortization of deferred financing costs		39				41				32
Provision (reduction) in allowance for doubtful accounts		20				58				(408		)
Net changes in:
Receivables		26				(2,340		)		(173		)
Inventories		516				(689		)		1,463
Other assets		354				(1,021		)		(56		)
Accruals and accounts payable		1,586				(311		)		13
Income tax contingency liability		(128		)		(8,544		)		—
Deferred margin on distributor inventory		3,216				—				—
Restructuring liabilities		(2,697		)		(2,404		)		(2,173		)
Net cash provided (used) by operating activities		(10,379		)		(15,387		)		(5,905		)
INVESTING ACTIVITIES:
Purchases of property, plant and equipment		(1,476		)		(878		)		(841		)
Purchase of short-term investments		(34,854		)		(59,327		)		(92,636		)
Proceeds from sale and maturities of short-term investments		37,591				89,170				64,569
Proceeds on product line sales and assets retirements		500				9				1,572
Acquisition of Telenexus and related costs		(3,218		)		—				—
Acquisition of EiC and related costs		(37		)		(10,747		)		—
Net cash provided (used) by investing activities		(1,494		)		18,227				(27,336		)
FINANCING ACTIVITIES:
Payments on long-term borrowings		(47		)		(104		)		(51		)
Net proceeds from issuances of common stock		1,947				11,676				3,459
Repurchase of common stock		(250		)		(920		)		(2,791		)
Net cash provided by financing activities		1,650				10,652				617
Net increase (decrease) in cash and equivalents		(10,223		)		13,492				(32,624		)
Cash and cash equivalents at beginning of year		24,392				10,900				43,524
Cash and cash equivalents at end of year		$	14,169			$	24,392			$	10,900
Other cash flow information:
Income taxes paid (refunded), net		$	10			$	867			$	(6,678	)
Interest paid		57				63				88
Noncash investing and financing activities:
Issuance of common stock for Telenexus acquisition		8,190				—				—
Issuance of common stock for EiC acquisition		—				2,484				—
Purchase of equipment under capital lease		—				—				96

See notes to consolidated financial statements.

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. ORGANIZATION AND OPERATIONS OF THE COMPANY

WJ Communications, Inc. (formerly Watkins-Johnson Company, the “Company”) was founded in 1957 in Palo Alto, California. The Company was originally incorporated in California and reincorporated in Delaware in August 2000. For more than 45 years, the Company developed and manufactured radio frequency (“RF”) microwave devices for government electronics and space communications systems used for intelligence gathering and communication. In 1996, the Company began to develop commercial applications for its military technologies. The Company’s current operations design, develop and market innovative, high-performance products for both current and next generation wireless and broadband cable networks, and radio frequency identification (“RFID”) systems worldwide. The Company’s products are comprised of advanced, highly functional RF semiconductors, components and integrated assemblies which seek to address the RF requirements of these various systems.

2. SIGNIFICANT ACCOUNTING POLICIES

PRINCIPLES OF CONSOLIDATION—The consolidated financial statements include the accounts of the Company and its subsidiaries after elimination of all intercompany balances and transactions.

RECLASSIFICATIONS—Certain prior year amounts have been reclassified to conform with the 2005 presentation. Such reclassifications did not have any impact on net loss or stockholders’ equity.

CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS—Cash and cash equivalents consist of money market funds and commercial paper acquired with remaining maturities of 90 days or less and are stated at cost plus accrued interest which approximates market value. Short-term investments consist primarily of high-grade debt securities (A rating or better) with maturities greater than 90 days from the date of acquisition and are classified as available-for-sale. Short-term investments classified as available-for-sale are reported at fair market value with unrealized gains or losses excluded from earnings and reported as other comprehensive income (loss), a separate component of stockholders’ equity, net of tax, until realized. Realized gains and losses are included in the accompanying consolidated statements of operations as other income—net.

FAIR VALUE OF FINANCIAL INSTRUMENTS—The carrying value of cash and equivalents, receivables and accounts payable are a reasonable approximation of their fair market value due to the short-term maturities of those instruments. Short-term investments are classified as available-for-sale and reported at fair market value with unrealized gains or losses excluded from earnings and reported as a separate component of stockholders’ equity, net of tax, until realized.

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SIGNIFICANT ACCOUNTING POLICIES (Continued)

INVENTORIES—Inventories are stated at the lower of cost, using average-cost basis, or market. Cost of inventory items is based on purchase and production cost including labor and overhead. Write-downs, when required, are made to reduce excess inventories to their estimated net realizable values. Such estimates are based on assumptions regarding future demand and market conditions. These write-downs amounted to $975,000 in the year ended December 31, 2005, $670,000 and $251,000 for the years ended December 31, 2004 and 2003, respectively. If actual conditions become less favorable than the assumptions used, an additional inventory write-down may be required. Inventories, at December 31, 2005 and 2004 consisted of the following (in thousands):

	December 31,
	2005		2004
Finished goods	$	1,683	$	1,944
Work in progress	1,697		2,338
Raw materials and parts	1,446		866
	$	4,826	$	5,148

PROPERTY, PLANT AND EQUIPMENT—Property, plant and equipment are stated at cost. Provision for depreciation and amortization is primarily based on the straight-line method over the assets’ estimated useful lives ranging from four to ten years. Leasehold improvements are amortized over the shorter of the remaining lease term or the asset’s useful life. Costs incurred to maintain property, plant and equipment that do not increase the useful life of the underlying asset are expensed as incurred.

At December 31, 2005 and 2004, property, plant and equipment consisted of the following (in thousands):

		December 31,
	Estimated Useful Life	2005			2004
Buildings and leasehold improvements	4-10 years	$	5,063		$	4,950
Machinery and equipment	5-7 yrs	24,696			26,239
		29,759			31,189
Accumulated depreciation and amortization		(21,840		)	(21,510		)
Property, plant and equipment—net		$	7,919		$	9,679

IMPAIRMENT OF LONG-LIVED ASSETS—In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, the Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Factors the Company considers that could trigger an impairment review include the following: significant underperformance relative to expected historical or projected, future operating results; significant changes in the manner of use of the acquired assets or the strategy for the overall business; significant negative industry or economic trends; or significant technological changes, which would render equipment and manufacturing processes obsolete. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of these assets to future undiscounted cash flows expected to be generated by these assets. If such assets are considered to be impaired, the impairment to be recognized is

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SIGNIFICANT ACCOUNTING POLICIES (Continued)

measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. In 2002, the Company recorded an asset impairment charge of $4.4 million for assets held for use and $3.9 million for assets held for sale as part of the Company’s restructuring initiative as detailed in Note 14.

REVENUE RECOGNITION—The Company recognizes revenue in accordance with SEC Staff Accounting Bulletin (“SAB”) 104, “Revenue Recognition.” SAB 104 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed or determinable; and (4) collectibility is reasonably assured. Determination of criteria (3) and (4) are based on management’s judgments regarding the fixed nature of the fee charged for products delivered and the collectibility of those fees. Effective for our second quarter ended July 3, 2005, the Company changed the application of its revenue recognition policy regarding its distributors. The Company had previously recognized revenue upon shipment to its distributors less estimated reserves for distributor right of return, authorized price reductions for specific end-customer sales opportunities and price protection based on known events and historical trends. Effective for the second quarter ended July 3, 2005, the Company recognizes revenue from its distribution channels when its distributors have sold the product to the end customer. Historically, we have received stock rotation requests from our distributors that were within the amounts estimated and contractually allowed with only one exception of an insignificant amount. However, the request for stock rotation during our second quarter ended July 3, 2005 was higher than the amount contractually allowed. The Company’s management, with the concurrence of the Company’s Audit Committee, believes the increasing percentage of new products introduced by us makes it likely that stock rotation reserves will continue to be difficult to estimate based on historical patterns and contractual provisions. Based on this change in facts and circumstances and our management’s future expectations, the Company believes that we can no longer reasonably estimate the amount of future returns from our distributors as of July 3, 2005. Accordingly, recognition of revenue and associated cost of sales on shipments to distributors is deferred until the resale to the end customer. For further discussion, see Note 3.

Authorized Price Reductions for Specific End-Customer Sales Opportunities (“Ship & Debit Allowance”): Beginning in September 2003, the Company entered into a program where the distributor would receive a credit if it sold specific product at a reduced price to specific end-customers pre-authorized by the Company. The Company maintains a log of all such pre-authorized price reductions which it accrues as a reduction to revenue in the period that the pre-authorization occurs per issue 4 of EITF 01-9 “Accounting for Consideration Given by a Vendor to a Customer”. As of December 31, 2005, 2004 and 2003, the Company’s Ship & Debit Allowance was $34,000, $5,000 and $29,000, respectively.

Distributor Right of Return: In accordance with Financial Accounting Standards Board (“FASB”) Statement No. 48 “Revenue Recognition When Right of Return Exists”, the Company accrued a reserve based on its reasonable estimate of future returns based on historical trends and contractual limitations. Per contractual agreement, the distributor may return product three times per year under the following conditions: the total value of inventory returned shall not exceed an amount equal to 5% of the total value of the distributor’s stock on hand of the Company’s products as reported in the prior month’s inventory report, the inventory is returned no earlier than 6 months and no later than 24 months from the date of the original invoice date and the product’s packaging has not been opened or any alteration or modification has been performed on the part. At the end of any given period, the Company reserved revenue equal to 5% of the distributor’s current reported inventory and cost of revenue for the associated cost of the estimated returns. Due to the Company’s change in application of its revenue recognition policy

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SIGNIFICANT ACCOUNTING POLICIES (Continued)

regarding its distributors, the Company no longer accrues a distributor stock rotation reserve. As of December 31, 2004, the Company’s distributor stock rotation reserve was $338,000.

Distributor Price Protection: If the Company reduces the prices of its products as negotiated with the distributor, the distributor may receive a credit for the difference between the price paid by the distributor and the reduced price on applicable unsold products remaining in the distributor’s inventory on the effective date of the price reduction assuming that inventory is less than 24 months old as determined by the original invoice date. When the Company recognized revenue upon shipment to its distributors, the Company reserved for distributor price protection per issue 4 of EITF 01-9 based on specific identification of its initiated price reductions and the associated reported distributor inventory. There were no such price reductions in 2005, 2004 or 2003.

Development Contracts: The Company may enter into contracts to perform research and development for others meeting the requirements of Statement of Financial Accounting Standards No. 68 “Research and Development Arrangements”. Revenue under these development agreements is recognized when applicable contractual non-refundable milestones have been met, including deliverables, and in any case, does not exceed the amount that would be recognized using the percentage-of-completion accounting method based on the actual physical completion of work performed and the ratio of costs incurred to total estimated costs to complete the contract in accordance with Accounting Research Bulletin 45 “Long-Term Construction Type Contracts” using the relevant guidance in the American Institute of Certified Public Accountants Statement of Position (“SOP”) 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. Given the duration and nature of these development contracts, the Company believes that recognizing revenue under the percentage completion method best represents the legal and economic results of contract performance on a timely basis. Losses on contracts are recognized when determined. Revisions in estimates are reflected in the period in which the conditions become known. These development contracts with customers have enabled the Company to accelerate its own product development efforts. Such development revenues have only partially funded its product development activities, and the Company generally retains ownership of the products developed under these arrangements. As a result, the Company classifies all development costs related to these contracts as research and development expenses. The achievement of contractual milestones is evidenced by written documentation provided by the customer in accordance with the applicable terms and conditions of each contract. In any period, progress on the contract is based on input measures (direct labor dollars, direct material costs and direct outside processing costs) in the ratio of costs incurred to total estimated costs. Estimated costs to complete are provided by engineering personnel directly involved in the development program and are reviewed by management and finance personnel for reasonableness given the known facts and circumstances. A number of internal and external factors can affect our estimates, including labor rates, utilization and efficiency variances and specification and testing requirement changes. If different conditions were to prevail such that accurate estimates could not be made, then the use of the completed contract method would be required and the recognition of all revenue and costs would be deferred until the project was completed. If we bill the customer prior to performing services under the development agreement, the amounts are recorded as deferred revenue. The Company recorded revenue of $832,000 under development agreements in 2005. The Company has no deferred revenue at December 31, 2005. No comparable amounts were included in 2004 or 2003.

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SIGNIFICANT ACCOUNTING POLICIES (Continued)

RECEIVABLES ALLOWANCES—Receivables amounts on the balance sheet are shown net of the following allowances:

	December 31,
	2005		2004
Allowance for doubtful accounts	$	15	$	79
Sales return allowance	73		74
Distributor stock rotation reserve (Note 3)	—		338
Ship & debit allowance	34		5
	$	122	$	496

PRODUCT WARRANTY—The Company generally sells products with a limited warranty of product quality and a limited indemnification of customers against intellectual property infringement claims related to the company’s products. Such warranty generally ranges from 12 to 24 months. The Company accrues for known warranty and indemnification issues if a loss is probable and can be reasonably estimated, and accrues for estimated incurred but unidentified issues based on historical activity. For further discussion, see Note 15.

INCOME TAXES—In accordance with SFAS No. 109, “Accounting for Income Taxes,” the consolidated financial statements include provisions for deferred income taxes using the liability method for transactions that are reported in one period for financial accounting purposes and in another period for income tax purposes. Deferred tax assets are recognized when management believes realization of future tax benefits of temporary differences is more likely than not. In estimating future tax consequences, generally all expected future events are considered (including available carryback claims), other than enactment of changes in the tax law or rates. Valuation allowances are established for those deferred tax assets where management believes it is not more likely than not such assets will be realized.

PER SHARE INFORMATION—Basic loss per share is computed using the daily weighted average number of common shares outstanding for the period. Diluted loss per share includes the above and reflects the potential dilution that could occur if stock options whose exercise price are less than the average share price for the period were exercised or converted into common stock and shares related to contributions under the Employee Stock Purchase Plan for pending purchases, however, such adjustments are excluded when they are anti-dilutive. In determining the dilutive effect of the stock options, the number of shares resulting from the assumed exercise of the options is reduced by the number of shares that could have been purchased by the Company with the proceeds from the exercise of such options.

CONCENTRATION OF CREDIT RISK—Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash, cash equivalents, short-term investments and trade receivables. The Company maintains cash in bank deposit accounts, which, at times, may exceed federally insured limits. The Company has not experienced any losses in such accounts. The Company invests in a variety of financial instruments such as money market funds, commercial paper and high quality corporate bonds, and, by policy, limits the amount of credit exposure with any one financial institution or commercial issuer. At December 31, 2005, Richardson Electronics, ZTE Corporation and Celestica represented 32%, 15% and 13% of the total accounts receivable balance, respectively. At December 31, 2004, Richardson Electronics and Celestica represented 46% and 10% of the total accounts

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SIGNIFICANT ACCOUNTING POLICIES (Continued)

receivable balance, respectively. The Company performs ongoing credit evaluations and maintains an allowance for doubtful accounts based upon the expected collectibility of receivables.

USE OF ESTIMATES—The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Key estimates include allowance for doubtful accounts, reserves for sales returns, write-down of excess and obsolete inventories, income tax contingency reserves, valuation of deferred tax assets and restructuring accruals. Actual results could differ from those estimates.

STOCK-BASED COMPENSATION—The Company accounts for stock-based compensation granted to employees and directors under the intrinsic value method as defined in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.”

During the year ended December 31, 2004, the Company modified two option agreements (extension of the option exercise period) resulting in $594,000 of severance expense which was recorded as selling and administrative expense.

As required under SFAS No. 123, “Accounting for Stock-Based Compensation,” and SFAS 148, “Accounting for Stock-Based Compensation Transition and Disclosure,” the pro forma effects of stock-based compensation on net loss and net loss per common share have been estimated at the date of grant as if the Company had accounted for such awards under the fair value method of SFAS 123 using the Black-Scholes option-pricing model. The Company has amortized to expense deferred stock compensation of $920,000, $308,000 and $149,000 in 2005, 2004 and 2003, respectively.

The weighted average fair value of stock-based awards granted in fiscal years 2005, 2004 and 2003 reported below have been estimated at the date of grant using the Black-Scholes option pricing model with the following assumptions:

	2005			2004			2003
Employee Stock Option Plans
Fair value	$	0.88		$	2.19		$	2.02
Dividend yield	0.0		%	0.0		%	0.0		%
Volatility	82.1		%	87.1		%	93.0		%
Risk free interest rate at the time of grant	4.1		%	3.0		%	2.6		%
Expected term to exercise (in months from the grant date)	48.0			48.0			48.0
Employee Stock Purchase Plan
Fair value	$	0.70		$	1.32		(1		)
Dividend yield	0.0		%	0.0		%	(1		)
Volatility	75.4		%	69.0		%	(1		)
Risk free interest rate at the time of grant	2.68		%	1.17		%	(1		)
Expected term to exercise (in months from the grant date)	6.0			6.0			(1		)

(1) No shares were issued under the Employee Stock Purchase Plan during 2003.

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SIGNIFICANT ACCOUNTING POLICIES (Continued)

The Black-Scholes model used by the Company to calculate option values, as well as other currently accepted option valuation models, were developed to estimate the fair values of freely tradable, fully transferable options without vesting restrictions, which significantly differ from the Company’s stock option awards. These models also require highly subjective assumptions, including future stock price volatility, and expected time until exercise, which greatly affect the calculated values.

The following table illustrates the effect on net loss had compensation cost for all of the Company’s stock option plans been determined based upon the fair value at the grant date for awards under these plans, and amortized to expense over the vesting period of the awards consistent with the methodology prescribed under SFAS 123, “Accounting for Stock-Based Compensation” (in thousands):

	Year Ending December 31,
	2005			2004			2003
Reported net loss	$	(20,988	)	$	(9,081	)	$	(14,310	)
Add: Total stock-based employee compensation expense included in reported net loss	920			308			149
Deduct: Total stock-based employee compensation expense under fair value based method for all awards	(1,116		)	(5,474		)	(2,555		)
Pro forma loss	$	(21,184	)	$	(14,247	)	$	(16,716	)
Reported net loss per basic and diluted share	$	(0.33	)	$	(0.15	)	$	(0.25	)
Pro forma net loss per basic and diluted share	$	(0.33	)	$	(0.24	)	$	(0.29	)

RECENT ACCOUNTING PRONOUNCEMENTS—On December 16, 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”). SFAS 123R eliminates the alternative of applying the intrinsic value measurement provisions of Opinion 25 to stock compensation awards issued to employees. Rather, the new standard requires enterprises to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide services in exchange for the award, known as the requisite service period (usually the vesting period).

The Company adopted SFAS 123R in January 2006 and currently does not expect to restate prior periods to conform to the new accounting standard as the Modified Prospective Application Method will be used. Under this method SFAS 123R is applied to new awards and to awards modified, repurchased or cancelled after the effective date. Additionally, compensation cost for the portion of awards for which the requisite service has not been rendered (such as unvested options) that are outstanding as of the date of adoption shall be recognized as the remaining requisite services are rendered. The compensation cost relating to unvested awards at the date of adoption shall be based on the grant-date fair value of those awards as calculated for pro forma disclosures under the original SFAS 123 adjusted for estimated forfeitures. See Note 2 to the consolidated financial statements included elsewhere in this Form 10-K under the caption “STOCK-BASED COMPENSATION” for information related to the pro forma effect on reported net income and net earnings per share of applying the fair value provisions of the SFAS 123. The balance of unearned stock-based compensation to be expensed in the period 2006 through 2010 related to share-based awards unvested at December 31, 2005, as previously calculated under the

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SIGNIFICANT ACCOUNTING POLICIES (Continued)

disclosure-only requirements of SFAS 123, is approximately $2.7 million. If there are any modifications or cancellations of the underlying unvested securities, the Company may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. To the extent that the Company grants additional future stock option and other share-base awards, its future stock-based compensation expense will be increased by the additional unearned compensation resulting from those additional grants. The fair value of these grants is not included in the amount above, as the impact of these grants cannot be predicted at this time because it will depend on the number of share-based payments granted and the then current fair values. The Company is currently in the process of determining our estimated forfeiture rate for purposes of adopting SFAS 123R and management estimates that the Company’s forfeiture rate will be between 10% and 25%, which will result in a reduction to the foregoing annual amoritization amounts.

In May 2005, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 154, “Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3” (“SFAS 154”). This Statement replaces APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for and reporting of a change in accounting principle. This Statement applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed.

Opinion 20 previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. This Statement requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. When it is impracticable to determine the period-specific effects of an accounting change on one or more individual prior periods presented, this Statement requires that the new accounting principle be applied to the balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable and that a corresponding adjustment be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period rather than being reported in an income statement. When it is impracticable to determine the cumulative effect of applying a change in accounting principle to all prior periods, this Statement requires that the new accounting principle be applied as if it were adopted prospectively from the earliest date practicable. This Statement shall be effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company adopted SFAS 154 in January 2006 and currently does not anticipate that it will have a significant effect on our financial statements or disclosures.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SIGNIFICANT ACCOUNTING POLICIES (Continued)

and currently does not anticipate that it will have a significant effect on our financial statements or disclosures.

3. REVENUE RECOGNITION

Historically, revenues from the Company’s distributors were recognized upon shipment based on the following factors: the Company’s sales prices are fixed or determinable by contract at the time of shipment, payment terms are fixed at shipment and are consistent with terms granted to other customers, the distributors have full risk of physical loss, the distributors have separate economic substance, the Company has no obligation with respect to the resale of the distributors’ inventory, and the Company believed it could reasonably estimate the potential returns from its distributors based on their history and its visibility to the distributors’ success with its products and into the market place in general. The Company accrued for distributor right of return based on known events and historical trends in accordance with Financial Accounting Standards Board (“FASB”) Statement No. 48 “Revenue Recognition When Right of Return Exists,” and for price protection in accordance with Emerging Issues Task Force Issue No. 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products)”. Through the Company’s first quarter ended April 3, 2005 the amount of those reserves had not been material. The Company accrued a reserve based on its reasonable estimate of future returns based on historical trends and contractual limitations. Per contractual agreement, Richardson Electronics LTD may return product three times per year under the following conditions: the total value of inventory returned shall not exceed an amount equal to 5% of the total value of the distributor’s stock on hand of the Company’s products as reported in the prior month’s inventory report, the inventory is returned no earlier than 6 months and no later than 24 months from the date of the original invoice date and the product’s packaging has not been opened or any alteration or modification has been performed on the product. The contractual agreement with WAV Wireless Outfitters included identical terms though the total value of inventory returned could not exceed an amount equal to 15% of the total value of its stock on hand of the Company’s products as reported in the prior month’s inventory report.

The Company has historically received stock rotation requests from its distributors that were within the amounts estimated and contractually allowed with the only exception being the stock rotation in February, 2004 which was approximately $37,000 in excess of the amount contractually allowed. However, the request from its distributor for stock rotation within the Company’s second quarter ended July 3, 2005 was again higher than the amount contractually allowed by approximately $51,000. Management, with the concurrence of the Company’s Audit Committee, believes the increasing percentage of new products introduced by the Company makes it likely that stock rotation reserves will continue to be difficult to estimate based on historical patterns and contractual provisions. Based on this change in facts and circumstances and management’s future expectations, the Company believes that it can no longer reasonably estimate the amount of future returns from its distributors as of July 3, 2005. Accordingly, recognition of revenue and associated cost of sales on shipments to distributors is deferred until the resale to the end customer. This change in application resulted in a $4.1 million revenue deferral in the Company’s second quarter of 2005 which is reflected in the accompanying consolidated statements of operations for 2005. Although revenue is deferred until resale, title of products sold to distributors transfers upon shipment. Accordingly, shipments to distributors are reflected in the consolidated balance sheets as accounts receivable and a reduction of inventories at the time of shipment. Deferred revenue and

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

3. REVENUE RECOGNITION (Continued)

the corresponding cost of sales on shipments to distributors are reflected in the consolidated balance sheet on a net basis as “Deferred margin on distributor inventory.”

As this change in the application of the Company’s revenue recognition policy is the result of a change in current facts and circumstances, in accordance with Accounting Principles Board Opinion No. 20 “Accounting Changes” paragraph 8, the Company accounted for the change within its second quarter ended July 3, 2005.

4. INVESTMENTS

Available-for-Sale Investments

Investments, which are classified as available-for-sale, are summarized below for December 31, 2005 and 2004 (in thousands):

														Classified on Balance Sheet as:
	Purchase/			Gross			Gross							Cash
	Amortized			Unrealized			Unrealized				Aggregate			and Cash			Short-term
	Cost			Gains			Losses				Fair Value			Equivalents			Investments
As of December 31, 2005
Corporate debt securities		$	16,069		$	—		$	(9	)		$	16,060		$	1,001		$	15,059
Money market funds		10,773			—			—				10,773			10,773			—
U. S. government agency		999			—			(6		)		993			—			993
Total		$	27,841		$	—		$	(15	)		$	27,826		$	11,774		$	16,052
As of December 31, 2004
Corporate debt securities		$	28,504		$	—		$	(19	)		$	28,485		10,759			$	17,726
Money market funds		12,742			—			—				12,742			12,742			—
Other debt securities		1,007			—			(1		)		1,006			—			1,006
Total		$	42,253		$	—		$	(20	)		$	42,233		$	23,501		$	18,732

As of December 31, 2005 and 2004, $17.1 million and $29.5 million of fixed income securities had contractual maturities of six months or less, respectively. There were no fixed income securities that had a contractual maturity beyond six months.

Impairment of Investments

The Company monitors its investment portfolio for impairment on a periodic basis. In the event that the carrying value of an investment exceeds its fair value and the decline in value is determined to be other-than-temporary, an impairment charge is recorded and a new cost basis for the investment is established. In order to determine whether a decline in value is other-than-temporary, the Company evaluates, among other factors: the duration and extent to which the fair value has been less than the carrying value; the financial condition of and business outlook for the company, including key operational and cash flow metrics, current market conditions and future trends in the company’s industry; the company’s relative competitive position within the industry; and the Company’s intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in fair value.

The duration of the unrealized losses on available-for-sale investments at December 31, 2005 and December 31, 2004 did not exceed 12 months. Market values were determined for each individual security

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

4. INVESTMENTS (Continued)

in the investment portfolio. The decline in value of these investments is primarily related to changes in interest rates. The Company does not believe that any of the unrealized losses represented an other-than-temporary impairment based on it evaluation of available evidence as of December 31, 2005.

Risk Management

The Company generally places its investments with high-credit-quality counterparties and, by policy, all financial instruments and counterparties must maintain the following minimally acceptable credit ratings: commercial deposits and corporate obligations A2/A, commercial paper A-1/P-1, municipal notes MIG 1/S and P-1, municipal bonds AAA and asset back securities AAA. The Company, by policy, also limits the amount of credit exposure with any one financial institution or commercial issuer. No significant concentration of credit risk existed at December 31, 2005.

5. ACQUISITION

EiC Acquisition

On June 18, 2004, the Company completed its acquisition of the wireless infrastructure business and associated assets from EiC. The aggregate purchase price was $13.3 million which included payments of cash of $10.0 million, the issuance of 737,000 shares of the Company’s common stock valued at $2.5 million, acquisition costs of $1.2 million (including $700,000 paid to a related party for investment banking services in connection with the acquisition) and $152,000 registration statement related expenses reduced by a $576,000 benefit from the termination settlement of the associated supply agreement with EiC recognized during our quarter ended December 31, 2004. In connection with the acquisition, $1.5 million in cash and 294,118 shares of common stock were held in escrow as security against certain financial contingencies. On March 30, 2005, the Company made a claim against the escrow account for unpaid invoices issued under the supply agreement. The Company received those funds on May 4, 2005. The uncontested amount was released to EiC on April 5, 2005 per the escrow agreement and the residual balance of the $1.5 million was released to EiC on May 4, 2005. The 294,118 shares in the escrow account less any shares for any properly noticed unpaid or contested amounts will be distributed within five days after March 31, 2006. On November 23, 2004 the Company filed a registration statement registering for resale by the seller of up to 442,882 shares of the Company’s common stock issued in the acquisition.

In addition to the closing consideration, EiC was originally entitled to further consideration of up to $7.0 million and $7.0 million in cash and shares of the Company’s common stock if certain revenue and gross margin targets were achieved by March 31, 2005 and March 31, 2006, respectively. The Company has determined that the revenue and gross margin targets were not met for the nine month period ending March 31, 2005. EiC subsequently notified the Company that it disagrees with the Company’s conclusion that the revenue and gross margin targets were not met for the nine month period ending March 31, 2005. While the Company believes EiC’s assertions are without merit and has notified EiC of such, there can be no assurances as to the eventual outcome of this matter.

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

5. ACQUISITION (Continued)

If the Company achieves certain revenue targets by March 31, 2006, it will be obligated to pay EiC the remaining contingent consideration of up to $7.0 million, ninety percent (90%) in its common stock and ten percent (10%) in cash. The number of shares of its common stock to be delivered is to be determined by dividing the value in dollars of the portion payable in its common stock by the average closing price of its common stock, as quoted on the NASDAQ National Market, during the ten consecutive trading days ending one trading day before the end of the period covered by the payment, provided, however, that in the event that the calculation of the average closing price results in a price per share for the first payment that would be less than $5.00 or for the second payment that would be less than $6.00, then the Company, at its option, in its sole discretion, may elect to make the payment part or all in cash and the balance, if any, in shares of its common stock. If EiC receives such consideration, the amounts will be recorded as an increase to goodwill. As of March 20, 2006 the Company has not yet determined if the revenue targets were met for the year ending March 31, 2006. The Company will not be able to make its determination until after it has completed its internal control procedures after its quarter end on April 2, 2006. The fair value of the Company’s common stock was determined based on the average closing price per share of the Company’s common stock over a 5-day period beginning two trading days before and ending two trading days after the amended terms of the acquisition were agreed to and announced (June 21, 2004).

The acquisition was accounted for using the purchase method of accounting in accordance with SFAS No. 141, “Business Combinations” (“SFAS No. 141”), and accordingly the Company’s consolidated financial statements from June 18, 2004 include the impact of the acquisition. The following table summarizes the allocation of the total purchase price of the EiC acquisition, as of the date of the acquisition (in thousands):

Property and equipment	$	1,124
Inventory.	2,038
In-process research and development	8,500
Developed technology	200
Goodwill	1,405
Total purchase price .	$	13,267

The acquisition was accounted for as a purchase transaction, and accordingly, the assets of EiC were recorded at their estimated fair values at the date of the acquisition. With the exception of the goodwill and acquired in-process research and development (“IPRD”), the identified intangible assets will be amortized on a straight-line basis over their estimated useful lives, with a weighted average life of approximately five years.

A portion of the purchase price, $8.7 million, was allocated to developed and core technology and in-process research and development (“IPRD”). Developed and core technology and IPRD were identified and valued through extensive interviews, analysis of data provided by EiC Corporation concerning developmental products, their stage of development, the time and resources needed to complete them, their expected income generating ability, target markets and associated risks. The income method was the primary technique utilized in valuing the developed and core technology and IPRD. Under the income method, fair value reflects the present value of the projected cash flows that are expected to be generated by the products incorporating the current technologies.

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

5. ACQUISITION (Continued)

Developmental projects that reached technological feasibility were classified as developed and core technology, and the $200,000 value assigned to developed technology was capitalized to be amortized using the straight-line method over a weighted-average period of five years. Developmental projects that had not reached technological feasibility, and had no future alternative uses were classified as IPRD. The $8.5 million value allocated to projects that were identified as IPRD was charged to acquired in-process research and development in 2004. The value assigned to IPRD comprises the following projects: 12V heterojunction bipolar transistor (“HBT”) power amplifiers ($1.5 million) and 28V HBT high power amplifiers ($7.0 million).

The nature of the efforts required to develop the acquired IPRD into commercially viable products principally relate to the completion of all planning, designing, prototyping, verification and testing activities that are necessary to establish that the products can be produced to meet their design specifications, including functions, features and technical performance requirements.

In valuing the IPRD, the Company considered, among other factors, the importance of each project to the overall development plan, the projected incremental cash flows from the projects when completed and any associated risks. The projected incremental cash flows were discounted back to their present value using an after-tax discount rate of 25%. This discount rate was determined after consideration of the Company’s weighted average cost of capital and the weighted average return on assets. Associated risks include the inherent difficulties and uncertainties in completing each project and thereby achieving technological feasibility, anticipated levels of market acceptance and penetration, market growth rates and risks related to the impact of potential changes in future target markets.

As part of the acquisition, the Company entered into a sublease with EiC Corporation for 28,160 square feet of space at their facility in Fremont, California. This sublease expired in December 2004 and converted into a month to month lease thereafter. At the end of January 2005 the Company moved the wafer fabrication facility from the Fremont location to its facility in Milpitas, California and ended this sublease.

Telenexus Acquisition

On January 28, 2005, the Company completed its acquisition of Telenexus, Inc. (“Telenexus”). Pursuant to an Agreement and Plan of Merger, dated January 19, 2005, by and between the Company, WJ Newco, LLC (the “WJ Sub”), Telenexus and Richard J. Swanson, Wilfred K. Lau, David Fried, Kurt Christensen and Mark Sutton (collectively the “Shareholders”), Telenexus merged with and into the WJ Sub effective on January 29, 2005. The WJ Sub was the survivor in the merger and is a wholly-owned subsidiary of the Company. Telenexus designs, develops, manufactures and markets radio frequency identification (“RFID”) reader products for a broad range of industries and markets. By virtue of the merger, the Company purchased through the WJ Sub all of the assets necessary for the conduct of the RFID business of Telenexus, consisting primarily of, and including, but not limited to RFID modules, baseband processing algorithm technology, applications software and realizations of several reader product designs. The consideration paid by the Company on the closing date in connection with the merger consisted of cash in the amount of $3.0 million, which was paid out of the Company’s cash reserves on the closing date, and 2,333,333 shares of the Company’s common stock valued at $8.2 million at the closing date. Including acquisition costs of $230,000, the aggregate purchase price for the net assets of Telenexus totaled $11.4 million. Of the closing consideration, cash in the amount of $500,000 and 333,333 shares of

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

5. ACQUISITION (Continued)

the Company’s common stock are being held in escrow with respect to any indemnification matter under the merger agreement. The outstanding cash balance of the escrow account less any properly noticed unpaid or contested amounts was to be distributed within two days after October 28, 2005. The Company released the full amount of the cash balance of the escrow account on October 31, 2005. The 333,333 shares in the escrow account less any shares for any properly noticed unpaid or contested amounts will be distributed within five days after July 28, 2006. The fair value of the Company’s common stock was determined based on the average closing price per share of the Company’s common stock over a 5-day period beginning two trading days before and ending two trading days after the amended terms of the acquisition were agreed to and announced (January 31, 2005). In addition to the closing consideration, the sellers may be entitled to further compensation of up to $2.5 million in cash and up to 833,333 shares of the Company’s common stock if the Company achieves certain revenue targets by July 28, 2006. Any change in the fair value of the net assets of Telenexus or any additional consideration to the Shareholders will change the amount of the purchase price allocable to goodwill. Two of the Shareholders, Richard J. Swanson and Wilred K. Lau also entered into three-year employment agreements with the Company. The acquisition was accounted for using the purchase method of accounting in accordance with SFAS No. 141, “Business Combinations” (“SFAS No. 141”), and accordingly the Company’s consolidated financial statements from January 28, 2005 include the impact of the acquisition.

In accordance with SFAS No. 141, the total purchase price was allocated to the tangible and intangible assets acquired and liabilities assumed based upon their respective estimated fair values at the acquisition date with the excess purchase price allocated to goodwill. The Company determined that acquiring Telenexus, Inc. was a more cost effective means of developing the RFID products and technology necessary to continue to enhance our RFID reader offerings to further capitalize on market opportunity than developing the products and technology internally. The acquisition also offers the Company the opportunity to shorten the time it takes to bring additional RFID reader products and technology to market. The valuation of the identifiable intangible assets acquired reflects management’s estimates based on, among other factors, a valuation of the intangible assets prepared by an independent third party. The following table summarizes the allocation of the total purchase price of the Telenexus acquisition, as of the date of the acquisition (in thousands):

Net tangible assets	$	579
In-process research and development	3,400
Amortizable intangible assets:
Developed technology	40
Customer relationships	900
Trademarks and trade names	700
Non-competition agreements	400
Goodwill	5,401
Total purchase price	$	11,420

With the exception of the goodwill and IPRD, the identified intangible assets consisting of existing technology, customer relationships, trademarks and trade names and non-competition agreements will be amortized on a straight-line basis over their estimated useful lives, with a weighted average life of approximately eight years. In accordance with SFAS No. 142, Goodwill and Other Intangible Assets

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

5. ACQUISITION (Continued)

(“SFAS No. 142”), goodwill of $5.5 million will not be amortized and will be tested for impairment at least annually or whenever events or changes in circumstances indicate that the carrying value may not be recoverable in accordance with the Company’s policy on impairment analysis.

Prior to the acquisition, the Company and Telenexus had entered into an agreement to jointly design, develop and produce a Personal Computer Memory Card International Association (“PCMCIA”) Type II Multi-Protocol RFID reader. The Company has evaluated the effective settlement of this preexisting executory contract and the associated reacquired right to the use of its technology in accordance with Emerging Issues Task Force (“EITF”) 04-1 “Accounting for Preexisting Relationships between the Parties to a Business Combination.” The Company has determined that the effective settlement of the executory contract and the associated reacquired right to use its technology was neither favorable or unfavorable as the agreement represented fair value when compared to similar market transactions and there were no stated settlement provisions in the contract.

A portion of the purchase price, $3.4 million, was allocated to developed and core technology and IPRD. Developed and core technology and IPRD were identified and valued through extensive interviews, analysis of data provided by Telenexus concerning developmental products, their stage of development, the time and resources needed to complete them, their expected income generating ability, target markets and associated risks. The income method was the primary technique utilized in valuing the developed and core technology and IPRD. Under the income method, fair value reflects the present value of the projected cash flows that are expected to be generated by the products incorporating the current technologies.

Developmental projects that reached technological feasibility were classified as developed and core technology, and the $40,000 value assigned to developed technology was capitalized to be amortized using the straight-line method over a weighted-average period of fourteen months. Developmental projects that had not reached technological feasibility, and had no future alternative uses were classified as IPRD. The $3.4 million value allocated to projects that were identified as IPRD was charged to acquired in-process research and development in the accompanying condensed consolidated statements of operations for the nine months ended October 2, 2005. The value assigned to IPRD comprises the following projects: multi-protocol readers ($1.3 million), Smart readers ($900,000) and Class 3 readers ($1.2 million). The value of these projects was determined by estimating the discounted net cash flows from the sale of the products resulting from the completion of the projects, reduced by the portion of the revenue attributable to developed technology and the percentage of completion of the project.

Products based on multi-protocol reader (“MPR”) technology are capable of reading tags of different classes (e.g., Class 0, Class 0+, Class 1, and Gen 2 tags) with a single reader. The hardware realization of the MPR products is based on a hardware stack consisting of an interface board, a control board, a radio frequency (“RF”) board and an antenna. A modular construction technique is employed such that differing combinations of boards can be used to produce different products. For example, the same antenna, RF board, and control board can be used with one interface board to provide an Ethernet connection to the host computer, or a different interface board to provide a serial interface to the host. Similarly, different RF boards can be used to provide one, two or four antenna ports for reading tags without changing the control board or interface board. This novel modular construction technique is a part of the MPR technology approach.

Smart reader technology is an extension of the MPR Technology. This technology provides an operating system (e.g., Linux, Windows® CE) in the embedded microprocessor on the interface board.

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

5. ACQUISITION (Continued)

With the previous RFID technologies, the host computer provided virtually every command to the reader. With Smart reader technology, the embedded controller can host middleware applications. These applications can take high-level commands from the host and then provide most of the lower-level commands internal to the reader. Thus relieving much of the command and processing burden from the host computer.

Class 3 tags are fundamentally different from the Class 0, 0+ and 1 tags in that they are battery assisted. This makes them more powerful and capable, and provides longer read range, but at the expense of battery life and cost. They are more appropriate for tracking higher-value assets. The air-interface protocol is different for the Class 3 readers and tags, and to date is not standardized (as is the case for Class 0 and 1 tags).

6. GOODWILL AND INTANGIBLE ASSETS

In connection with the acquisition of the wireless infrastructure business and associated assets from EiC on June 18, 2004, the Company recorded $1.8 million of goodwill. Adjustments to the EiC goodwill subsequent to the EiC acquisition date, resulted primarily from a $576,000 benefit from the termination settlement of the associated supply agreement with EiC and partially offset by $152,000 of additional registration statement related expenses. In connection with the acquisition of Telenexus acquisition on January 28, 2005, the Company recorded $5.5 million of goodwill. Adjustments to the Telenexus goodwill through December 2005, subsequent to the Telenexus acquisition date, resulted primarily from collection of a previously unrecognized pre-acquisition accounts receivable and finalization of direct acquisition costs. This goodwill was based upon the values assigned to the transactions at the time they were announced in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”). The changes in the carrying value of goodwill as of December 31, 2005 are as follows (in thousands):

	EiC		Telenexus				Total
Balance as of December 31, 2004	$	1,368		$	—		$	1,368
Purchased goodwill	—			5,464			5,464
Adjustments to goodwill	37			(63		)	(26		)
Balance as of December 31, 2005	$	1,405		$	5,401		$	6,806

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

6. GOODWILL AND INTANGIBLE ASSETS (Continued)

The Company periodically evaluates its goodwill in accordance with SFAS No. 142 for indications of impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors the Company considers important that could trigger an impairment review include significant under-performance relative to historical or projected future operating results, significant changes in the manner of the Company’s use of the acquired assets or the strategy for the Company’s overall business, or significant negative industry or economic trends. If these criteria indicate that the value of the goodwill may be impaired, an evaluation of the recoverability of the net carrying value is made. Irrespective of the aforementioned circumstances where impairment indicators are present, the Company is required by SFAS No. 142 to test its goodwill for impairment at least annually. The Company has chosen the end of its fiscal month of May as the date of its annual impairment test.

In accordance with SFAS No. 142 paragraph 30, “A reporting unit is an operating segment or one level below an operating segment (referred to as a component). A component of an operating segment is a reporting unit if the component constitutes a business for which discrete financial information is available and segment management regularly reviews the operating results of that component. However, two or more components of an operating segment shall be aggregated and deemed a single reporting unit if the components have similar economic characteristics. An operating segment shall be deemed to be a reporting unit if all of its components are similar, if none of its components is a reporting unit, or if it comprises only a single component. The relevant provisions of Statement 131 and related interpretive literature shall be used to determine the reporting units of an entity.” The Company’s Chief Operating Decision Maker (“CODM”) is the CEO. While the Company’s CODM monitors the sales of various products, operations are managed and financial performance evaluated based upon the sales and production of multiple products employing common manufacturing and research and development resources; sales and administrative support; and facilities. This allows the Company to leverage its costs in an effort to maximize return. The Company believes that any allocation of such shared expenses to various products would be impractical, arbitrary and currently does not make such allocations internally. As such, the Company considers itself a single reporting unit.

The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill. SFAS No. 142 paragraph 30 states: “The fair value of an asset (or liability) is the amount at which that asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Thus, the fair value of a reporting unit refers to the amount at which the unit as a whole could be bought or sold in a current transaction between willing parties. Quoted market prices in active markets are the best evidence of fair value and shall be used as the basis for the measurement, if available.” As of June 3, 2005 (the closest trading date prior to the end of the Company’s fiscal month of May) the fair value of the Company was $133.9 million based on a per (common) share price of $2.09 as reported on the NasdaqNM (ticker “WJCI”) and 64,066,380 common shares outstanding. As of June 5, 2005 the Company’s carrying amount, including goodwill was $56.2 million. As the fair value of the Company exceeds its carrying amount, the Company’s goodwill is considered not impaired.

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

6. GOODWILL AND INTANGIBLE ASSETS (Continued)

Intangible assets are recorded at cost, less accumulated amortization. The following tables present details of the Company’s purchased intangible assets (in thousands):

As of December 31, 2005:

	Useful			Accumulated
Description	Life	Gross		Amortization			Net
EiC acquisition
Purchased developed technology	5 years	$	200		$	60	$	140
Telenexus acquisition
Purchased developed technology	1.2 years	40			32		8
Customer relationships.	7 years	900			118		782
Trademarks and trade names	12 years	700			54		646
Non-competition agreements	4 years	400			92		308
Total identified intangible assets		$	2,240		$	356	$	1,884

As of December 31, 2004:

Useful

Accumulated

Description

Life

Gross

Amortization

Net

EiC acquisition

Purchased developed technology

5 years

200

180

For the year ended December 31, 2005, amortization of purchased intangible assets included in cost of goods sold was approximately $72,000. For the year ended December 31, 2005, amortization of purchased intangible assets included in operating expense was approximately $264,000. For the year ended December 31, 2004, amortization of purchased intangible assets included in cost of goods sold was approximately $20,000. There was no amortization of purchased intangible assets in 2003. Amortization is computed using the straight-line method over the estimated useful life of the intangible asset. The intangible assets related to purchased developed technology is amortized to cost of goods sold. The intangible assets related to customer relationships, trademarks and trade names and non-competition agreements with sales/engineering personnel are amortized to operating expense. The Company expects that annual amortization of acquired intangible assets to be as follows (in thousands):

	EiC		Telenexus			Total
Fiscal year:
2006	$	40		$	295	$	335
2007	40			287		327
2008	40			287		327
2009	20			195		215
2010	—			187		187
2011 and beyond	—			493		493
Total amortization	$	140		$	1,744	$	1,884

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

7. UNAUDITED PRO FORMA RESULTS OF OPERATIONS

The following unaudited pro forma consolidated financial data represents the combined results of operations as if Telenexus’ business had been combined with the Company at the beginning of the respective period. This pro forma financial data includes the straight line amortization of intangibles over their respective estimated useful lives and excludes the write-off of IPRD of $3.4 million (in thousands, except per share amounts):

	December 31,
	2005			2004
Net sales	$	31,675		$	34,687
Loss from operations	$	(18,759	)	$	(17,877	)
Net loss	$	(17,690	)	$	(9,612	)
Basic and diluted net loss per share	$	(0.27	)	$	(0.15	)
Basic and diluted average shares	64,335			62,731

The unaudited pro forma results of operations is presented for illustrative purposes only and is not intended to represent what the Company’s results of operations would have been if the acquisition had occurred on those dates or to project the Company’s results of operations for any future period. Since the Company and Telenexus were not under common control or management for any period presented prior to the acquisition, the unaudited pro forma results of operations may not be comparable to, or indicative of, future performance. These results do not reflect any additional costs or cost savings resulting from the acquisition.

8. BORROWING ARRANGEMENTS

On December 27, 2005, the Company entered into the fourth amendment (the “Amendment”) to its Amended and Restated Loan and Security Agreement between Comerica Bank and the Company dated September 23, 2003 and as amended June 13, 2005, July 12, 2005 and September 28, 2005. The effective date of the Amendment is December 22, 2005. Under the new terms, the revolving credit facility (“Revolving Facility”) provides for a maximum credit extension of $10.0 million, with a $5.0 million sub-limit to support letters of credit, a $250,000 sub-limit for foreign exchange transactions and a $200,000 sub-limit for corporate credit cards. The Revolving Facility matures on December 21, 2006. Interest rates on outstanding borrowings are periodically adjusted based on certain financial ratios and are initially set, at the Company’s option, at LIBOR plus 2.0% or Prime. The Revolving Facility requires the Company to maintain certain financial ratios and contains limitations on, among other things, the Company’s ability to incur indebtedness, pay dividends and make acquisitions without the bank’s permission. The Revolving Facility is secured by substantially all of the Company’s assets. The Company was in compliance with the covenants as of December 31, 2005. As of December 31, 2005 and December 31, 2004, there were no outstanding borrowings under the Revolving Facility. The Company has letters of credit of $3.2 million available as of December 31, 2005 against which no amounts have been drawn.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

9. OTHER LONG-TERM OBLIGATIONS

Long-term obligations, excluding amounts due within one year, consist of the following (in thousands):

	December 31,
	2005		2004
Environmental remediation (Note 12)	$	60	$	69
Restructuring accrual (Note 14)	13,390		16,069
Deferred rent and deposits	596		726
Long-term advances and deposits	29		—
Total	$	14,075	$	16,864

10. STOCKHOLDERS’ EQUITY

On January 28, 2004, the Company completed a secondary underwritten public offering of 2,000,000 shares of common stock at $5.75 per share, resulting in net proceeds of $10.1 million.

In March 2003, the Company’s Board of Directors (the “Board”) authorized the repurchase of up to $2.0 million of the Company’s common stock. In October 2003, the Board approved an additional $2.0 million to expand this existing share repurchase program increasing the total amount authorized to $4.0 million. Purchases under this stock repurchase program were made in the open market, through block trades or otherwise. Depending on market conditions and other factors, these purchases were commenced or suspended at any time or from time-to-time without prior notice. During the year ended December 31, 2003, $2.8 million was utilized to purchase 1,340,719 shares of the Company’s common stock at a weighted average purchase price of $2.08 per share. All of the purchases were made on the Nasdaq National Market at prevailing open market prices using general corporate funds. This stock repurchase program ended as of the annual shareholder meeting on July 22, 2004. On July 27, 2004 the Company announced that its Board of Directors authorized a new repurchase program of up to $2.0 million of the Company’s common stock. This new program was effective July 27, 2004 and replaced all previous repurchase programs. Under this new program, $920,000 was utilized to purchase 429,053 shares of the Company’s common stock at a weighted average purchase price of $2.12 per share. This program expired on July 26, 2005. The repurchases reduced the Company’s cash and interest income during the period and correspondingly reduced the number of the Company’s outstanding shares of common stock.

During the year ended December 31, 2004, the Company modified two option agreements (to extend the option exercise period) resulting in $594,000 of severance expense which was recorded as selling and administrative expense in the accompanying consolidated statements of operations for the year ended December 31, 2004 and an increase to additional paid-in capital in the accompanying consolidated balance sheet at December 31, 2004.

STOCK OPTION PLANS—During 2000, the Company’s “2000 Stock Incentive Plan” and “2000 Non-Employee Director Stock Compensation Plan” (collectively the “Plans”) were adopted and approved by the Board and the Company’s stockholders. Under the Plans, the Company may grant incentive awards in the form of options to purchase shares of the Company’s common stock, restricted shares, common stock and stock appreciation rights to participants, which include non-employee directors, officers and employees of and consultants to the Company and its affiliates. On May 22, 2002, the Board approved the

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

10. STOCKHOLDERS’ EQUITY (Continued)

adoption of an amendment to the Company’s “2000 Stock Incentive Plan” to increase the number of shares of common stock authorized for issuance from 16,500,000 to 19,000,000 shares. This plan amendment did not affect any other terms of the “2000 Stock Incentive Plan.” On May 29, 2003, the Board approved the adoption of an amendment to the Company’s “2000 Non-Employee Director Compensation Plan” to increase the number of shares of common stock authorized for issuance from 570,000 to 800,000, which was approved by the Company’s stockholders on July 15, 2003 at the Company’s Annual Meeting of Stockholders. Also on May 29, 2003, the Board approved the adoption of a second amendment to the Company’s “2000 Stock Incentive Plan” so that options granted to employees under the “2000 Stock Incentive Plan” will qualify as performance-based compensation under Internal Revenue Code Section 162(m) and thereby not be subject to a deduction limitation. Particularly, the amendment to the “2000 Stock Incentive Plan” provides that no employee or prospective employee shall be granted one or more options within any fiscal year which in the aggregate are for the purchase of more than 3,000,000 shares. The total number of shares of common stock authorized for issuance pursuant to the Plans is 19,800,000 shares.

On May 23, 2001, the Company’s 2001 Employee Stock Incentive Plan (the “Plan”) was adopted and approved by the Board and the Company’s stockholders. The Plan may grant incentive awards in the form of options to purchase shares of the Company’s common stock, restricted shares, common stock and stock appreciation rights to participants, which include employees which are not officers and directors of the Company and its affiliates and consultants to the Company and its affiliates. The total number of shares of common stock reserved and available for grant under the Plan is 2,000,000 shares. Shares subject to award under the Plan may be authorized and unissued shares or may be treasury shares. Stock options may include incentive stock options, nonqualified stock options or both, in each case, with or without stock appreciation rights.

The Company’s stock option plans (“Plans”) provide that options granted under the Plans will have a term of no more than 10 years. Options granted under the Plans have vesting periods ranging from two to four years. The provisions of the Plans provide that under certain circumstances, such as a change in control, the achievement of certain performance objectives, or certain liquidity events, the outstanding option may be subject to accelerated vesting. As of December 31, 2005 the number of shares available for future grants under the above plans was 5,734,342. Stock options may include incentive stock options, nonqualified stock options or both, in each case, with or without stock appreciation rights.

Activity under the stock option plans during 2005, 2004 and 2003 are set forth below:

			Weighted Average
	Shares		Exercise Price
2003
Granted (weighted average fair value of $2.02 per option)	1,470,000			$	2.93
Exercised	(2,534,724	)		$	1.37
Cancelled	(1,771,901	)		$	1.50
At December 31:
Outstanding	12,428,034			$	1.88
Exercisable	5,076,882			$	1.66

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

10. STOCKHOLDERS’ EQUITY (Continued)

			Weighted Average
	Shares		Exercise Price
2004
Granted (weighted average fair value of $2.19 per option)	3,046,500			$	3.27
Exercised	(934,107	)		$	1.27
Cancelled	(813,031	)		$	0.98
At December 31:
Outstanding	13,727,396			$	2.26
Exercisable	6,389,431			$	2.03

			Weighted Average
	Shares		Exercise Price
2005
Granted (weighted average fair value of $0.87 per option)	1,728,000			$	1.43
Exercised	(1,377,960	)		$	1.06
Cancelled	(4,710,677	)		$	3.08
At December 31:
Outstanding	9,366,759			$	1.87
Exercisable	5,225,843			$	2.02

The following table summarizes information concerning currently outstanding and exercisable options at December 31, 2005:

	Options Outstanding							Options Exercisable
			Weighted						Weighted
			Average Years		Weighted				Average
	Number		of Remaining		Average			Number	Exercise
Range of Exercise Price	Outstanding		Contractual Life		Exercise Price			Exercisable	Price
$0.01 to $0.01		40,945		2.5		$	0.01	30,135		$	0.01
$0.80 to $1.14		872,024		8.7		$	0.92	111,524		$	0.81
$1.37 to $1.91		5,565,840		4.7		$	1.39	3,198,654		$	1.37
$2.09 to $2.96		2,182,400		3.3		$	2.68	1,641,950		$	2.83
$3.19 to $4.25		611,500		8.3		$	3.43	167,875		$	3.49
$5.48 to $6.67		17,000		7.0		$	5.89	6,575		$	6.07
$9.75 to $12.94		63,500		1.3		$	10.00	61,000		$	9.88
$15.00 to $15.00		750		4.6		$	15.00	450		$	15.00
$26.75 to $26.75		12,800		4.8		$	26.75	7,680		$	26.75
$0.01 to $26.75		9,366,759		5.0		$	1.87	5,225,843		$	2.02

EMPLOYEE STOCK PURCHASE PLAN (“ESPP”)—In May 2001, the Company’s stockholders approved the adoption of the Company’s 2001 Employee Stock Purchase Plan (the “Purchase Plan”). Up to 1,500,000 shares of Common Stock may be issued under the Purchase Plan. Under the plan, all eligible employees may purchase shares of the Company’s common stock at six-month intervals at 85% of fair market value (calculated in the manner provided under the plan). Employees purchase such stock using payroll deductions, which may not exceed 15% of their total cash compensation. In fiscal 2005, 142,453 shares and 267,417 shares were issued under this plan at an average price of $1.99 and $1.11 for the plans

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

10. STOCKHOLDERS’ EQUITY (Continued)

ended April 2005 and October 2005, respectively. In fiscal 2004, 54,912 shares and 103,689 shares were issued under this plan at an average price of $3.25 and $1.97 for the plans ended April 2004 and October 2004, respectively. The plan was suspended in the fourth quarter of 2002 due to the Fox Paine Acquisition Proposal (see Note 18) and was not reinstated until the fourth quarter of 2003, therefore there were no shares issued under the Employee Stock Purchase Plan in 2003. At December 31, 2005, 546,574 shares were available for future issuance under the plan.

11. INCOME TAXES

The benefit from federal and state income taxes is as follows. Foreign income (loss) before income taxes was insignificant for all years.

	2005			2004			2003
	(in thousands)
Current:
Federal	$	(123	)	$	(7,674	)	$	(167	)
State	3			—			(480		)
Total current	(120		)	(7,674		)	(647		)
Deferred:
Federal	—			—			—
State	—			—			—
Total deferred	—			—			—
Total	$	(120	)	$	(7,674	)	$	(647	)

In 2005, The Company recorded a net tax benefit of $120,000 as the statute had expired on certain estimated federal tax exposures during the current year. The tax benefit for 2004 of $7.7 million resulted from a revision of the Company’s estimated income tax contingency liability due to the receipt of the final assessment from the Internal Revenue Service related to the audit of the Company’s 1996 through 2000 tax returns. In 2003, the Company recorded a tax benefit of $647,000 related to an income tax refund of $480,000 from the State of Maryland as the result of amending the Company’s 1999 state tax return and an adjustment to the tax contingency liability of $167,000 for additional federal income tax refund determined after finalizing the 2002 carryback claim filed in the first quarter of 2003 and miscellaneous tax payments.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

11. INCOME TAXES (Continued)

The differences between the effective income tax rate as applied to loss from operations and the statutory federal income tax rate are as follows:

	2005		2004		2003
Statutory federal tax rate	(35.0	)%	(35.0	)%	(35.0	)%
Foreign sales benefit	—		—		(2.3	)
Research and development credit	(3.0	)	(3.1	)	(3.2	)
State taxes, net of federal tax benefit	(5.7	)	(5.7	)	(5.7	)
In-process research and development	6.6		—		—
Expired foreign tax credit	2.1		—		—
Other	1.6		0.3		(2.0	)
Tax reserve no longer required	(0.6	)	(45.8	)	—
Change in valuation allowance	33.4		43.5		43.7
Effective tax rate	(0.6	)%	(45.8	)%	(4.5	)%

Deferred tax assets are recognized when management believes realization of future tax benefits of temporary differences is more likely than not. In estimating future tax consequences, all expected future events are considered (including available carryback claims), other than enactment of changes in the tax law or rates. Valuation allowances are established for those deferred tax assets where management believes it is not more likely than not such assets will be realized. Deferred tax amounts are comprised of the following at December 31 (in thousands):

	2005			2004
Net operating loss	$	19,304		$	14,498
Restructuring accrual	6,835			7,913
Depreciation and amortization	12,998			11,257
Accounts receivable valuation	38			32
Inventory valuation	2,394			996
Tax credits	8,158			8,631
Employee benefit related accruals	477			492
Other	398			290
Total deferred tax assets	50,602			44,109
Valuation allowance	(50,602		)	(44,109		)
Total deferred tax assets	$	—		$	—
Income tax contingency liability	$	1,818		$	1,946

As of December 31, 2005, the Company had $1,709,000 in federal minimum tax credit carryforwards which are available indefinitely. The Company also had R&D tax credit carryforwards of $4,873,000 which begin to expire in 2012. Additionally, the Company had state tax credit carryforwards of $2,424,000 of which $583,000 begin to expire in 2009 and $1,841,000 are available indefinitely.

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

11. INCOME TAXES (Continued)

At December 31, 2005 the Company had $47,594,000 of federal net operating loss carryforwards which will expire beginning in 2023. The Company also had state net operating loss carryforwards of $46,042,000 which begin to expire in 2013.

Current federal and state tax laws include substantial restrictions on the utilization of net operating losses and tax credits in the event of an “ownership change” of a corporation. Accordingly, the Company’s ability to utilize net operating loss and tax credit carryforwards may be limited as a result of such an ownership change. Such a limitation could result in the expiration of carry forwards before they are utilized.

12. COMMITMENTS AND CONTINGENCIES

Commitments

The Company leases its corporate headquarters and manufacturing facilities under various non-cancelable operating leases expiring through January, 2011. See Note 14 for a discussion of restructuring charges recorded related to these leases.

Minimum lease commitments as of December 31, 2005 under noncancellable leases are as follows (in thousands):

	Operating Leases
Lease payments:
2006		$	4,589
2007		4,261
2008		4,417
2009		4,442
2010		3,117
Remaining years		142
Total		$	20,968

Rent expense in 2005, 2004 and 2003 was $3.1 million, $3.2 million and $3.1 million, respectively.

The Company subleases to third parties approximately 31,800 square feet of its abandoned leased space under noncancellable operating leases expiring through January, 2008. This sublease income is incorporated in the restructuring charges related to our lease loss accruals.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

12. COMMITMENTS AND CONTINGENCIES (Continued)

Minimum sublease income commitments as of December 31, 2005 under noncancellable leases are as follows (in thousands):

	Operating Leases
Sublease rental income:
2006		$	365
2007		218
2008		15
2009		—
2010		—
Remaining years		—
Total		$	598

Sublease rental income earned in 2005, 2004 and 2003 was $424,000 $759,000 and $965,000, respectively.

Environmental Remediation

Our current operations are subject to federal, state and local laws and regulations governing the use, storage, disposal of and exposure to hazardous materials, the release of pollutants into the environment and the remediation of contamination. The Company has an accrued liability of $66,000 as of December 31, 2005 to offset estimated program oversight, remediation actions and record retention costs. In 2005 the accrued liability was reduced by $100,000 when it was determined that the probability of an assessment for a prior violation was remote. Expenditures charged against the provision totaled $9,000, $14,000 and $11,000 in 2005, 2004 and 2003, respectively.

The Company continues to be in compliance with the remedial action plans being monitored by various regulatory agencies at its former Palo Alto and Scotts Valley sites. The Company has entered into funded fixed price remediation contracts and obtained cost-overrun and unknown pollution conditions insurance coverage. The Company believes that it is remote that it would incur any liability beyond which it has recorded. The Company does ultimately retain responsibility for these environmental liabilities and in the unlikely event that the environmental firm and the insurance company do not meet their obligations.

Indemnification

As part of the Company’s normal ongoing business operations and consistent with industry practice, the Company enters into numerous agreements with other parties, which apportion future risks among the parties to the transaction or relationship governed by the agreements. One method of apportioning risk is

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12. COMMITMENTS AND CONTINGENCIES (Continued)

the inclusion of provisions requiring one party to indemnify the other against losses that might otherwise be incurred by the other party in the future. Many of the Company’s agreements contain an indemnity or indemnities that require us to perform certain acts, such as remediation, as a result of the occurrence of a triggering event or condition. The Company is a party to a variety of agreements pursuant to which it may be obligated to indemnify the other party with respect to certain matters. Typically, these obligations arise in the context of contracts entered into by the Company, under which the Company customarily agrees to hold the other party harmless against losses arising from a breach of representations and covenants related to such matters as title to assets sold, certain IP rights, specified environmental matters, and certain income taxes. In each of these circumstances, payment by the Company is conditioned on the other party making a claim pursuant to the procedures specified in the particular contract, which procedures typically allow the Company to challenge the other party’s claims. Further, the Company’s obligations under these agreements may be limited in terms of time and/or amount, and in some instances, the Company may have recourse against third parties for certain payments made by the Company.

The nature of these numerous indemnity obligations are diverse and each has different terms, business purposes, and triggering events or conditions. Consistent with customary business practice, any particular indemnity obligation incurred is the result of a negotiated transaction or contractual relationship for which we have accepted a certain level of risk in return for a financial or other type of benefit. In addition, the indemnities in each agreement vary widely in their definitions of both triggering events and the resulting obligations contingent on those triggering events. It is not possible to predict the maximum potential amount of future payments under these or similar agreements due to the conditional nature of the Company’s obligations and the unique facts and circumstances involved in each particular agreement. Historically, payments made by the Company under these agreements have not had a material effect on the Company’s business, financial condition or results of operations and the Company is unable to estimate the maximum potential impact of these indemnification provisions on its future results of operations.

As permitted under Delaware law, the Company has agreements whereby we indemnify our officers and directors for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The indemnification period covers all pertinent events and occurrences during the officer’s or director’s lifetime. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has director and officer insurance coverage that reduces its exposure and enables it to recover a portion of any future amounts paid. The Company believes the estimated fair value of these indemnification agreements in excess of applicable insurance coverage is minimal.

Other Contingencies

In addition to the above matters, the Company is involved in various legal actions which arose in the ordinary course of its business activities. Management does not currently believe that the final resolution of these matters will ultimately have a material impact on the Company’s results of operations or financial position.

13. EMPLOYEE BENEFIT PLANS

The Company has an Employees’ Investment 401(k) Plan that covers substantially all employees and provides that the Company match employees’ salary deferrals up to 3% of eligible employee

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13. EMPLOYEE BENEFIT PLANS (Continued)

compensation. The amounts charged to operations were $414,000, $391,000 and $359,000 in 2005, 2004 and 2003, respectively.

14. RESTRUCTURING CHARGES

Fourth Quarter 2002 Restructuring Plan

Over the course of 2002, the Company began to design and manufacture semiconductors utilizing additional manufacturing technologies at external wafer fabrication foundries. The Company believed that this approach was required in order to continue to offer competitive products and expected that a greater number of its future products would be developed in this fashion. The Company at that time believed that this business strategy offered considerable other advantages such as allowing it to focus its resources on product development and marketing, minimizing capital expenditures, reducing operating expenses, allowing it to continue to offer competitive pricing, reducing time to market, reducing technology and product risks and facilitating the migration of the Company’s products to new process technologies, which reduce costs and optimize performance. On December 17, 2002, the Company’s Board of Directors approved a plan to completely outsource the Company’s internal wafer fabrication within one year and close its own wafer fabrication facility (the “fab closure”), which original plan was subsequently modified in 2003 and 2004 as described below.

Lease Loss—The fab closure would have resulted in additional excess space of approximately 35,000 square feet for which the Company would have had a remaining two year commitment after the anticipated fab closure. The original decision resulted in a lease loss of $4.3 million, comprised of future lease payments net of broker commissions and other facility costs. In determining this estimate, the Company made certain assumptions with regards to its ability to sublease the space in line with the Company’s best estimate of current market conditions.

During the fourth quarter of 2003 the Company decided that additional time would be needed to effect the complete outsourcing of its internal wafer fabrication due to an unplanned increase in near-term product demand and additional qualification procedures associated with outsourced wafer fabrication. The Company planned to continue to operate its fab through April 2004. As such, the additional four months of rent and facility costs would be incurred as an operating expense resulting in an approximate $364,000 reduction in the lease loss accrual.

During the second quarter of 2004, the Company delayed the closure of its internal wafer fabrication facility (“fab”) for a minimum of three additional months to assess the integration of the EiC acquisition (see Note 5) into its existing operations which resulted in a $430,000 reduction in its lease loss accrual. During the third quarter of 2004, the Company decided not to close its fab as the Company believed that integrating the newly acquired fab from EiC with its pre-existing fab will offer the Company certain benefits over outsourcing the pre-existing fab. As such, the Company reversed the remainder of this lease loss accrual of $3.6 million in the second quarter of 2004. The Company continues to evaluate the use of outside wafer fabrication facilities and potential benefits from outsourcing where practicable under the circumstances.

Workforce reduction—As a result of the originally planned fab closure, approximately 10% of the Company’s workforce (20 employees) would have been eliminated, which would have resulted in severance payments of $279,000 during 2004. The Company ultimately paid out $194,000 of the accrued severance to

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

14. RESTRUCTURING CHARGES (Continued)

terminated employees. The remaining accrual of $85,000 was reversed upon the Company’s decision not to close the fab.

Impairment of Long Lived Assets—Assets to be held and used—The original 2002 decision to utilize the Company’s internal wafer fabrication equipment and related leasehold improvements for only one more year triggered an impairment under SFAS No. 144. Management measured the recoverability of these assets through a comparison of the carrying amount of these assets to future undiscounted cash flows expected to be generated by these assets over their remaining year of life. As such, the carrying value of these assets were written down to the estimated future cash flows that are directly associated with and that were expected to arise as a direct result of the use and eventual disposition of these assets. Management estimated the future cash flows using a traditional present value approach based on management’s assumptions regarding the intended use of these assets consistent with the Company’s budget and projections as well as the planned eventual disposition of the asset group through sale. Management estimated the disposition value of these assets after consideration of several factors including the condition and management’s intended use of the equipment, offers made for similar equipment the Company intended to sell and the results of an independent third party appraisal. Management employed a risk-free interest rate commensurate with the Company’s size, capital structure and stock volatility in relation to the overall market. This action resulted in a $4.2 million asset impairment charge in 2002.

Third Quarter 2002 Restructuring Plan

As a result of the prolonged downturn in the telecommunications industry and the uncertainty as to when the telecommunications equipment market will recover, in July 2002 the Company announced a workforce reduction and its second restructuring program in the previous two years.

Workforce reduction—Approximately 22% of the Company’s workforce (50 employees) was eliminated, which resulted in severance payments of $507,000 during the third quarter of 2002.

During the first quarter of 2003, it was determined that one of the employees slated to be terminated would instead be retained for another position. As such, $21,000 of the third quarter 2002 restructuring charge was reversed in 2003.

Lease Loss—In the third quarter of 2002, the Company decided to abandon a portion of its leased facility based on revised anticipated demand for its products and current market conditions. This excess space, for which the Company had a remaining eight year commitment, is located on the first floor of the Company’s current corporate headquarters and originally housed a portion of the Company’s optics and integrated assemblies manufacturing operations. This decision resulted in a lease loss of $10.6 million, comprised of future lease payments net of anticipated sublease income, broker commissions and other facility costs, and an asset impairment charge of $3.2 million for tenant improvements deemed no longer realizable. In determining this estimate, the Company made certain assumptions with regards to its ability to sublease the space and reflected offsetting assumed sublease income in line with the Company’s best estimate of current market conditions.

During the fourth quarter of 2002, based on a continuing deterioration in the real estate market and difficulties subleasing its available space, the Company revised its assumptions regarding sublease occupancy rates and market rates downward resulting in an additional lease loss of $674,000.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

14. RESTRUCTURING CHARGES (Continued)

During the fourth quarter of 2003, after reviewing current information regarding continuing deterioration in the real estate market, difficulties subleasing its available space and facility costs, the Company revised its lease loss assumptions. $23,000 of the lease loss was reversed as reduced facility costs (mainly property taxes and utilities) were largely offset by reductions in estimated sublease occupancy and market rates.

During the third quarter of 2004, after reviewing current information regarding reduced facility operating costs (predominantly building maintenance costs), the Company revised its lease loss assumptions resulting in a reversal of $377,000 of the lease loss.

As of December 31, 2005, the maximum potential amount of the lease loss for this property is $7.1 million.

Impairment of Long Lived Assets:

Assets held for sale—Due to the prolonged downturn in the telecommunications industry, especially related to the Company’s fiber optics products, management made a decision during the third quarter of 2002 to exit the fiber optics business after current contractual obligations have been satisfied. This decision resulted in a significant overcapacity of certain manufacturing equipment and the Company initiated a plan to sell this equipment. The Company’s excess capacity resulted in a total charge of $3.9 million related to these assets. Assets to be held for sale were measured at the lower of carrying amount or fair value less cost to sell. Management determined fair market value after consideration of several factors including the condition of the equipment, offers made by potential buyers of the equipment and the results of an independent third party appraisal. The majority of these impaired assets were sold in the fourth quarter of 2002.

During the fourth quarter of 2003, management determined that the remaining assets held for sale could not be sold. As such, the assets were scrapped resulting in an additional charge of $151,000.

Assets to be held and used—During the third quarter of 2002, management identified manufacturing equipment exclusively supporting certain in-warranty optics and fixed wireless products as well as manufacturing equipment supporting final orders for certain other optics and fixed wireless products and determined that the estimated future undiscounted cash flows did not support the carrying value of these assets. As such, the carrying value of these assets was written down to the estimated future cash flows that are directly associated with and that are expected to arise as a direct result of the use and eventual disposition of these assets, which management determined after consideration of several factors including the condition and management’s intended use of the equipment, offers made for similar equipment the Company intended to sell and the results of an independent third party appraisal. This action resulted in a $200,000 asset impairment charge.

Third Quarter 2001 Restructuring Plan

Lease Loss and Leasehold Impairment—In September 2001, the Company decided to abandon a leased facility based on revised anticipated demand for its products and current market conditions. This excess facility, for which the Company had a ten year commitment, is located adjacent to the Company’s current corporate headquarters and was originally developed to house additional administrative and corporate offices to accommodate planned expansion. This decision resulted in a lease loss of $7.2 million,

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

14. RESTRUCTURING CHARGES (Continued)

comprised of future lease payments net of anticipated sublease income, broker commissions and other facility costs, and an asset impairment charge of $2.6 million on tenant improvements deemed no longer realizable. In determining this estimate, the Company made certain assumptions with regards to its ability to sublease the space and reflected offsetting assumed sublease income in line with the Company’s best estimate of current market conditions.

During the third and fourth quarters of 2002, based on an overall deteriorating real estate market and difficulties subleasing its available space, the Company revised its assumptions regarding sublease occupancy rates and market rates downward resulting in additional lease loss accruals of $4.5 million and $1.8 million, respectively.

During the fourth quarter of 2003, after reviewing current information regarding continuing deterioration in the real estate market, difficulties subleasing its available space and facility costs, the Company revised its lease loss assumptions. $203,000 of additional lease loss was accrued as reductions in estimated sublease occupancy and market rates were partially offset by reduced facility costs (mainly property taxes and utilities).

During the third quarter of 2004, after reviewing current information regarding continuing deterioration in the real estate market, difficulties subleasing its available space and increasing facility operating costs, the Company revised its lease loss assumptions resulting in $538,000 of additional lease loss.

As of December 31, 2005, the maximum potential amount of the lease loss for this property is $10.8 million which is partially offset by $604,000 of minimum sublease income commitments under noncancellable sublease rental agreements and $540,000 of estimated net sublease income.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

14. RESTRUCTURING CHARGES (Continued)

The following table summarizes restructuring accrual activity recorded during the years 2001 though December 31, 2005 (in thousands):

	Q3 2001
	Restructuring
	Plan			Q3 2002 Restructuring Plan								Q4 2002 Restructuring Plan
	Lease			Workforce			Lease		Asset			Workforce			Lease		Asset
	Loss			Reduction			Loss		Impairment			Reduction			Loss		Impairment			Total
Q3 2001 charge to expense		$ 9,797			$ —		$ —			$ —			$ —		$ —			$ —		$ 9,797
Non-cash charges(1)		(2,503	)		—		—			—			—		—			—		(2,503	)
Cash payments		(463	)		—		—			—			—		—			—		(463	)
Balance at December 31, 2001		6,831			—		—			—			—		—			—		6,831
Q3 2002 charge to expense		—			507		13,841			4,087			—		—			—		18,435
Q4 2002 charge to expense		—			—		—			—			279		4,285			4,277		8,841
2002 additional charge		6,283			—		674			—			—		—			—		6,957
Non-cash charges(2)		(22	)		—		(2,930	)		(4,087	)		—		—			(4,277	)	(11,316	)
Cash payments		(1,002	)		(437	)	(290	)		—			—		—			—		(1,729	)
Balance at December 31, 2002		12,090			70		11,295			—			279		4,285			—		28,019
2003 additional charge (credit)		203			(21	)	(23	)		151			—		(364	)		—		(54	)
Non-cash charges		—			—		(15	)		(151	)		—		—			—		(166	)
Cash payments		(782	)		(49	)	(1,316	)		—			(26	)	—			—		(2,173	)
Balance at December 31, 2003		11,511			—		9,941			—			253		3,921			—		25,626
2004 additional charge (credit)		538			—		(377	)		—			(85	)	(3,921	)		—		(3,845	)
Non-cash charges		12			—		30			—			—		—			—		42
Cash payments		(1,003	)		—		(1,233	)		—			(168	)	—			—		(2,404	)
Balance at December 31, 2004		11,058			—		8,361			—			—		—			—		19,419
2005 additional charge (credit)		—			—		—			—			—		—			—		—
Non-cash charges		46			—		8			—			—		—			—		54
Cash payments		(1,420	)		—		(1,277	)		—			—		—			—		(2,697	)
Balance at December 31, 2005		$ 9,684			$ —		$ 7,092			$ —			$ —		$ —			$ —		$ 16,776

(1) Non-cash charges related to the Q3 2001 Restructuring Plan lease loss represents $2.5 million of tenant improvements deemed no longer realizable.

(2) Non-cash charges related to the Q3 2002 Restructuring Plan lease loss represents $3.2 million of tenant improvements deemed no longer realizable net of a $310,000 write-off of accrued deferred rent.

Of the accrued restructuring charge at December 31, 2005, the Company expects $3.4 million of the lease loss to be paid out over the next twelve months. As such, this amount is recorded as a current liability and the remaining $13.4 million to be paid out over the remaining life of the lease of approximately four years is recorded as a long-term liability.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

15. WARRANTIES

The Company generally sells products with a limited warranty of product quality and a limited indemnification of customers against intellectual property infringement claims related to the company’s products. Such warranty generally ranges from 12 to 24 months. The Company accrues for known warranty and indemnification issues if a loss is probable and can be reasonably estimated, and accrues for estimated incurred but unidentified issues based on historical activity. The Company estimates the cost of warranty based on the warranty period for the product, the historical field return rates for a given product or family of products and the average cost required to repair or replace the product. Allowances for estimated warranty costs are recorded during the period of sale. The determination of such allowances requires us to make estimates of product return rates and expected costs to repair or replace the products under warranty. If actual return rates and/or repair and replacement costs differ significantly from our estimates, adjustments to recognize additional cost of sales may be required in future periods. Components of the reserve for warranty costs during 2005 and 2004 consisted of the following (in thousands):

	December 31,
	2005			2004			2003
Beginning balance	$	54		$	36		$	54
Additions related to current period sales	22			74			36
Warranty costs incurred in the current period	(24		)	(58		)	(48		)
Adjustments to accruals related to prior period sales.	(12		)	2			(6		)
Ending balance	$	40		$	54		$	36

16. BUSINESS SEGMENT REPORTING

In 1997, the Company adopted SFAS 131, “Disclosures about Segments of an Enterprise and Related Information.” As an integrated products provider, the Company currently has one reportable segment. The Company’s Chief Operating Decision Maker (“CODM”) is the CEO. While the Company’s CODM monitors the sales of various products, operations are managed and financial performance evaluated based upon the sales and production of multiple products employing common manufacturing and research and development resources; sales and administrative support; and facilities. This allows the Company to leverage its costs in an effort to maximize return. Management believes that any allocation of such shared expenses to various products would be impractical, and currently does not make such allocations internally.

The CODM does, however, monitor sales by products at a more detailed level than those depicted in the Company’s historical general purpose financial statements as follows (in thousands):

	Year Ended
	December 31,			December 31,			December 31,
	2005			2004			2003
Semiconductor and RFID		$	31,201		$	29,808		$	20,246
Wireless Integrated Assemblies and Fiber Optics		396			2,528			6,319
Total		$	31,597		$	32,336		$	26,565

On May 14, 2003, the Company completed the sale of its Thin-Film product line to M/A-COM, a unit of Tyco Electronics previously announced in December, 2002. The sale included equipment, inventory, intellectual property, training and services. The Company received total proceeds of $1.8 million and recorded a net gain of $1.1 million as other income in the accompanying financial statements for 2003. The

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

16. BUSINESS SEGMENT REPORTING (Continued)

Company had initially received an advance payment on this agreement of $272,000 in 2002 which was included as accrued liabilities in the Company’s consolidated balance sheets. That advance payment is now recognized as part of the $1.8 million of proceeds during 2003. The Thin-Film product line contributed $855,000 to our semiconductor sales in 2003.

The Company believes it is more meaningful in terms of concentration of risk to combine the sales to manufacturing subcontractors with the end customer who ultimately controls product demand. Sales to individual customers representing greater than 10% of Company consolidated sales during at least one of the past three years are as follows (in thousands):

	Year Ended
	December 31,			December 31,			December 31,
	2005			2004			2003
Lucent Technologies, Inc.(1)		$	392		$	2,233		$	6,047
Celestica		4,060			3,768			1,347
Richardson Electronics Ltd.(2)		14,194			16,681			12,440

(1) Includes sales to Lucent Technologies, Inc. and sales to its manufacturing subcontractors.

(2) Richardson Electronics Ltd. is the sole worldwide distributor of the Company’s complete line of RF semiconductor products.

Sales to unaffiliated customers by geographic area are as follows (in thousands):

	Year Ended
	December 31,			December 31,			December 31,
	2005			2004			2003
United States		$	17,800		$	20,904		$	17,987
Export Sales from United States:
Europe		1,632			2,435			2,658
China		4,900			3,800			1,848
Other		7,265			5,197			4,072
Total		$	31,597		$	32,336		$	26,565

Long-lived assets located outside of the United States are insignificant.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

QUARTERLY FINANCIAL DATA—UNAUDITED

The following table sets forth, for the periods presented, selected data from our consolidated statements of operations on a quarterly basis. The consolidated statements of operations data have been derived from our unaudited consolidated financial statements. In the opinion of management, these statements have been prepared on substantially the same basis as the audited consolidated financial statements and include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the financial information for the periods presented. This information should be read in conjunction with the consolidated financial statements and notes to those financial statements included elsewhere in this filing.

	Three Months Ended
	April 3,			July 3,			Oct. 2,			Dec. 31,
	2005			2005			2005			2005
	(In thousands, except per share data)
Consolidated Statements of Operations Data:
Sales	$	7,774		$	4,023	(1)	$	8,094		$	11,706
Cost of goods sold	4,348			2,870			3,774			5,914
Gross profit	3,426			1,153			4,320			5,792
Operating expenses:
Acquired in-process research and development(2)	3,400			—			—			—
Research and development	4,743			4,397			4,451			4,480
Selling and administrative	3,189			4,824		(3)	3,632			3,650
Total operating expenses	11,332			9,221			8,083			8,130
Loss from operations	(7,906		)	(8,068		)	(3,763		)	(2,338		)
Interest income	240			261			272			275
Interest expense.	(23		)	(24		)	(29		)	(20		)
Other income—net	5			3			3			3
Loss from operations before income taxes	(7,684		)	(7,828		)	(3,517		)	(2,080		)
Income tax benefit/(provision)	—			—			123			(3		)
Net loss	$	(7,684	)	$	(7,828	)	$	(3,394	)	$	(2,083	)
Basic and diluted net loss per share	$	(0.12	)	$	(0.12	)	$	(0.05	)	$	(0.03	)
Basic and diluted shares used to calculate net loss per share	63,027			64,055			64,516			65,084

1) Effective for the Company’s second quarter ended July 3, 2005, the Company changed the application of our revenue recognition policy regarding its distributors (see Note 3 to the consolidated financial statements). This change in application resulted in a $4.1 million revenue deferral in the Company’s second quarter of 2005.

2) During the first quarter of 2005, $3.4 million of the purchase price for the acquisition of Telenexus, Inc. was allocated to acquired in-process research and development expense (see Note 5 to the consolidated financial statements).

3) The second quarter of 2005 includes a $1.2 million charge for separation expenses related to the Company’s former CEO.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

QUARTERLY FINANCIAL DATA—UNAUDITED (Continued)

	Three Months Ended
	March 28,				June 27,			Sept. 26,			Dec. 31,
	2004				2004			2004			2004
	(In thousands, except per share data)
Consolidated Statements of Operations Data:
Sales		$	7,071		$	8,414		$	8,929		$	7,921
Cost of goods sold		3,195			3,308			4,536			4,240
Gross profit		3,876			5,106			4,393			3,681
Operating expenses:
Acquired in-process research and development(1)		—			8,500			—			—
Research and development		4,103			4,131			4,354			4,650
Selling and administrative		2,846			2,958			3,523			3,176
Restructuring reversals(2)		—			(430		)	(3,416		)	—
Total operating expenses		6,949			15,159			4,461			7,826
Loss from operations		(3,073		)	(10,053		)	(68		)	(4,145		)
Interest income		166			155			167			195
Interest expense		(25		)	(28		)	(20		)	(32		)
Other income—net		—			—			—			5
Income (loss) from operations before income taxes		(2,932		)	(9,926		)	79			(3,977		)
Income tax benefit		6,542			—			1,133			—
Net income (loss)		$	3,610		$	(9,926	)	$	1,212		$	(3,977	)
Basic net income (loss) per share		$	0.06		$	(0.16	)	$	0.02		$	(0.07	)
Basic average shares		59,396			60,254			60,908			60,968
Diluted net income (loss) per share		$	0.05		$	(0.16	)	$	0.02		$	(0.07	)
Diluted average shares		67,476			60,254			65,913			60,968

1) During the second quarter of 2004, $8.5 million of the purchase price for the acquisition of the wireless infrastructure business and associated assets from EiC was allocated to acquired in-process research and development expense (see Note 5 to the consolidated financial statements).

2) During the second quarter of 2004, the Company delayed the closure of its internal wafer fabrication facility (“fab”) for a minimum of three months to assess the integration of the EiC acquisition into its existing operations which resulted in an approximate $430,000 reduction in its lease loss accrual. During the third quarter of 2004, the Company decided to not close its fab as the Company believes that integrating the newly acquired fab from EiC with its pre-existing fab will offer the Company certain benefits over outsourcing the pre-existing fab. As such, the Company reversed the remainder of this lease loss accrual of $3.6 million. Also during the third quarter of 2004, the Company revised its lease loss assumptions for its other facilities based on reductions in sublease occupancy rates and current facility costs. As such the Company accrued $161,000 of additional lease loss.

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Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

Item 9a. CONTROLS AND PROCEDURES

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures.

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 as of the end of the period covered by this report pursuant to Exchange Act Rule 13a-15. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of December 31, 2005 to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with generally accepted accounting principles due solely to the following material weakness (the results of management’s assessment were reviewed with the Audit Committee):

Although we have already taken some actions to remediate the material weakness described above, we believe that further action is required to complete our remediation, including the need to develop and implement enhanced processes. The effectiveness of the steps we have taken to date and the steps we are still in the process of completing is subject to continued management review, as well as Audit Committee oversight, and we may make additional changes to our internal control over financial reporting other than those described above.

Not withstanding this material weakness, we believe that the consolidated financial statements included in this report fairly present our consolidated financial position as of, and the consolidated results of operations for the year ended, December 31, 2005.

Changes in Internal Control Over Financial Reporting.

Other than the material weakness described above, there has been no change in our internal control over financial reporting during the fourth quarter of 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Management’s Annual Report on Internal Control Over Financial Reporting.

The “Report of Management” regarding management’s assessment of our internal control over financial reporting as of December 31, 2005 is set forth in Part II Item 8 of this Annual Report on Form 10-K which is incorporated herein by reference. Based on an assessment of such criteria, our management concluded that we did not maintain effective internal control over financial reporting as of December 31, 2005 due solely to the material weakness noted above. Our management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2005 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report set forth in Part II Item 8 of this Annual Report on Form 10-K which is incorporated herein by reference.

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Inherent Limitations on Effectiveness of Controls

The company’s management, including the Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.

Item 9b. OTHER INFORMATION

None.

PART III

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The following table sets forth information about our directors and executive officers (ages are as of March 21, 2006):

Name	Age	Position
W. Dexter Paine, III	45	Chairman of the Board
Bruce W. Diamond	46	President, Chief Executive Officer and Director
Herald Y. Chen	36	Director
Michael E. Holmstrom	63	Director
Catherine P. Lego	49	Director
Jack G. Levin	58	Director
Liane J. Pelletier	48	Director
Robert Whelton.	66	Director
Dag F. Wittusen	61	Director
Rainer N. Growitz	50	Interim Chief Financial Officer, Vice President—Finance and Secretary
Mark S. Knoch	42	Vice President—Operations
Haresh P. Patel	44	Senior Vice President—Sales and Marketing
David R. Pulvino	46	Chief Accounting Officer—Principal Accounting Officer
Morteza Saidi	53	Vice President—Engineering

Directors of the Company

W. Dexter Paine, III, the Chairman of the Board of Directors and a director since January 2000, is the co-founder of Fox Paine & Company, LLC and has been its President since its inception in 1997. Mr. Paine also serves as a director of Alaska Communications Systems Group Inc. (NasdaqNM: ALSK), the leading

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diversified facilities-based telecommunications provider in Alaska and since September 2003 he has served as a director of United America Indemnity, Ltd. (NasdaqNM:INDM). From 1994 until founding Fox Paine, Mr. Paine served as a senior partner of Kohlberg & Company. Prior to joining Kohlberg & Company, Mr. Paine served as a general partner at Robertson Stephens & Company. Mr. Paine has a B.A. in economics from Williams College.

Bruce W. Diamond was appointed to President, Chief Executive Officer of WJ Communications in June 2005 and has served as a director since July 2003. Mr. Diamond has the strategic and overall operating responsibility for continuing to position WJ Communications into a leading supplier of RF solutions for the wireless infrastructure and RFID reader markets. From November 2002 to June 2005, Mr. Diamond served as Chief Operating Officer and Executive Vice President for ZiLOG, Inc., a provider of integrated 8-bit microcontrollers (MCU) and universal remote control solutions. From January 2001 through October 2002 he served as President and Chief Operating Officer for Sipex, Inc., an analog semiconductor company, where he was responsible for day-to-day operations including development of the optical storage, power and interface products. From October 1997 to December 2000, Mr. Diamond served as Senior Vice President of Operations for ANADIGICS, Inc., an RF-based semiconductor integrated circuit company, where he was responsible for building an industry leading GaAs (Gallium Arsenide) wafer fabrication facility. He also held various senior positions within National Semiconductor Corporation. Mr. Diamond received his B.S. degree in electrical engineering from the University of Illinois at Champaign-Urbana.

Herald Y. Chen, a director since January 2006, Mr. Chen has served as a Managing Director of Fox Paine & Company, LLC since December 2002. Prior to joining Fox Paine, Mr. Chen was co-founder and CFO of Jamcracker, Inc., an on-demand, infrastructure software and services company where he served from July 1999 to December 2002. Prior to joining Jamcracker, Inc., he was an investment professional at Kohlberg Kravis Roberts & Company, and Goldman, Sachs & Co. Mr. Chen received his B.S. in both Mechanical Engineering and in Finance, from the University of Pennsylvania and his M.B.A. from Stanford’s Graduate School of Business.

Michael E. Holmstrom, a director since July 2004, has over 35 years financial experience in the telecommunications industry and has been providing financial consulting services since March 2002. Previously, Mr. Holmstrom was at Elektryon Inc. where he served as President until March 2002. On February 1, 2002, Elektryon filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code in connection with the sales of its assets to a third party. Prior to joining Elektryon as Chief Financial Officer in 2000, Mr. Holmstrom served as Senior Vice President and Chief Financial Officer at Alaska Communications Systems Group beginning in 1999. From 1998 to 1999 Mr. Holmstrom was Chief Financial Officer for Atlantic Tele-Network in the U.S. Virgin Islands. From 1996 to 1998 he was the Chief Operating Officer for Spectrum Network Systems, Ltd. in Sydney, Australia. Prior to 1996, Mr. Holmstrom held numerous senior management and consulting positions including Vice President of Unregulated Operations, Chief Financial Officer and then President of CP National Corporation, Executive-in-Residence professor of business strategy at Texas A&M University, Vice President of Financial and Business Planning at Pacific Telecom, and Vice President of Finance at Alascom, Inc. Mr. Holmstrom has a B.S. in Business Administration from Gannon University.

Catherine P. Lego, a director since October 2004, Ms. Lego is currently Managing Partner of The Photonics Fund which is focused on investing in early stage component, module and systems companies in the fiber optic telecommunications market since December 1999. Ms. Lego also serves on the Board of Directors of SanDisk Corporation (NasdaqNM:SNDK), LAM Research Corporation (NasdaqNM:LRCX) and private photonics company K2 Optronics. Prior to forming The Photonics Fund, Ms. Lego provided consulting services to early stage electronic companies at Lego Ventures and was a General Partner at Oak Investment Partners. Prior to Oak Investment Partners, Ms. Lego was a CPA with Coopers and Lybrand. She received her M.S. from NY University School of Business and her B.A. from Williams College.

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Jack G. Levin, a director since July 2004, Mr. Levin was the Chief Operation Officer with Fox Paine and Company from February 2004 through March 2005. Prior to joining Fox Paine, Mr. Levin was a founder and served as a managing member of Kalkhoven, Pettit and Levin Ventures, LLC, a venture capital firm focused on the fiber optic and telecommunications industry since 2001. Previously, Mr. Levin was a partner of, and Director of Legal and Regulatory Affairs for Montgomery Securities. During his 17 years at Montgomery Securities (and it’s successor firm, Banc of America Securities, LLC), Mr. Levin was an active member of the investment banking commitment committee, the investment committees of the firm’s venture capital partnerships and the managing partner of MontWest Capital Partners, a joint venture of Montgomery Securities and Westinghouse Financial Corporation, established to do leveraged buyouts. Mr. Levin attended Amherst College (A.B., Political Science, Cum Laude, Woodruff Fellowship Award, 1969) and the Columbia University School of Law, (J.D., Harlan Fiske Stone Scholar, 1973). Mr. Levin is a retired member of the Bar of the State of New York.

Liane J. Pelletier, a director since October 2003, Ms. Pelletier serves as Chairwoman, Chief Executive Officer and President of Alaska Communications Systems Group Inc. (NasdaqNM: ALSK). Prior to joining Alaska Communications Systems Group Inc in October 2003, Ms. Pelletier was with Sprint Corporation for 17 years, where she served in numerous capacities including Chief Integration Officer and Senior Vice President, Corporate Strategy & Business Development. Ms. Pelletier also served as a Vice President in a wide variety of departments, including corporate strategy, customer acquisition and retention, and marketing positions to both business and consumer customers. Before joining Sprint, Ms. Pelletier worked as a consultant at Touche Ross and Temple, Barker, Sloane. Ms. Pelletier has an MBA from M.I.T. and B.A. from Wellesley College.

Robert Whelton, a director since February 2006, Mr. Whelton is currently an Executive Vice President of Operations for Micrel, Inc. (NasdaqNM:MCRL), a leading manufacturer of IC solutions for the worldwide analog, Ethernet and high bandwidth markets. Prior to joining Micrel in January 1998, Mr. Whelton was the Executive Vice President of Operations for Micro Linear Corp., a fabless semiconductor company specializing in wireless integrated circuits. Prior to joining Micro Linear Corp., he was employed by National Semiconductor Corp., where he served as Vice President of the Analog division. Mr. Whelton received his B.S.E.E. from the University of California, Berkeley and his M.S.E.E. from the University of Santa Clara.

Dag F. Wittusen, a director since July 2003, has over thirty years of financing and investment banking experience. Mr. Wittusen has served as Chief Executive Officer of his own investment and financial advisory firm, Beddingen Finans AS since April 2005. From 1996 through March 2005, Mr. Wittusen was a partner and Senior Executive with the Aker ASA and Kvaerner ASA group of industrial investment companies in Norway. Prior to this, he was co-founder and managing partner of Orkla Finans AS, Oslo based investment bank. Mr. Wittusen previously served as Senior Vice President of Eksportfinans, Oslo, and on the staff of the World Bank, Washington, D.C. He received a B.A. degree with Honors in Political Science and Economics from Brown Unversity and an M.P.A. in International Economics from Princeton University. Mr.Wittusen resides in Oslo, Norway.

Executive Officers of the Company

Bruce W. Diamond was appointed as President and Chief Executive Officer of WJ Communications in June 2005. Mr. Diamond’s previous work experience is described above.

Rainer N. Growitz is serving as our Interim Chief Financial Officer since August 31, 2005. Mr. Growitz was appointed Vice President Finance and Secretary following our recapitalization merger in January 2000 and is responsible for corporate financial planning, forecasting and management for WJ Communications. From 1997 until January 2000, Mr. Growitz served as Director of Finance. He joined WJ Communications

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in 1978 and held a variety of finance, contracts and managerial positions. Mr. Growitz received a B.S. in Accounting from San Jose State University.

Mark S. Knoch was appointed Vice President of Operations of WJ Communications in August of 2005 and is responsible for overseeing the manufacturing of RF semiconductor and RFID products. Prior to joining WJ Communications, Mr. Knoch was Vice president of Operations at ZiLOG, Inc. (“ZiLOG”) where he was responsible for all manufacturing and supply chain activities for the company. While at ZiLOG he also served as president of ZiLOG’s manufacturing facility in the Philippines. Prior to joining ZiLOG in 2004, he served as Vice President, Supply Chain for Sipex, Inc., an analog semiconductor company, where he managed the supply chain and order fulfillment from 2001 to 2004. Mr. Knoch also held senior planning and operations positions at ANADIGICS, Inc., and American Microsystems Incorporated, and Advanced Micro Devices in Austin, TX. Mr. Knoch received his B.S. in Electrical Engineering from Kansas State University.

Haresh P. Patel was appointed to Senior Vice President of Sales and Marketing of WJ Communications in October 2005. Mr. Patel brings over 22 years of experience in the semiconductor industry. Previously, Mr. Patel served as Vice President of Worldwide Sales and Marketing at Agilent Technology’s $2B Semiconductor Division. Prior to joining Agilent Technology in 2000, Mr. Patel was with PMC-Sierra Inc. a leader in Datacom, Telecom and Storage Semiconductor Products where he served as Vice President of Worldwide Sales beginning in 1997. Mr. Patel has also held various senior sales and product management positions at Hyundai, Fujitsu, and Texas Instruments. Throughout his career Mr. Patel has focused on and built relationships with leading customers including, Cisco, LG, Samsung, Sony Ericsson, Siemens, Nokia, Huawei, Lucent and ZTE. He received his B.S. degree in Electrical Engineering from the University of Notre Dame, South Bend, IN.

David R. Pulvino was appointed Chief Accounting Officer—Principal Accounting Officer in January 2005 and is currently responsible for SEC reporting, Corporate Governance/GAAP compliance and Tax. Previously, Mr. Pulvino served as our Corporate Controller following our recapitalization merger in January 2000 where he was responsible for directing all of our accounting operations. From 1997 through January 2000, Mr. Pulvino served as Director of Accounting. Mr. Pulvino joined WJ Communications in 1981 and has held a variety of accounting and managerial positions. Mr. Pulvino received a B.S. in Accounting from Santa Clara University, California.

Morteza Saidi joined WJ Communications in January 2006 as Vice President of Engineering. In this position Mr. Saidi is responsible for directing and managing the engineering groups within the Company including developing new technologies and new products for the wireless and RFID markets. From 2004 to 2006 he served as founder and CEO at S-Communications, a leading-edge fabless semiconductor company. Prior to that Mr. Saidi served as a consultant for PCI Communications from 2003 to 2004. Previously, Mr. Saidi co-founded Resonext Communications in 2000 and where he served as Chief Technology Officer and Vice President of RF and Analog until the company was acquired by RF Micro Devices in December 2002. Previously, he held the director of RF development position at VLSI Technology. In addition, Mr. Saidi has held a number of management positions with Philips Semiconductor, has published a number of articles in the technical journals, and has assisted in filing 30 patents. Mr. Saidi received both his Bachelor of Science degree and Masters of Science in Electrical Engineering from the University of Michigan.

Audit Committee and Audit Committee Financial Expert

The Audit Committee is currently composed of directors Holmstrom and Lego. The Board of Directors has determined that both Mr. Holmstrom and Ms. Lego are an “independent director” as that term is defined in Rule 4200(15) of the Nasdaq Marketplace Rules. Our Board of Directors has determined that Mr. Holmstrom qualifies as an “audit committee financial expert” as such term is defined

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in Item 401(h) of Regulation S-K. Stockholders should understand that this designation is a disclosure requirement of the SEC related to Mr. Holmstrom’s experience and understanding with respect to certain accounting and auditing matters. The designation does not impose on Mr. Holmstrom any duties, obligations or liability that are greater than are generally imposed on him as a member of the Audit Committee and Board of Directors, and his designation as an audit committee financial expert pursuant to this SEC requirement does not affect the duties, obligations or liability of any other member of the Audit Committee or Board of Directors.

Section 16(a) Beneficial Ownership Reporting Compliance

For the fiscal year ended December 31, 2005, we believe, based solely on a review of Forms 3, 4 and 5 (including amendments) with which it has been furnished, that all filings required pursuant to Section 16(a) of the Securities Exchange Act of 1934, as amended, relating to us were timely made.

Code of Ethics

We have adopted a written code of ethics that applies to our principal executive officer, principal financial officer and principal accounting officer, responsive to Section 406 of the Sarbanes-Oxley Act of 2002 and the rules of the SEC. A copy of our code of ethics which is captioned “Senior Financial Officer Code of Business Conduct and Ethics Policy” is posted and publicly available on our internet website at www.wj.com. This website address is intended to be an inactive, textual reference only; none of the material on this website is part of this report. If there are any amendments to or waivers, of the code of ethics, we intend to promptly disclose the nature of any such amendment or waiver on our website.

Item 11. EXECUTIVE COMPENSATION

Compensation of Directors

General

Directors who are also employed by us do not receive any additional compensation for their services as a director. Non-employee directors are eligible to participate in the WJ Communications, Inc. amended and restated 2000 Non-Employee Director Stock Compensation Plan (the “Non-Employee Director Plan”) approved by the stockholders at the Company’s 2003 annual meeting:

· Each non-employee director who joins the Board will receive an option to acquire 25,000 shares of common stock with an exercise price equal to the fair market value of the common stock upon the commencement of his or her directorship. Any director, officer, employee, partner or other affiliate of Fox Paine and/or its controlled affiliates who becomes a member of the Board shall not be eligible for the initial option award;

· Each non-employee director who is re-elected to the Board will receive an option to acquire 10,000 shares of common stock with an exercise price equal to the fair market value of the common stock upon the re-election of his or her directorship;

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· Each non-employee director will receive an annual cash award of $15,000 for every full year in which he or she serves;

· Each non-employee director that serves as chair of the Audit Committee will receive an annual cash award of $10,000 for every full year in which he or she serves;

· Each other non-employee director that serves as a member of the Audit Committee will receive an annual cash award of $5,000 for every full year in which he or she serves;

· Annual cash awards shall be payable quarterly in four equal installments beginning on the date on which the annual meeting of stockholders is held. In the event that a non-employee director’s directorship is terminated before completion of a full service year, the annual cash award will be prorated according to the time served during such service year;

· Each non-employee director will receive $1,000 in cash for each Board or Committee meeting attended except if there are multiple meetings on the same day in which case the maximum payment will be $1,000;

· Each non-employee director shall be reimbursed for reasonable, out-of-pocket expenses incurred in attending meetings of the Board or any committee thereof.

Option Vesting

Options to purchase shares of Common Stock issued pursuant to the Non-Employee Director Plan will vest and become exercisable in cumulative annual installments of 25% on each of the first, second, third and fourth anniversaries of the date of the grant of the option, unless a change in control (as defined in the Non-Employee Director Plan) occurs, whereby all options vest and become immediately exercisable in exchange for the per share consideration to be received in the change in control by holders of Common Stock, or the cash equivalent of the same, at the discretion of the Board of Directors or any committee thereof to which the Board delegates administration of the Non-Employee Director Plan (the “Plan Administrator”).

Deferral

Each non-employee director may elect to defer receipt of all or a portion of the cash otherwise payable. In the event such an election is made, the electing non-employee director will receive his or her cash in one or a series of distributions to commence as soon as practicable following the date of termination of his or her directorship. In the event a change in control occurs, all deferred cash is distributed to the electing non-employee director.

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Compensation of Executive Officers

The following table sets forth the compensation earned for services rendered to the Company in all capacities for the fiscal years ended December 31, 2005, 2004 and 2003 by the Company’s Chief Executive Officer and its four next most highly compensated executive officers who earned more than $100,000 during the fiscal year ended December 31, 2005 (the “Named Executive Officers”):

							Long-Term Compensation
							Restricted
							Stock		Securities		All Other
Name and	Annual Compensation						award		Underlying		Compensation
Principal Position	Year		Salary($)		Bonus($)		($)		Options		($) (1)
Current Officers:
Bruce W. Diamond(2)		2005		166,924		—		745,000		—		4,442
President and Chief Executive Officer		2004		—		—		—		10,000		—
		2003		—		—		—		25,000		—
Thomas R. Kritzer(3)		2005		200,200		—		—		—		6,006
Senior Vice President, Corporate Development		2004		200,200		17,000		—		25,000		6,006
		2003		200,200		10,000		—		—		6,000
Ronald N. Buswell(3)		2005		185,120		—		—		—		5,340
Vice President, Sales and Marketing		2004		185,120		29,500		—		30,000		5,554
		2003		185,120		5,000		—		—		5,554
Rainer N. Growitz		2005		159,632		—		—		—		4,789
Interim Chief Financial Officer		2004		150,020		16,000		—		25,000		4,501
Vice President Finance and Corporate Secretary		2003		150,020		3,000		—		—		3,289
David R. Pulvino		2005		143,102		—		—		—		4,293
Chief Accounting Officer		2004		140,036		23,000		—		34,500		4,201
		2003		140,036		3,500		—		—		4,075
Former Officers:
Michael R. Farese, Ph.D(4)		2005		183,078		—		—		—		1,126,650
Former President and Chief Executive Officer		2004		350,000		65,000		—		1,400,000		8,708
		2003		350,000		40,000		—		—		6,000

(1) Represents Company’s annual contribution to the Named Executive Officers 401(k) plan account.

(2) Mr. Diamond was appointed President and Chief Executive Officer on June 28, 2005. Pursuant to his employment agreement, Mr. Diamond was granted 500,000 shares of time-vesting restricted stock on July 29, 2005 which had a dollar value of $745,000 on the date of the grant and $810,000 as of December 31, 2005. For 2003 and 2004 Securities Underlying Options represents grants Mr. Diamond received in connection with his service as a non-employee member of the Board of Directors. Mr. Diamond voluntarily forfeited his 2005 bonus as provided in his employment agreement.

(3) As of January 10, 2006 Mssrs. Kritzer and Buswell are deemed not to be executive officers of the Company due to the nature of their current positions though they continue to be employed by the Company.

(4) Dr. Farese served as the Company’s President and Chief Executive Officer until his resignation on June 27, 2005. Dr. Farese’s 2005 All Other Compensation total includes severance payments of $559,423 in cash and 328,500 shares of restricted stock having a value, as of the June 28, 2005 grant date, of $561,735, in connection with his separation agreement. His separation agreement also provided for the cancellation of the 1,400,000 stock options granted to him in 2004.

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Option/SAR Grants in Last Fiscal Year. The following table sets forth grants of options to purchase shares of Common Stock during the fiscal year ended December 31, 2005 to each of the Named Executive Officers:

Individual Grants

Potential

Percent Of

Realizable Value At

Number of

Total

Assumed Annual

Securities

Options

Rates Of Stock

Underlying

Granted to

Exercise

Price Appreciation

Options

Employees

Price

Expiration

For Option Term

Name

Granted (#)

In Fiscal Year

($/Sh)

Date

5% ($)

10% ($)

(a)

(b)

(c)

(d)

(e)

(f)

(g)

Current Officers:

Bruce W. Diamond

—

President and Chief Executive Officer

Thomas R. Kritzer(1)

—

Senior Vice President, Corporate

Development

Ronald N. Buswell(1)

—

Vice President, Sales and Marketing

Rainer N. Growitz

—

Interim Chief Financial Officer

Vice President Finance and

Corporate Secretary

David R. Pulvino

—

Chief Accounting Officer

Former Officers:

Michael R. Farese, Ph.D.

—

Former President and Chief

Executive Officer

(1) As of January 10, 2006 Mssrs. Kritzer and Buswell are deemed not to be executive officers of the Company due to the nature of their current positions though they continue to be employed by the Company.

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Aggregated Option/SAR Exercises in Last Fiscal Year and Fiscal Year-End Option/SAR Values. The following table sets forth information with respect to the Named Executive Officers concerning option exercises for the fiscal year ended December 31, 2005, and exercisable and unexercisable options held as of December 31, 2005:

Name

Shares Acquired
On Exercise (#)

Value
Realized

Number of Securities
Underlying
Unexercised
Options/SARs at
Fiscal Year-End(#)
Exercisable/Unexercisable

Value of Unexercised
In-the-Money
Options/SARs at
Fiscal Year-End($)(1)
Exercisable/Unexercisable

Current Officers:

Bruce W. Diamond

—

15,000 / 20,000

$9,125 / $9,125

President and Chief

Executive Officer

Thomas R. Kritzer (2)

27,500

54,660

549,279 / 738,500

103,178 / $146,312

Senior Vice President,

Corporate Development

Ronald N. Buswell (2)

25,000

50,544

215,507 / 144,000

$35,037 / $21,335

Vice President, Sales

and Marketing

Rainer N. Growitz

14,000

27,753

233,064 / 155,000

$40,383 / $25,100

Interim Chief Financial

Officer Vice President

Finance and Corporate

Secretary

David R. Pulvino

3,933

9,034

127,735 / 81,562

$26,725 / $11,550

Chief Accounting

Officer

Former Officers:

Michael R. Farese, Ph.D.

20,000

11,865

1,450,000 /—

$—/ $—

Former President

and Chief Executive

Officer

(1) Aggregate values in these two columns represent the excess of $1.58 per share, the market value of the Common Stock as of December 31, 2005, over the respective exercise prices of the options. The actual amount, if any, realized upon exercise of stock options will depend upon the market price of the Common Stock relative to the exercise price per share of the stock option at the time the stock option is exercised. There is no assurance that the values of unexercised in-the-money options reflected above will be realized.

(2) As of January 10, 2006 Mssrs. Kritzer and Buswell are deemed not to be executive officers of the Company due to the nature of their current positions though they continue to be employed by the Company.

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Employment Contracts, Termination of Employment, and Change in Control Arrangements

Employment Agreement with Bruce W. Diamond.

On June 28, 2005, the Company entered into an employment agreement with Mr. Diamond (the “Employment Agreement”), the Company’s new President and Chief Executive Officer. The Employment Agreement, which was approved by the Compensation Committee of the Board of Directors (the “Compensation Committee”), is effective for three years with automatic one-year extensions thereafter.

The material terms of the Employment Agreement include the following: (i) Mr. Diamond’s annual base salary will be $350,000. The annual base salary may be increased in the years following the first anniversary of the effective date, but may not be decreased; (ii) beginning in fiscal year 2006, Mr. Diamond is eligible for an annual bonus target opportunity of one-hundred percent (100%) of his current annual base salary, of which fifty percent (50%) is based on achievement of defined financial performance objectives and fifty percent (50%) is based on defined major business objectives as determined by the Compensation Committee, (iii) an annual bonus target opportunity for the fiscal year ending December 31, 2005 of fifty percent (50%) of annual base salary is based on defined objectives but will not be less than $50,000 if Mr. Diamond remains employed through December 31, 2005; and (iv) a grant of 1,000,000 shares of restricted common stock at a purchase price equal to the par value of the common stock of $0.01 per share of which 500,000 shares are Time-Vested Restricted Stock and vest over 36 months and 500,000 shares of Performance-Vested Restricted Stock which shall vest conditioned upon the satisfaction of certain performance targets and objectives to be determined by the Company with the performance period for such award to be not more than two (2) years or in the case of performance criteria conditioned on appreciation in the value of the Company’s common stock, the price targets designated by the Company.

Mr. Diamond’s employment agreement also provides for other benefits including the right to participate in fringe benefit plans, life and disability insurance plans, expense reimbursement, reimbursement for documented supplemental life insurance, estate and tax planning, and vacation in accordance with the Company’s top management vacation policy.

Pursuant to the Employment Agreement, if the Company terminates Mr. Diamond’s employment other than for cause or disability or if Mr. Diamond terminates his employment with the Company for good reason, and Mr. Diamond’s employment is not terminated automatically as a result of his death, the Company will pay him an amount equal to one hundred fifty percent of his annual base salary as in effect immediately prior to the termination of the employment period and eighteen months accelerated vesting with respect to any outstanding, unvested time-vested restricted stock and reimbursement for premiums paid for continued health benefits for Mr. Diamond and his dependents under the Company’s health plans for eighteen months following the termination of his employment with the Company. Notwithstanding the preceding sentence, the severance benefit shall be computed as an amount equal to two hundred ninety-nine percent of his annual base salary as in effect immediately prior to the termination of the employment period, full vesting with respect to any outstanding, unvested time-vested restricted stock and performance-vested restricted stock and reimbursement for premiums paid for continued health benefits for Mr. Diamond and his dependents under the Company’s health plans for thirty-six months with such amounts to be paid within thirty days of the date of such termination, in each case solely in a circumstance in which there is a termination of Mr. Diamond’s employment within three months prior to or nine months following the occurrence of a change in control either by the Company other than for cause or by him with good reason.

Employment Agreement with Rainer N. Growitz

Effective January 31, 2000, the Company entered into an employment agreement with Mr. Growitz for the position of Vice President of Finance. The employment agreement is effective for three years with

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automatic one-year extensions thereafter unless advance written notice of an intention not to extend the term is provided by either the Company or Mr. Growitz.

Under the employment agreement, Mr. Growitz is entitled to receive an annual base salary of $150,020 and will be eligible to participate in the Company’s discretionary cash bonus plan, up to a maximum of 60% of base salary, based on appropriate business and financial targets and individual objectives. Mr. Growitz’s employment agreement also provides for other benefits including the right to participate in fringe benefit plans, life and disability insurance plans, expense reimbursement, reimbursement for documented supplemental life insurance, estate and tax planning, and vacation in accordance with the Company’s top management vacation policy.

Pursuant to the employment agreement, if the Company terminates Mr. Growitz’s employment other than for cause or disability or if Mr. Growitz terminates his employment with the Company for good reason, and Mr. Growitz’s employment is not terminated automatically as a result of his death, the Company will pay him an amount equal to one hundred percent of his annual base salary. Not withstanding the preceding sentence, the Company shall pay Mr. Growitz an amount equal to one hundred fifty percent of his annual base salary solely in a circumstance in which there has occurred a change in control within three months prior to any termination for good reason or by the Company other than for cause.

Separation Agreement with Michael R. Farese, PhD.

The Company entered into a separation agreement dated June 28, 2005 with Dr. Farese (the “Separation Agreement”), the Company’s former President and Chief Executive Officer. The material terms of the Separation Agreement include the following: (i) payment of any unpaid but accrued base salary and payment for 20 days of vacation time; (ii) a single payment equal to one hundred fifty percent (150%) of Dr. Farese’s annual base salary (in the aggregate amount of $525,000); (iii) 1.5 million of the options granted to Dr. Farese pursuant to the Executive Time Vesting Stock Option Agreement dated March 4, 2002 are fully vested and the time period during which these vested options can be exercised following the separation date shall be eighteen months per the terms of Dr. Farese’s amended and restated employment agreement dated November 11, 2004; (iv) 328,500 shares of Company stock pursuant to a customary form of Restricted Stock Agreement issued under the Company’s 2000 Stock Incentive Plan which shares are fully vested and non-forfeitable and (v) other incidental benefits including continued health insurance benefits for Dr. Farese and his dependents for one year. As a result of the Separation Agreement, the 1.4 million share option grant previously made to Dr. Farese in March 2004 and referenced in the proxy statement filed in 2005 were cancelled in lieu of Dr. Farese’s acceptance of the 328,500 restricted stock unit awarded in the separation agreement. Furthermore, Dr. Farese did not receive the restricted stock units referenced in the Company’s proxy statement filed during 2005.

Compensation Committee Interlocks and Insider Participation

Mr. Paine and Ms. Pelletier served as members of the Compensation Committee of our board of directors during the fiscal year ended December 31, 2005. None of these individuals was an officer or employee of the Company or of any of its subsidiaries during the fiscal year ended December 31, 2005, or ever has been an officer of the Company or any of its subsidiaries. Mr. Paine is affiliated with Fox Paine. See Item 13 “Certain Relationships and Related Transactions” for information regarding Fox Paine.

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Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The following table lists, as of March 15, 2006, information as to the beneficial ownership of Common Stock by (i) each of the Company’s directors and nominee for directorship, (ii) each executive officer of the Company for whom information is given in the Summary Compensation Table under “Compensation of Executive Officers” below, (iii) all directors and executive officers as a group, and (iv) each person or entity believed by the Company to beneficially own more than five percent (5%) of the Common Stock outstanding. Except as otherwise indicated in the footnotes below, each beneficial owner has the sole power to vote and to dispose of all shares held by that holder. In each instance, information as to the number of shares owned and the nature of ownership has been provided by the individuals identified or described and is not within the direct knowledge of the Company.

Name and Address of Beneficial Owner (1)	Amount and Nature of Beneficial Ownership (2)		Percent of Common Stock (2)
Fox Paine Capital, LLC(3)		25,492,044		38.8	%
Fox Paine Capital Fund, L.P.(3)		24,155,413		36.8	%
FPC Investors, L.P.(3)		358,422		*
Kopp Investment Advisors, LLC(4)		10,123,791		15.4	%
W. Dexter Paine, III(5)		25,547,173		38.9	%
Herald Y. Chen(6)		25,492,044		38.8	%
Liane J. Pelletier(7)		15,000		*
Dag F. Wittusen(8)		15,000		*
Michael E. Holmstrom(9)		16,250		*
Jack G. Levin		—		*
Catherine P. Lego(10)		36,250		*
Robert Whelton		—		*
Bruce W. Diamond(11)		998,671		1.5	%
Rainer N. Growitz(12)		291,198		*
David R. Pulvino(13)		212,112		*
Michael R. Farese, Ph.D.(14)		1,664,061		2.5	%
*All directors and executive officers as a group (14 persons)(15)		27,141,574		41.0	%

* The percentage of shares beneficially owned does not exceed 1%.

(1) Unless otherwise indicated, the address of e ach of the beneficial owners identified is c/o WJ Communica tions, Inc., 401 River Oaks Parkway, San Jose, California 95134.

(2) Unless otherwise noted, each person has voting and investment power, with respect to all such shares. Based on 65,689,880 shares of Common Stock outstanding. Pursuant to the rules of the Securities and Exchange Commission, certain shares of Common Stock which a person has the right to acquire within 60 days of the date hereof pursuant to the exercise of stock options are deemed to be outstanding for the purpose of computing the percentage ownership of such person but are not deemed outstanding for the purpose of computing the percentage ownership of any other person.

(3) Fox Paine & Company, LLC is the manager of (i) Fox Paine Capital Fund, LP (“LP1”), a direct owner of 24,155,413 shares of Common Stock of WJ Communications, Inc. (the “Issuer”), and (ii) FPC Investors, LP (“LP2”) (collectively, LP1 and LP2 are “LPs”), a direct owner of 358,422 shares of Common Stock of the Issuer. Fox Paine Capital, LLC is the General Partner of each of the LPs and the manager of each of WJ Coinvestment Fund I, LLC, WJ Coinvestment Fund III, LLC and WJ Coinvestment Fund IV, LLC (collectively, the “Funds”), which directly own 601,478, 251,155 and 125,576 shares, respectively, of Common Stock (the “Shares”) of the Issuer. As a result, each of the

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Reporting Persons may be deemed to be the indirect beneficial owners of 25,492,044 shares of Common Stock of the Issuer owned by the LPs and the Funds.

(4) As reported by Kopp Investment Advisors, LLC and related entities on Schedule 13G filed with the Securities and Exchange Commission on January 30, 2006. In its Schedule 13G, Kopp Investment Advisors, LLC states that as of December 31, 2005, it has sole voting power as to 7,356,841 shares, shared voting power as to no shares, sole dispositive power with respect to 2,500,000 shares and shared dispositive power with respect to 5,404,891 shares. In addition, Mr. LeRoy C. Kopp, who controls Kopp Holding Company, LLC which owns 100% of Kopp Investment Advisors, LLC, has sole voting power as to 2,218,900 shares, shared voting power as to no shares, sole dispositive power with respect to 2,218,900 shares and shared dispositive power with respect to no shares. The address of Kopp Investment Advisors, LLC and related entities is 7701 France Avenue South, Suite 500, Edina, MN 55435

(5) Includes 25,492,044 shares beneficially owned as described in footnote 3, 47,629 shares awarded to Mr. Paine under the amended and restated 2000 Non Employee Director Stock-Compensation Plan receipt of which has been deferred, and 7,500 shares issuable to Mr. Paine subject to currently exercisable options.

(6) Includes 25,492,044 shares beneficially owned as described in footnote 3.

(7) Represents 15,000 shares issuable to Ms. Pelletier subject to currently exercisable options.

(8) Represents 15,000 shares issuable to Mr. Wittusen subject to currently exercisable options.

(9) Represents 10,000 shares held of record by Mr. Holmstrom and 6,250 shares issuable to subject to currently exercisable options.

(10) Represents 30,000 shares held of record by Ms. Lego and 6,250 shares issuable subject to currently exercisable options.

(11) Represents 20,000 shares held of record by Mr. Diamond, 15,000 shares issuable subject to currently exercisable options and 963,671 shares of restricted stock. Pursuant to his employment agreement, Mr. Diamond was granted 500,000 shares of time-vesting restricted stock on July 29, 2005 and 500,000 shares of performance-vesting restricted stock on January 16, 2006. The number of shares in the table includes the net number of shares of restricted stock beneficially owned as of such date after the disposition of an aggregate of 36,329 shares of vested time-vesting shares of restricted stock solely for withholding tax purposes

(12) Represents 48,054 shares held of record by Mr. Growitz and 243,064 shares issuable subject to currently exercisable options.

(13) Represents 84,382 shares held of record by Mr. Pulvino and 127,730 shares issuable subject to currently exercisable options.

(14) Represents 214,061 shares held of record by Dr. Farese and 1,450,000 shares issuable subject to currently exercisable options. Dr. Farese was our CEO until June 27, 2005and the number of shares is as of such date.

(15) Includes shares deemed to be beneficially owned by Mr. Paine as a result of their relationships with and to Fox Paine Capital. Excluding such shares, all directors and executive officers as a group beneficially own 1,649,530 shares held of record and 435,794 shares issuable under currently exercisable options.

126

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Management Agreement

On January 31, 2000, Fox Paine Capital Fund, an investment fund managed by Fox Paine & Company, LLC (“Fox Paine & Company” or “Fox Paine”), became the controlling stockholder of the Company. Fox Paine Capital Fund acquired its controlling position in an all cash merger between FP-WJ Acquisition Corp. and the Company, then called Watkins-Johnson Company (the “Recapitalization Merger”), whereby Fox Paine Capital Fund and its co-investors paid a total of $50.8 million for approximately 91.1% of the Common Stock of the Company (or $41.125 per pre-split share as the Common Stock was then constituted). Messrs. Paine and Chen are affiliated with Fox Paine.

As part of the Recapitalization Merger, the Company entered into a management agreement with Fox Paine & Company. Since the Recapitalization Merger, and for each subsequent year, the Company will pay Fox Paine a fee in the amount of 1% of the Company’s net income before interest expense, interest income, income taxes, depreciation and amortization and equity in earnings (losses) of minority investments, calculated without regard to the fee. In exchange for its management fee, Fox Paine assists the Company with its strategic planning, budgets and financial projections and helps the Company identify possible strategic acquisitions and recruit qualified management personnel. Fox Paine also assists in customer and supplier relationships on behalf of the Company and consults with the Company on various matters including tax planning and public relations strategies, economic and industry trends and executive compensation. Due to the Company’s loss incurred from 2002, 2003 and 2004, no management fees were paid to Fox Paine for the years ended December 31, 2003, December 31, 2004 and December 31, 2005. The Company has agreed to reimburse Fox Paine for its expenses incurred in providing these services. The Company paid Fox Paine $29,000, $108,000 and $6,000 for the reimbursement of expenses incurred by Fox Paine for the years ended December 31, 2005, December 31, 2004 and December 31, 2003, respectively. The Company also paid Fox Paine $700,000 in July of 2004 for investment banking services rendered in connection with the EiC Acquisition that was completed on June 18, 2004 (For further discussion, see Note 5 to the consolidated financial statements included elsewhere in this Form 10-K).

Fox Paine will continue to provide management services under this agreement until its affiliates no longer own shares of Common Stock or are no longer represented on the Board of Directors. The management agreement with the Company is similar to those entered into between Fox Paine and each of the other companies acquired by Fox Paine’s affiliates. In connection with this agreement, the Company has agreed to indemnify Fox Paine against various liabilities that may arise as a result of the management services it will perform for the Company. The Company has also agreed to reimburse Fox Paine for its expenses incurred in providing these services.

Shareholders’ Agreement

On January 31, 2000, the Company entered into a shareholders’ agreement with Fox Paine Capital Fund, investors affiliated with Fox Paine Capital Fund and several non-fund investors, including co-investors and certain employees of the Company. Under the shareholders’ agreement, subject to limited exceptions:

· Fox Paine Capital Fund and its affiliates, as a group, may make up to five demands for registration under the Securities Act of their shares of Common Stock;

· In the event the Company registers any of its equity securities under the Securities Act, or shares of Common Stock of Fox Paine Capital Fund pursuant to a demand registration, each of the Company’s other stockholders who are a party to the agreement, may exercise piggyback registration rights to include all or a portion of its shares of Common Stock in the registration.

127

In the event that either Fox Paine Capital Fund and its affiliates makes a demand for registration, the Company has agreed to pay all expenses related to that registration. The Company has also agreed to indemnify Fox Paine Capital Fund against various liabilities associated with such registration.

The shareholders’ agreement also provides that the Company’s stockholders who are a party to the agreement will vote their shares in order to ensure that if and to the extent Fox Paine Capital Fund owns shares of Common Stock, Fox Paine Capital Fund will be represented on the Board of Directors.

Fox Paine exercised registration rights in connection with the secondary underwritten public offering that we completed January 28, 2004.

Item 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

Fees billed by our principal accounting firm, Deloitte & Touche LLP, the member firms of deloitte touche tohmatsu, and their respective affiliates (collectively, the “Deloitte Entities”) are as follows:

	Year Ended
	December 31,			December 31,
	2005			2004
Audit fees		$	708,600		$	781,258
Audit-related fees		161,195			53,116
Tax fees		134,546			261,526
All other fees		—			—
Total		$	1,004,341		$	1,095,900

Audit fees billed or expected to be billed by the Deloitte Entities include professional services rendered for the audit of our annual financial statements, the reviews of the financial statements included in our Quarterly Reports on Form 10-Q and the filing of Registration Statements with the Securities and Exchange Commission and fees required by the Sarbanes-Oxley Act of 2002. Audit-related fees are fees billed for assurance and related services that are reasonably related to the performance of the audit or review of financial statements and included due diligence related to mergers and acquisitions, and consulting on financial accounting/reporting standards and controls. Tax fees are professional services rendered for tax compliance, tax consulting and tax planning including services related to the audit of our 1996 through 2000 tax returns by the Internal Revenue Service and associated amended state returns. All Other Fees consist of fees for products and services other than the services reported above.

The Audit Committee has considered whether the provision of non-audit services is compatible with maintaining the principal accountant’s independence and has concluded that the non-audit services provided by the Deloitte Entities are compatible with maintaining the Deloitte Entities’ independence.

Pre-Approval Policies and Procedures

The Audit Committee approves in advance all audit and permissible non-audit services to be performed by our independent registered public accounting firm. The Audit Committee considers whether the provision of any proposed non-audit services is consistent with the SEC’s rules on auditor independence and has pre-approved certain specified audit and non-audit services to be provided by the Deloitte Entities for up to twelve (12) months from the date of the pre-approval. If there are any additional services to be provided, a request for pre-approval must be submitted by management to the Audit Committee for its consideration. The Audit Committee pre-approved all of the services performed in 2005 and 2004 by the Deloitte Entities relating to the “Audit Fees,” “Audit-Related Fees,” “Tax Fees” and “All Other Fees” described above as required by the Sarbanes-Oxley Act of 2002.

128

PART IV

Item 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

1. Financial Statements

The consolidated financial statements, and related notes thereto, of the Company, and the Report of Independent Registered Public Accounting Firm listed in the accompanying Index to Consolidated Financial Statements on page 3 are filed as part of this Form 10-K.

2. Financial Statement Schedules

The following financial statement schedule of the Company is filed as part of this Form 10-K. All other schedules have been omitted because they are not applicable, not required, or the information is included in the consolidated financial statements or notes thereto.

	Page
Schedule II—Valuation and Qualifying Accounts		135

3. Exhibits

The exhibits listed on the following index to exhibits are filed as part of, or hereby incorporated by reference into, this Form 10-K.

Incorporated by Reference

Exhibit

Filing

Filed

Number

Exhibit Description

Form

File No

Exhibit

Date

Herewith

2.1

Agreement and Plan of Merger, dated October 25, 1999, by and between FP-WJ Acquisition Corp. and the Registrant

8-K

1-5631

2.1

10/28/99

3.1

Certificate of Incorporation of the Registrant

S-1/A

333-38518

3.1

7/12/00

3.2

By-Laws of the Registrant

S-1/A

333-38518

3.2

7/12/00

4.1

Specimen of Common Stock Certificate

8-A

000-31337

4.1

8/14/00

4.2*

Shareholders’ Agreement, dated as of January 31, 2000, by and among the Registrant, the Parties listed on the signature pages thereto and certain stockholders of the Registrant

S-1/A

333-38518

4.2

7/26/00

10.1*

Employment Agreement, dated as of January 31, 2000, by and between the Registrant and Thomas R. Kritzer

S-1/A

333-38518

10.4

7/12/00

10.2*

Employment Agreement, dated as of January 31, 2000, by and between the Registrant and
Rainer N. Growitz

S-1/A

333-38518

10.6

7/12/00

10.3*

WJ Communications, Inc. 2000 Stock Incentive Plan

S-1/A

333-38518

10.8

7/12/00

129

Incorporated by Reference

Exhibit

Filing

Filed

Number

Exhibit Description

Form

File No

Exhibit

Date

Herewith

10.4

Lease (Phase I) dated March 24, 2000, by and between the Registrant and 401 River Oaks, LLC

S-1/A

333-38518

10.9

7/12/00

10.5

Lease (Phase II) dated March 24, 2000, by and between the Registrant and 401 River Oaks, LLC

S-1/A

333-38518

10.10

7/12/00

10.6

Management Agreement, dated as of January 31, 2000, by and between Registrant and Fox Paine & Company, LLC

S-1/A

333-38518

10.17

7/12/00

10.7

WJ Communications, Inc. 2000 Non-Employee Director Stock Compensation Plan

S-8

333-52408

99.2

12/21/00

10.8*

Employment Agreement, by and between the Registrant and Michael R. Farese, Ph.D.

8-K

000-31337

10.1

11/15/04

10.9

Amended and Restated WJ Communications, Inc. 2002 Non-Employee Director Stock Compensation Plan

10-Q

000-31337

10.1 and 10.2

8/12/03

10.10*

Second Amendment to WJ Communications, Inc. 2000 Stock Incentive Plan

10-Q

000-31337

10.1 and 10.2

8/12/03

10.11

Amended and Restated Loan and Security Agreement, dated September 29, 2003, by and among the Registrant and Comerica Bank

10-Q

000-31337

10.1 and 10.2

10/30/03

10.12

Intellectual Property Security Agreement, dated September 29, 2003, by and among the Registrant and Comerica Bank

10-Q

000-31337

10.1 and 10.2

10/30/03

10.13

Acquisition related agreements by and between WJ Communications, Inc., EiC Corporation and EiC Enterprises Limited dated June 18, 2004

8-K

000-31337

2.1, 2.2, 4.1,
4.2 and 10.1

7/2/04

10.14*

Employment Agreement, by and between the Registrant and Ephraim Kwok

8-K

000-31337

10.1

12/21/04

10.15

8-K

000-31337

2.1 and 4.1

2/3/05

130

Incorporated by Reference

Exhibit

Filing

Filed

Number

Exhibit Description

Form

File No

Exhibit

Date

Herewith

10.16*††

Employment Agreement by and between WJ Communications, Inc. and Richard J. Swanson dated January 28, 2005

8-K

000-31337

10.1

2/3/05

10.17*††

Employment Agreement by and between WJ Communications, Inc. and Wilfred K. Lau dated January 28, 2005

8-K

000-31337

10.2

2/3/05

10.18*

Employment agreement between the Registrant and Javed S. Patel

10-Q

000-31337

10.1

5/18/05

10.19*

Employment agreement between the Registrant and Neil Morris, Ph.D.

10-Q

000-31337

10.2

5/18/05

10.20*

Employment agreement between the Registrant and Robert J. Bayruns

10-Q

000-31337

10.3

5/18/05

10.21

Acquisition related agreements by and among WJ Communications, Inc., WJ Newco, LLC, Telenexus, Inc. and Richard J. Swanson, Wilfred K. Lau, David Fried, Kurt Christensen and Mark Sutton dated January 28, 2005 to refile Exhibit 2.1 to include certain information that was previously redacted pursuant to a confidential treatment request. The Exhibit 2.1 attached hereto supersedes in its entirety the exhibit previously filed on Form 8-K on February 3, 2005.

8-K/A

000-31337

2.1

6/24/05

10.22*

Separation Agreement, dated as of June 28, 2005, by and between the Registrant and Michael R. Farese, Ph.D.

8-K

000-31337

10.1

7/1/05

10.23*

Employment Agreement, dated as of June 28, 2005, by and between the Registrant and Bruce W. Diamond

8-K

000-31337

10.2

7/1/05

10.24*

Employment offer letter, dated as of July 18, 2005, by and between the Company and Mark S. Knoch

8-K

000-31337

10.1

8/4/05

10.25*

Employment agreement, dated October 19, 2005, by and between the Company and Haresh P. Patel

8-K

000-31337

10.1

10/28/05

131

Incorporated by Reference

Exhibit

Filing

Filed

Number

Exhibit Description

Form

File No

Exhibit

Date

Herewith

10.26

Amendment No. 4 to Loan and Security Agreement by and between the Company and Comerica Bank dated December 27, 2005

8-K

000-31337

10.1

1/3/06

10.27*†

Employment Agreement, dated as of December 21, 2005, by and between the Registrant and Mark S. Knoch

10.28*

Employment Agreement, dated as January 13, 2006, of by and between the Registrant and Morteza Saidi

21.1

Subsidiaries of the registrant

23.1

Consent of Deloitte & Touche, LLP, Independent Registered Public Accounting Firm

24.1

Power of Attorney (see signature page)

31.1

Certification of Bruce W. Diamond, Chief Executive Officer (principal executive officer), pursuant to Rule 13a-14 of the Securities Exchange Act of 1934.

31.2

Certification of Rainer N. Growitz, Interim Chief Financial Officer (principal financial officer), pursuant to Rule 13a-14 of the Securities Exchange Act of 1934.

32.1

Certification of Bruce W. Diamond, principal executive officer, Pursuant To 18 U.S.C. Section 1350.

32.2

Certification of Rainer N. Growitz, principal financial officer, Pursuant To 18 U.S.C. Section 1350.

* Indicates a contract, compensatory plan or arrangement in which directors or executive officers are eligible to participate.

† Confidential treatment has been requested with respect to the redacted portions of the referenced exhibit.

†† Confidential treatment has previously been granted by the SEC for certain portions of the referenced exhibit pursuant to Rule 406 under the Securities Act.

132

SCHEDULE II

WJ COMMUNICATIONS, INC. AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
FOR THE YEARS ENDED DECEMBER 31, 2005, 2004 and 2003
(in thousands)

	Balance at			Charged (Credits)				Charged to							Balance at
	Beginning of			to Costs and				Other			Recoveries/				End of
Description	Period			Expenses				Accounts			(Write-offs)				Period
Year ended December 31, 2005
Deducted from asset accounts:
Allowance for doubtful accounts		$	79		$	32			$	—		$	(96	)		$	15
Sales return allowance		74			511				—			(512		)		73
Distributor stock rotation reserve		338			26				—			(364		)		—
Ship & debit allowance		5			89				—			(60		)		34
Warranty reserve		54			22				—			(36		)		40
Total		$	550		$	680			$	—		$	(1,068	)		$	162
Year ended December 31, 2004
Deducted from asset accounts:
Allowance for doubtful accounts		$	21		$	51			$	—		$	7			$	79
Sales return allowance		75			760				—			(761		)		74
Distributor stock rotation reserve		196			847				—			(705		)		338
Ship & debit allowance		29			35				—			(59		)		5
Warranty reserve		36			76				—			(58		)		54
Total		$	357		$	1,769			$	—		$	(1,576	)		$	550
Year ended December 31, 2003
Deducted from asset accounts:
Allowance for doubtful accounts		$	429		$	(393	)		$	—		$	(15	)		$	21
Sales return allowance		116			481				—			(522		)		75
Distributor stock rotation reserve		247			219				—			(270		)		196
Ship & debit allowance		—			32				—			(3		)		29
Warranty reserve		54			30				—			(48		)		36
Total		$	846		$	369			$	—		$	(858	)		$	357

135

x	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
	EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2005
OR
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
	SECURITIES EXCHANGE ACT OF 1934

DELAWARE		94-1402710
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)
401 River Oaks Parkway, San Jose, California		95134
(Address of principal executive offices)		(Zip Code)

		Page
PART I
Item 1.	Business		4
Item 1a.	Risk Factors		17
Item 1b.	Unresolved Staff Comments		34
Item 2.	Properties		34
Item 3.	Legal Proceedings		34
Item 4.	Submission of Matters to a Vote of Security Holders		34
PART II
Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities		35
Item 6.	Selected Consolidated Financial Data		38
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		41
Item 7a.	Quantitative and Qualitative Disclosure About Market Risks		64
Item 8.	Consolidated Financial Statements and Supplementary Data		65
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure		113
Item 9a.	Controls and Procedures		113
Item 9b.	Other Information		114
PART III
Item 10.	Directors and Executive Officers of the Registrant		114
Item 11.	Executive Compensation		118
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters		125
Item 13.	Certain Relationships and Related Transactions		127
Item 14.	Principal Accountant Fees and Services		128
PART IV
Item 15.	Exhibits and Financial Statement Schedules		129
	Signatures		133

	Page
Report of Management		66
Reports of Independent Registered Public Accounting Firm		67
Consolidated Balance Sheets		70
Consolidated Statements of Operations		71
Consolidated Statements of Comprehensive Loss		72
Consolidated Statements of Stockholders’ Equity		73
Consolidated Statements of Cash Flows		75
Notes to Consolidated Financial Statements		76

Signature	Title	Date
/s/ BRUCE W. DIAMOND	President, Chief Executive Officer	3/30/2006
Bruce W. Diamond	(principal executive officer) , Director
/s/ RAINER N. GROWITZ	Interim Chief Financial Officer	3/30/2006
Rainer N. Growitz	Vice President of Finance and Corporate Secretary
	(principal financial officer)
/s/ DAVID R. PULVINO	Chief Accounting Officer	3/30/2006
David R. Pulvino	(principal accounting officer)
/s/ W. DEXTER PAINE, III	Chairman of the Board	3/30/2006
W. Dexter Paine, III
/s/ MICHAEL E. HOLMSTROM	Director	3/30/2006
Michael E. Holmstrom
/s/ LIANE J. PELLETIER	Director	3/30/2006
Liane J. Pelletier
/s/ DAG F. WITTUSEN	Director	3/30/2006
Dag F. Wittusen

/s/ JACK G. LEVIN	Director	3/30/2006
Jack G. Levin
/s/ CATHERINE P. LEGO	Director	3/30/2006
Catherine P. Lego
/s/ HERALD Y. CHEN	Director	3/30/2006
Herald Y. Chen
/s/ ROBERT WHELTON	Director	3/30/2006
Robert Whelton

WJ COMMUNICATIONS, INC.

(Registrant)

March 30, 2006

/s/ BRUCE W. DIAMOND

Bruce W. Diamond

President and Chief Executive Officer