The following discussion of our financial condition and results of operations should be read in conjunction with the condensed unaudited consolidated financial statements and notes to those statements included elsewhere in this Quarterly Report on Form 10-Q for the three and nine months ended September 30, 2009 and our audited consolidated financial statements for the year ended December 31, 2008 included in our Annual Report on Form 10-K.

This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. These statements relate to future periods, future events or our future operating or financial plans or performance. These statements can often be identified by the use of forward-looking terminology such as "expects," "believes," "intends," "anticipates," "estimates," "plans," "may," or "will," or the negative of these terms, and other similar expressions. These forward-looking statements include statements as to the source of our revenues, our ability to generate revenues, our ability to sustain our growth rate and return to profitability, expected growth in our target markets and application-specific products, our expectation regarding the increase in certain expenses, our cash needs, our capital requirements, our market risk sensitivity, our business and product strategies, our anticipated tax rate, industry trends and our anticipation that developments in our technologies and new products will increase our target market share.

These forward-looking statements reflect our current views with respect to future events, are based on assumptions and are subject to risks and uncertainties. These risks and uncertainties could cause actual results to differ materially from those projected and include, but are not limited to, fluctuations in our revenue and operating results, our ability to return to profitability, the demand for our products in our target markets, our ability to compete, our dependence on key and highly skilled personnel, the ability to develop new products and to enhance our existing products, the continued seasonality of our business due to our target markets and location of our customers, our ability to integrate businesses that we may acquire, our ability to estimate and predict customer demand, economic volatility in either domestic or foreign markets, the impact of any change in United States federal income tax laws and the loss of any beneficial tax treatment that we currently enjoy, our reliance on independent foundries and subcontractors for the manufacture, assembly and testing of our products, the length of our sales cycle and reliance on distributors, our ability to protect our intellectual property, the cyclical nature of the semiconductor industry, our ability to raise capital, the potential volatility of our stock, the outcome of future litigation and the other risks set forth under PART II - OTHER INFORMATION, Item 1A. "Risk Factors." Given these risks and uncertainties, you should not place undue reliance on these forward-looking statements. Except as required by federal securities laws, we undertake no obligation to update any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.

In this report all references to "Techwell," "we," "us" or "our" mean Techwell, Inc.

Techwell is our registered trademark. We also refer to trademarks of other corporations and organizations in this Form 10-Q.

Overview

We are a fabless semiconductor company that designs, markets and sells mixed signal integrated circuits for two primary markets: security surveillance and automotive infotainment. We design application-specific products for our two primary markets that enable the conversion of analog video signals to digital form and perform advanced digital video processing to facilitate the display, storage and transport of video content. We believe this application specific product strategy allows us to better address varying customer requirements, fully leverage our technology capabilities and achieve greater share within our two core markets. To a lesser extent, we market and sell video decoders to the consumer market. Our semiconductors are based on our proprietary architecture and mixed signal technologies that we believe provide high video quality under a wide range of signal conditions, enable high levels of integration and are cost-effective.

Our business has experienced significant growth primarily as a result of our ability to develop new products, obtain design wins and convert these design wins into revenues. We generated revenues from the sale of over 25 different products in the quarter ended September 30, 2009.

We have three principal semiconductor product lines: security surveillance products, automotive infotainment products and consumer products. Our security surveillance products integrate important functions required to display, store and transport analog video signals from security surveillance cameras. For example, we integrate multiple video decoders into a single semiconductor. As a result, this semiconductor is able to receive and decode analog video signals from multiple cameras into a standard digital format. In addition, we integrate a multiplexor, a key technology required to combine multiple video signals into a single video signal, and a display processor, a key technology required to display multiple video channels. In 2007, we introduced our first integrated security surveillance product, which integrated four video decoders and a system controller and a multiplexor on a single semiconductor. In December 2008, we introduced a new security surveillance product which includes a 16 channel multiplexer and supports the display of multiple standard definition and high definition video sources. We currently sell our security surveillance products to customers for the following applications: embedded digital video recorders, or DVRs, PC-based DVRs, networked video recorders, or NVRs, and multiplexors.

Our automotive infotainment products integrate important functions required to display popular analog video, high definition video and PC graphics signals on a LCD display. These key functions include a video decoder, deinterlacer and scaler. In addition, our newer generation automotive infotainment products integrate a timing controller to interface directly with certain types of LCD displays and image enhancement functionality to improve overall video quality. In January 2008, we announced the introduction of five new LCD display processors designed for the automotive end market. These new products are designed to provide advanced image processing, an integrated programmable timing controller and multiple analog and digital video inputs.

Our consumer products are high performance mixed signal semiconductors that decode analog TV broadcast signals, including NTSC, PAL and SECAM, and popular analog video signals, including composite, S-Video, component and SCART, into a standard digital format. Our consumer products integrate proprietary sync processing, color demodulating and digital 2D and 3D comb filtering, which are the key technologies required for high performance video decoding. We offer a broad range of consumer products at various price points and with varying features. We have developed our video decoder products for applications within the consumer markets such as advanced TV, multifunction LCD monitor, DVD recorder and camcorders. In the future, however, we intend to focus our development efforts specifically on applications for the security surveillance and automotive infotainment markets and as a result, we anticipate our consumer revenues will decline over the next several quarters.

Our other products include early generation mixed signal semiconductors for digital video applications and PCI video decoder products, which are video decoders that utilize peripheral component interconnect, or PCI, technology for personal computer applications.

Although our revenues have grown rapidly since 2004, we do not expect to achieve similar growth rates in the future. We currently expect to increase our expense levels in the future to support increased research and development efforts in order to bring new products to our primary markets. These expenditures may not result in increased revenue or profitability in the future. In addition, our ability to increase our revenues will depend on increased demand for digital video applications in the security surveillance and automotive infotainment markets. Although we believe our two primary markets will experience growth in the next few years, actual growth of these markets is uncertain. In addition, the timing of orders by and shipments to our customers, as well as general trends in our two primary markets, can cause our revenue growth to be inconsistent.

We undertake significant product development efforts well in advance of a product's release, and in advance of receiving purchase orders from our customers. Our product development efforts, which are focused on developing new designs with broad demand and potential for future derivative products, typically take from six to 24 months until production begins, depending on the product's complexity. If we secure a design win, the system designer is likely to continue to use the same or enhanced versions of our product across a number of their models, which tends to extend the life cycles of our products. Conversely, if a competitor secures the design win, it may be difficult for us to sell into the customer's application for an extended period. Our sales cycle typically ranges from six to 24 months. Due to the length of our product development and sales cycle, the majority of our revenues for any period is generally weighted toward products introduced for sale, meaning products for which we commenced placing orders with our manufacturing subcontractors, in the prior one or two years. As a result, our present revenues are not necessarily representative of future sales because our future sales are likely to be comprised of a different mix of products, some of which are now in the development stage.

As a fabless semiconductor company, we outsource all of our manufacturing, assembly and test functions to third-party vendors primarily located in Taiwan. This business model enables us to reduce our capital expenditures and fixed costs, while focusing our engineering and design resources on our core strength, the design of mixed signal semiconductors for digital video applications.

We sell our products to distributors that fulfill third-party orders for our products. We also sell directly, using independent sales representatives, to original equipment manufacturers, or OEMs, and to original design manufacturers, or ODMs. For the nine months ended September 30, 2009, we derived 76% of our revenues from products sold to distributors and 24% from products sold to OEMs or ODMs. For the year ended December 31, 2008, we derived 79% of our revenues from products sold to distributors and 21% from products sold to OEMs or ODMs. Our gross margins have not historically been significantly different between sales to distributors and sales to OEMs or ODMs through orders procured by independent sales representatives. However, our operating profit on sales through orders procured by independent sales representatives can be less due to the payment of commissions to sales representatives which we record as sales and marketing expense.

We received an aggregate of 75% and 80% of our revenues from our ten largest customers for the three months ended September 30, 2009 and 2008, respectively. For the three months ended September 30, 2009, Lacewood International Corporation, or Lacewood, a distributor, accounted for 38% of our revenues. For the three months ended September 30, 2008, Lacewood and AV Tech Corporation, or AV Tech, accounted for 37% and 11% of our revenues, respectively. For the nine months ended September 30, 2009, Lacewood accounted for 37% of our revenues. For the nine months ended September 30, 2008, Lacewood and AV Tech accounted for 32% and 11% of our revenues, respectively.

We derive substantially all of our revenues from sales to foreign customers, particularly in Asia, which sales accounted for 97% and 98% of our revenues for the nine months ended September 30, 2009 and 2008, respectively. The table below indicates the percentage of total revenues by geographic location for the periods indicated:

                  Three Months Ended     Nine Months Ended
                    September 30,          September 30,
                   2009        2008       2009        2008
China                  53 %        41 %       51 %        35 %
South Korea            20          25         22          28
Taiwan                 20          29         18          31
Japan                   5           3          6           4
United States           1           1          1           1
Other                   1           1          2           1
Total revenues        100 %       100 %      100 %       100 %

We received 51% and 35% of our revenues from China in the nine months ended September 30, 2009 and 2008, respectively. The percentage increase between 2009 and 2008 was primarily due to an increase in revenue from our security surveillance customers in China who are benefitting from the relative strength in the Chinese domestic economy. We received 18% and 31% of our revenues from Taiwan in the nine months ended September 30, 2009 and 2008, respectively. The decrease was primarily due to a decline in revenues from consumer markets, whose products were primarily sold to customers in Taiwan.

We believe that a substantial majority of our revenues will continue to come from customers located in Asia, where most of the electronic devices that use our semiconductors are manufactured. As a result of this regional customer concentration, we may be subject to environmental, economic, cultural and political events as well as other developments that impact our customers in Asia. All of our sales currently are denominated in U.S. dollars. Therefore, an increase in the value of the U.S. dollar relative to foreign currencies could make our products less competitive in international markets. Substantially all of our cost of revenues and a majority of our operating expenses are also denominated in U.S. dollars. As a result, we believe that our overall exposure to foreign exchange risk is low.

At September 30, 2009, we had two international subsidiaries, one in Japan and one in China. We also have two international branches, one in South Korea and one in Taiwan. At September 30, 2009, 64 of our 165 employees were located in our international subsidiaries and branch offices. Our China and Japan subsidiaries are involved in both product development and technical marketing support. Our Taiwan and Korea branches primarily provide technical marketing support.

It is difficult for us to forecast the demand for our products, in part because of the highly complex supply chain between us and the end markets that incorporate our products. Demand for new features changes rapidly. Distributors and ODMs add an additional layer of complexity. We must, therefore, forecast demand not only from our direct customers, but also from other participants in this multi-level distribution channel. Because of our lengthy product development cycle, it is critical for us to anticipate changes in demand for our various product features and the applications they serve, to allow sufficient time for product design. Our failure to accurately forecast demand can lead to product shortages that can impede production by our customers and harm our relationship with these customers. Conversely, our failure to forecast declining demand or shifts in product mix can result in excess or obsolete inventory.

Generally, the average selling price of our products will decline over the life of the product. Our experience to date is that the decline has not had a material effect on our gross margins, as price reductions have been mitigated by lower per unit costs associated with both high unit volume and the transition of our products to smaller process geometries.

We expect our revenues to be lower in the first calendar quarter of each year. The most significant factor for this decline is because most of our semiconductors are sold to customers located in Asia, primarily to customers located in regions who observe the Lunar New Year holiday. Typically, our customers' offices are closed for a week or more during the extended holiday period, which negatively impacts our business during the first calendar quarter of the year. As a result of seasonality associated with our customer concentration in Asia, we expect our revenues to be lower in the first calendar quarter of each year.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based upon our condensed unaudited consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed unaudited consolidated financial statements requires us to make estimates and judgments that affect the reported amount of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. We evaluate our estimates on an on-going basis, including those related to inventory valuations, valuation of investments, income taxes and stock-based compensation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making the judgments we make about the carrying values of assets and liabilities that are not readily apparent from other sources. Because these estimates can vary depending on the situation, actual results may differ from the estimates.

We believe the following critical accounting policies affect our more significant judgments used in the preparation of our condensed unaudited consolidated financial statements.

Revenue Recognition. Revenues from product sales are recognized upon shipment, provided that title and risk of loss has passed to the customer, persuasive evidence of an arrangement exists, the price is fixed or determinable and collectibility is probable. We do not allow for price protection or stock rotation rights with any of our distributors. If we change our practice and allow stock rotation or price protection in the future, we would have to evaluate the consequences on the timing of our revenue recognition, which could lead to the deferral of the revenues subject to such uncertainties unless reasonable estimates of returns or price reductions can be made at the time of shipment.

Fair Value Measurements. Effective January 1, 2008, we adopted the authoritative guidance for fair value measurements and the fair value option for financial assets and financial liabilities. The guidance defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements required under other accounting guidance. The guidance clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants and also requires that a fair value measurement reflect the assumptions market participants would use in pricing an asset or liability based on the best information available. Assumptions include the risks inherent in a particular valuation technique (such as a pricing model) and/or the risks inherent in the inputs to the model. These assumptions are volatile and subject to change as the underlying sources of these assumptions and market conditions change. Refer to Note 2 to our consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2008 for the fair value hierarchy, and Note 5 to our condensed unaudited consolidated financial statements included in this Quarterly Report on Form 10-Q for inputs to valuation techniques and fair value measurements of financial assets carried at fair value.

Inventory Valuation. Inventory is valued at the lower of cost or market, computed on a first-in, first-out basis. We evaluate inventory for excess and obsolescence and write-down units that are unlikely to be sold based upon a six month demand forecast. This evaluation may take into account matters including expected demand, anticipated sales price, product obsolescence and other factors. If actual future demand for our products is less than currently forecasted, additional inventory write-downs may be required. Once inventory costs are written down, such revised costs are maintained until the product is sold or scrapped. If a unit that has been written down is subsequently sold, the cost associated with the revenue from this unit is reduced to the extent of the write-down, resulting in an increase in gross profit.

Accounting for Income Taxes. In accounting for income taxes, we are required to estimate our current tax expense together with assessing temporary differences resulting from differing treatments of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. We must assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. Significant management judgment is required to assess the likelihood that our deferred tax assets will be recovered from future taxable income. At September 30, 2009, our total deferred tax assets were principally comprised of research and other credit carryforwards, stock-based compensation and expense accruals.

We assess the recoverability of our deferred tax assets. To assess the likelihood that the deferred tax assets will be recovered from future taxable income, we considered both positive evidence that indicates a valuation allowance is not needed and negative evidence that indicates a valuation allowance is needed. As of September 30, 2009, we believe that our predictable strong earnings provide ample evidence that no valuation allowance is required at this time as it is more likely than not the deferred tax assets will be realized in the future.

Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining deferred tax assets. In the event that we determine all or part of the net deferred tax assets are not realizable in the future, we will make an adjustment to the valuation allowance that would be charged to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties. Resolution of these uncertainties in a manner inconsistent with management's expectations could have a material impact on our financial condition and operating results.

We file income tax returns in the U.S. federal jurisdiction, various states and foreign jurisdictions. We are currently under examination by the Internal Revenue Service for the tax years 2007 and 2008. The outcome of the examination is not known, and therefore, we are unable to estimate the effect of the audit to our financial position, results of operations or cash flows.

Stock-Based Compensation. For the three and nine months ended September 30, 2009 and 2008, stock-based compensation expense includes compensation costs related to estimated fair values of stock options and awards granted after January 1, 2006 and compensation costs related to unvested stock options at January 1, 2006 based on the intrinsic values.

For options granted after January 1, 2006, we use the straight-line method for expense attribution. For options granted prior to January 1, 2006, we use the multiple grant approach for expense attribution, which results in substantially higher amounts of amortization in earlier years as opposed to the straight-line method, which results in equal amortization over the vesting period of the options.

The fair value of options granted after January 1, 2006 is estimated on the grant date using the Black-Scholes option valuation model. The expected term assumption calculation was based on historical data as adjusted for any changes in future expectations. We relied exclusively on historical volatility in the expected volatility assumption calculation since we do not have any publicly traded options. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected term of the option and the estimated forfeiture rate is based on our historical forfeiture experience.

The following assumptions are used to value stock options granted in the periods presented:

                            Three Months Ended           Nine Months Ended
                              September 30,                September 30,
                            2009         2008          2009            2008
Expected term (years)          4.34         4.28            4.34            4.28
Risk-free interest rate        2.01 %       2.79 %   1.52 - 2.01 %   2.57 - 2.86 %
Expected volatility           53.00 %      51.00 % 53.00 - 54.00 % 51.00 - 64.00 %
Expected dividend                 -            -               -               -

Stock-based compensation expense for restricted stock awards is determined using the fair value of our stock on the date of the grant and is recognized on a straight-line basis over the service period.

Stock-based compensation expense is allocated among cost of revenues, research and development expenses and selling, general and administrative expenses, respectively, based upon the employee's job function. We expect to continue to recognize substantial amounts of stock-based compensation expense relating to our employee stock options and awards in future periods.

Results of Operations



The following table is derived from our selected financial data and sets forth
our historical operating results as a percentage of revenues:



                                         Three Months Ended       Nine Months Ended
                                           September 30,            September 30,
                                         2009         2008        2009         2008
Revenues                                   100.0 %      100.0 %    100.0 %      100.0 %
Cost of revenues*                           39.1         37.0       39.6         38.0
Gross profit                                60.9         63.0       60.4         62.0
Operating expenses:
Research and development*                   29.3         24.0       34.4         23.9
Selling, general and administrative*        21.3         19.3       27.4         21.5
Total operating expenses                    50.6         43.3       61.8         45.4
Income (loss) from operations               10.3         19.7       (1.4 )       16.6
Interest income                              2.0          2.7        2.6          3.5
Income before income taxes                  12.3         22.4        1.2         20.1
. . .