Forward-looking Statements
This Management's Discussion and Analysis of Financial Condition and Results of Operations contains "forward-looking statements" that are based on current expectations, estimates, beliefs, assumptions and projections about our business. Words such as "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates" and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks and uncertainties that are difficult to predict and which may cause actual outcomes and results to differ materially from what is expressed or forecasted in such forward-looking statements. A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in Part II, Item 1A of this Quarterly Report on Form 10-Q. These forward-looking statements speak only as of the date on which they are made, and we do not undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date of this Quarterly Report on Form 10-Q. If we do update or correct one or more forward-looking statements, you should not conclude that we will make additional updates or corrections with respect thereto or with respect to other forward-looking statements. Except where the context otherwise requires, in this Quarterly Report on Form 10-Q, the "Company," "Pixelworks," "we," "us" and "our" refer to Pixelworks, Inc., an Oregon corporation, and its wholly-owned subsidiaries.

Overview
We are an innovative designer, developer and marketer of video and pixel processing semiconductors and software for high-end digital video applications and hold 116 patents related to the visual display of digital image data. Our solutions enable manufacturers of digital display and projection devices, such as large-screen flat panel televisions and digital front projectors, to manufacture their products with a consistently high level of video quality, regardless of the content's source or format. Our core technology leverages unique proprietary techniques for intelligently processing video signals from a variety of sources to ensure that all resulting images are optimized. Additionally, our products help our customers reduce costs and differentiate their display and projection devices, an important factor in industries that experience rapid innovation.
Our business also includes the license of technologies developed for our integrated circuit ("IC") semiconductor products to non-competitive customers and partners, as well as co-development arrangements with current or prospective IC customers. Pixelworks was founded in 1997 and is incorporated under the laws of the state of Oregon.

Results of Operations

Revenue, net
Net revenue for the three and six month periods ended June 30, 2012 and 2011, was as follows (dollars in thousands):
Three Months Ended Six Months Ended June 30, June 30, 2012 2011 % Change 2012 2011 % Change Revenue, net $ 15,524 $ 15,690 (1 )% $ 29,854 $ 30,390 (2 )%

Net revenue decreased $0.2 million, or 1%, from the second quarter of 2011 to the second quarter of 2012, and decreased $0.5 million, or 2%, from the first half of 2011 to the first half of 2012. Revenue related to IC product sales was $13.2 million and $15.7 million for the second quarter of 2012 and 2011, respectively and was $25.5 million and $30.4 million for the first half of 2012 and 2011, respectively. Revenue related to licensing agreements was $2.3 million and $4.4 million for the second quarter and first half of 2012, respectively. Our revenue in the 2011 periods did not include revenue associated with licensing agreements.
The decrease in revenue related to IC product sales was primarily attributable to a 20% decrease in average selling price ("ASP"), from the second quarter of 2011 to the second quarter of 2012 and a 14% decrease in ASP from the first half of 2011 to the first half of 2012. The decreases in ASP were primarily due to a greater proportion of unit sales of our MotionEngine® co-processor ICs, which have a lower price point than our other product lines. The decrease was also attributable to reduced pricing on our earlier generation digital projector products. Volume of units sold did not have a significant impact on changes in revenue from the 2012 periods compared to the 2011 periods. The decrease in revenue related to IC product sales was partially offset by the revenue recorded in 2012 related to licensing agreements.

Cost of revenue and gross profit
Cost of revenue and gross profit for the three and six month periods ended June 30, 2012 and 2011, was as follows (dollars in thousands):

                                        Three Months Ended June 30,                         Six Months Ended June 30,
                                               % of                    % of                     % of                     % of
                                 2012         revenue      2011       revenue       2012       revenue       2011       revenue
Direct product costs and
related overhead 1           $   7,272         47  %     $ 8,003        51 %     $ 13,528       45  %     $ 15,820        52 %
Licensing costs 2                  403          3              -         0            505        2               -         -
Inventory charges 3                 (3 )        0            104         1            (11 )      -             302         1
Other cost of revenue 4            193          1            164         1            364        1             277         1
Total cost of revenue        $   7,865         51  %     $ 8,271        53 %     $ 14,386       48  %     $ 16,399        54 %
Gross profit                 $   7,659         49  %     $ 7,419        47 %     $ 15,468       52  %     $ 13,991        46 %

1 Includes purchased materials, assembly, test, labor, employee benefits, warranty expense and royalties all of which are related to sales of IC products.

2 Includes direct labor costs and allocated overhead associated with license revenue arrangements.

3 Includes charges to reduce inventory to lower of cost or market less a benefit for sales of previously written down inventory.

4 Includes stock based compensation and additional amortization of a non-cancelable prepaid royalty.

Gross profit margin increased to 49% in the second quarter of 2012, up from 47% in the second quarter of 2011, and increased to 52% in the first half of 2012, up from 46% in the first half of 2011. The increase during the 2012 periods compared to the 2011 periods was primarily due to the recognition of higher margin license revenue during the 2012 periods.
The favorable impact of licensing revenue on gross margin was partially offset by $0.3 million of non-recurring charges related to a discontinued product during the second quarter of 2012 as well as an increased proportion of unit sales from our MotionEngine® co-processor IC products which have lower margins than our other product offerings.
Pixelworks' gross margin is subject to variability based on changes in revenue levels, recognition of license revenue, product mix, startup costs, and the timing and execution of manufacturing ramps as well as other factors. Research and development
Research and development expense includes compensation and related costs for personnel, development-related expenses, including non-recurring engineering and fees for outside services, depreciation and amortization, expensed equipment, facilities and information technology expense allocations and travel and related expenses.
Co-development agreement
During the second quarter of 2012, we entered into a best efforts co-development agreement with a customer to defray a portion of the research and development expenses we expect to incur in connection with our development of an integrated circuit product to be sold exclusively to the customer. We expect our development costs to exceed the amounts received from the customer, and although we expect to sell units of the product to the customer, there is no commitment or agreement from the customer for such sales at this time. Additionally, we retain ownership of any modifications or improvements to our pre-existing intellectual property and may use such improvements in products sold to other customers.

Under the co-development agreement, $3.5 million was payable by the customer as of the date of the agreement and two additional payments of $1.75 million are each payable upon completion of certain development milestones. As amounts become due and payable without recourse, they are offset against research and development expense up to the amount of related costs incurred. During the second quarter of 2012, we incurred development costs and recognized an offset to research and development expense of $0.4 million.

During the second half of 2012, we expect to record an offset to research and development expense of $3.1 million for the remaining deferred research and development reimbursement.

2012 v. 2011
Research and development expense for the three month periods ended June 30, 2012 and 2011, was as follows (dollars in thousands):

Research and development expense decreased $0.8 million, or 15%, from the second quarter of 2011 to the second quarter of 2012. The decrease is primarily attributable to the following:

• A benefit of $0.4 million recognized in the second quarter of 2012 for the co-development agreement described above; and

• A decrease of $0.3 million due to direct labor costs and allocated overhead associated with the utilization of research and development engineers on license revenue agreements. These costs were recorded in cost of revenue and the reclassification of future expenditures from research and development to cost of revenue is dependent on the timing of any future license revenue agreements.

Research and development expense for the six month periods ended June 30, 2012 and 2011, was as follows (dollars in thousands):

Research and development expense decreased $1.7 million, or 15%, from the first half of 2011 to the first half of 2012. The decrease is primarily attributable to the following:

• Non-recurring engineering and outside services expense decreased $0.7 million due to the timing of development activities;

• A decrease of $0.5 million due to direct labor costs and allocated overhead associated with the utilization of research and development engineers on license revenue agreements. These costs were recorded in cost of revenue and the reclassification of future expenditures from research and development to cost of revenue is dependent on the timing of any future license revenue agreements; and

• A benefit of $0.4 million recognized in the second quarter of 2012 for the co-development agreement described above.

Selling, general and administrative
Selling, general and administrative expense includes compensation and related costs for personnel, sales commissions, allocations for facilities and information technology expenses, travel, outside services and other general expenses incurred in our sales, marketing, customer support, management, legal and other professional and administrative support functions.
Selling, general and administrative expense for the three and six month periods ended June 30, 2012 and 2011, was as follows (dollars in thousands):

Selling, general and administrative expense increased $0.1 million or 4% from the first quarter of 2011 to the first quarter of 2012 and $0.3 million or 4% from the first half of 2011 to the first half of 2012. The increase during the 2012 periods compared to the 2011 periods is primarily due to an increase in compensation expense due to annual merit salary increases which occurred in the third quarter of 2011 and an increased management bonus accrual. Other income (expense), net
Net other income (expense) for the three and six month periods ended June 30, 2012 and 2011, was as follows (dollars in thousands):

                                    Three Months Ended                         Six Months Ended
                                         June 30,                                  June 30,
                                     2012          2011        $ Change        2012        2011       $ Change
Interest expense and other, net
1                                $    (101 )     $  (140 )   $       39     $   (199 )   $  (306 )   $    107
Gain on sale of patents 2                -             -              -            -       1,600       (1,600 )
Gain on sale of marketable
securities 3                             -             -              -            -         264         (264 )
Total other income (expense),
net                              $    (101 )     $  (140 )   $       39     $   (199 )   $ 1,558     $ (1,757 )

1 Interest expense and other, net consists of interest expense, interest income and amortization of debt issuance costs. The decrease from the first half of 2011 to the first half of 2012 is primarily due to a decrease in interest expense and amortization of debt issuance costs attributable to the repayment of our convertible subordinated debentures in the second quarter of 2011.

2 In the first quarter of 2011, we sold certain patents and related rights and materials for proceeds and a net gain of $1.6 million. All of the patents were originally obtained by us during our June 2005 acquisition of Equator Technologies, Inc., and the underlying technologies pertain to markets that we no longer pursue.

3 Realized gains on the sale of available-for-sale marketable securities.

Provision (benefit) for income taxes
The provision (benefit) for income taxes during the 2011 and 2012 periods is primarily comprised of current and deferred tax expense in profitable cost-plus foreign jurisdictions, accruals for tax contingencies in foreign jurisdictions and benefits for the reversal of previously recorded foreign tax contingencies due to the expiration of the applicable statutes of limitation. Due to the full valuation allowance on our U.S. net operating losses, we do not incur significant U.S. income tax expense or benefit. We recorded a benefit for the reversal of previously recorded tax contingencies of $1.0 million and $0.3 million during the first half of 2012 and the first half of 2011, respectively.

Liquidity and Capital Resources

Cash and cash equivalents
Total cash and cash equivalents were $15.1 million at December 31, 2011 and June 30, 2012. Cash flows during the first half of 2012 included $1.4 million provided by operating activities due primarily to changes in working capital and $0.2 million in proceeds from the issuance of common stock, offset by $1.5 million used for payments on property and equipment and other asset financing.

As of June 30, 2012, our cash and cash equivalents balance of $15.1 million consisted of $1.7 million in cash and $13.4 million in cash equivalents held in U.S. denominated money market funds. Although we did not hold short- or long-term investments as of June 30, 2012, our investment policy requires that our portfolio maintains a weighted average maturity of less than 12 months. Additionally, no maturities can extend beyond 24 months and concentrations with individual securities are limited. Investments must be rated at least A-1 / P-1 / F-1 by at least two Nationally Recognized Statistical Rating Organizations, and our investment policy is reviewed at least annually by our Audit Committee. Although cash balances held at our foreign subsidiaries would be subject to U.S. taxes if repatriated, we have sufficient U.S. net operating losses to offset the liability associated with any such repatriation and foreign taxes due upon repatriation would not be significant.
Accounts receivable, net
Accounts receivable, net increased to $5.3 million as of June 30, 2012 from $4.6 million as of December 31, 2011. The average number of days sales outstanding increased to 31 days as of June 30, 2012 from 24 days as of December 31, 2011. The increase in accounts receivable and days sales outstanding was primarily due to $1.9 million of license revenue recorded during the second quarter of 2012 for which we anticipate receiving payment in the third quarter of 2012. Inventories
Inventories increased to $4.2 million as of June 30, 2012 from $4.1 million as of December 31, 2011. Inventory turnover increased to 8.5 as of June 30, 2012 from 8.0 as of December 31, 2011, primarily due to increased material costs and increased costs associated with IP license revenue during the second quarter of 2012 which resulted in increased cost of sales relative to average inventory balances. Inventory turnover is calculated based on annualized operating results and average inventory balances for the respective quarters. Capital resources
Short-term line of credit
On December 21, 2010, we entered into a Loan and Security Agreement (the "Revolving Loan Agreement") with Silicon Valley Bank (the "Bank"). The Revolving Loan Agreement provides for a secured working capital-based revolving line of credit (the "Revolving Line") in an aggregate amount of up to the lesser of
(i) $10.0 million, or (ii) 80% of eligible domestic accounts receivable and certain foreign accounts receivable. In addition, the Revolving Loan Agreement provides for non-formula advances of up to $10.0 million which may be made solely during the last five business days of any fiscal month or quarter and which must be repaid by the Company on or before the fifth business day after the applicable fiscal month or quarter end. Due to their repayment terms, non-formula advances do not provide the Company with usable liquidity. The Revolving Loan Agreement contains customary affirmative and negative covenants as well as customary events of default. The occurrence of an event of default could result in the acceleration of the Company's obligations under the Revolving Loan Agreement and an increase to the applicable interest rate, and would permit the Bank to exercise remedies with respect to its security interest. As of June 30, 2012, we were in compliance with all of the terms of the Revolving Loan Agreement. As of June 30, 2012 and December 31, 2011, we had no outstanding borrowings under the Revolving Line.

Liquidity
As of June 30, 2012, we have no short- or long-term debt and our cash and cash equivalents balance of $15.1 million is highly liquid. We anticipate that our existing working capital, as well as funds available under our Revolving Line, will be adequate to fund our operating, investing and financing needs for the next twelve months. If necessary, management will pursue financing arrangements including the issuance of debt or equity securities or will reduce expenditures, in order to meet the Company's cash requirements. There is no assurance that, if required, we will be able to raise additional capital or reduce discretionary spending to provide the required liquidity which, in turn, may have an adverse effect on our results of operations and financial position.
From time to time, we may evaluate acquisitions of businesses, products or technologies that complement our business. Any further transactions, if consummated, may consume a material portion of our working capital or require additional financing activities, including the issuance of equity securities that may result in dilution to existing shareholders. Contractual Payment Obligations
Our contractual obligations for 2012 and beyond are included in our Annual Report on Form 10-K for the year ended December 31, 2011, filed with the Securities and Exchange Commission on March 8, 2012. Our obligations for 2012 and beyond have not changed materially as of June 30, 2012.

Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements that have, or are reasonably likely to have, a material current or future effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources.