Tough times necessitate tough decisions and tougher strategic actions. Without the assurance of an "inevitable industry upturn," we turned our focus toward three main areas: Higher profitability Better return on our invested capital and Increased emphasis on our higher-margin analog businesses.

One outcome of this focus was our decision to exit two businesses. We also modified our business model to both reduce the ongoing level of capital expenditures and to prioritize the use of capital to produce higher returns for our shareholders. We continued to re-deploy our investment dollars into higher-value, higher-margin analog businesses.

As a result of these strategic actions implemented in 2003, National is now well positioned for revenue growth and sustained profitability going forward. As we enter the new fiscal year, we are confident that the changes we have made will be reflected in improved overall results — regardless of the state of the economy.

These strategic actions, while critical, were only part of our story in fiscal 2003. During a year in which industry revenues were essentially flat, National grew sales 12 percent over fiscal 2002. Gross margins increased to 43.4 percent in 2003, up from 37 percent in 2002. Our operating results also improved significantly year-on-year. Although we reported a net loss of $33 million for fiscal 2003, principally because of special charges related to the strategic actions noted above, our operating results excluding these charges actually showed a net income of $24 million --- more than $150 million better than the previous year. The company also continued to strengthen its balance sheet, ending the year with more than $900 million in cash reserves, minimal debt, and reduced inventories.

After a lengthy strategic review of our growth opportunities, and in recognition of changing market conditions, we decided to exit two under-performing business lines to intensify our focus on higher-value, higher-margin analog technologies. We closed our Cellular Baseband business unit and reached an agreement to sell our Information Appliance business, which consisted primarily of the Geode™ processor line. Exiting these businesses, together with other streamlining measures, not only generated significant savings in R&D expense, but also reduced any near-term need for in-house advanced digital processes, allowing us to restructure our relationship with Taiwan Semiconductor Manufacturing Co. Ltd.(TSMC) and eliminate an ongoing technology license fee.

Together, all of these actions will provide an annual cost savings of about $120 million, or $30 million per quarter. Approximately $25 million of that per-quarter savings was achieved by the end of the fourth quarter of fiscal 2003. The remainder is expected to be achieved starting in the second quarter of fiscal 2004, following the completion of our sale of the Information Appliance business to Advanced Micro Devices, Inc.

Overall, because we exited of the two businesses and focused on analog technologies, the company has been able to aggressively implement a capital spending model that runs at 10 percent of sales, compared to our formerrun-rate which was often 20 percent or higher. This is a major change for National, one that brings expenditures and depreciation into tighter alignment with our profit objectives.

In line with this model, we signed a new manufacturing agreement with TSMC for products and services at .15- micron and below, to assure a source of technology and supply for any products that might require more advanced geometries.

Consistent with our return on capital objectives, National announced in July 2003 a program to repurchase up to $400 million of National's stock. With our current business model, we can address National's markets with less capital. After streamlining our expenses and focusing on our core analog strengths, and with our strong cash position and virtually no debt, we decided that a stock repurchase program would be a natural next step for us to increase shareholder value and demonstrate our commitment to National's future.

National is a world leader in standard linear analog products. According to Databeans™, a recognized market research firm, we grew analog sales during calendar year 2002 at a greater rate than our top four competitors, realizing 11 percent year-on-year growth, clearly gaining market share in these key analog technology areas.

More importantly, the growth rates for areas within the analog market in which National is a major player are projected to outpace the growth rate of the overall semiconductor market. The Semiconductor Industry Association in June 2003 forecast growth for the worldwide semiconductor industry at 9.4 percent over calendar year 2002. The $9 billion standard linear market is forecast to grow 15 percent, and within that area, the power management space is forecast to grow at an even faster rate of 18 percent.

Power management and amplifier technologies make up the centerpiece of our overall analog portfolio. Together, these two areas currently combine to make up about one-half of National's revenues. In 2003, National continued to aggressively focus our engineering resources on developing multiple new applications where our capabilities, such as power management and signal amplification, make a critical difference for customers.

These efforts are paying dividends in the form of new products. In fiscal 2003, our revenue from new analog products, which we define as products released within the last three years, was 50 percent higher than in the previous year.

Analog technology provides real-world benefits for people who use electronics, including better sound, longer battery life, crisper and brighter displays, smaller size, lighter weight, and greater portability. Here is a sampling of some of the major product announcements that National made in key analog markets during fiscal 2003:

National and the UK-based ARM Ltd. announced a strategic business relationship to jointly develop and market power-efficient systems based on the ARM embedded processor. New systems using National's PowerWise™ technologies are expected to increase the battery life of handheld portable devices in several phases from 25 percent up to 400 percent.

We introduced the LM5000 family, the first fully integrated switching regulator circuits that operate from 10 to 100 volts for high voltage power conversion applications. This high-voltage product capability is critical in base stations, servers, cars, and other systems that have demanding power needs.

National launched complete analog power management and lighting solutions for handheld devices. These innovative, mixed-signal power and lighting management circuits are designed for cell phones and other portable devices such as personal digital assistants (PDAs).

We introduced a revolutionary "amplifier in a microphone" technology that expands our market opportunities to provide world-class sound systems for microphones, headsets, telephone handsets, and other portable applications. This new technology enables us to provide customers with a complete audio integration platform inside a microphone that provides crystal-clear sound and replaces older JFET amplifier technologies.

Working with Microsoft, National created a custom multi-chip solution for Microsoft's new Smart Personal Objects Technology (SPOT) initiative. National's reference platform solution uses power management and amplifier chips and also includes a custom baseband processor with digital signal processing (DSP) accelerators built on an industry-standard ARM7 core and a custom-designed radio chip. Thanks to National's ultra-small chip packaging, the entire solution fits handily into a wristwatch.

These projects and alliances are enabling National to gain share in our target markets for analog components and subsystems, including handsets, flat-panel displays, PCs, and networks. We are increasing the penetration of our analog components and subsystems in mobile phones for key global customers such as Nokia, Motorola, and Samsung. We are also growing dollar content in flat-panel displays with Samsung and LG Electronics, the world leaders in this market. Every flat-panel display represents up to $20 of silicon sales opportunity for National Semiconductor. We are also growing dollar content in notebook computers for key customers such as IBM and Hewlett-Packard. As the notebook market continues to grow in prominence, in the office or at home or at school, our silicon sales opportunity could yield up to $20 per notebook. In the networking arena, we now offer complete solutions that enhance network security and manageability.

Our progress in 2003 did not come easily. The objectives we accomplished were made possible by the dedication and performance of National's employees. Because of their continued contributions, National not only creates world-class technology, but offers best-in-class performance in critical support areas such as product cycle times and global logistics. And we continued to expand upon an already impressive library of intellectual property.

Although the economic conditions in 2003 were difficult, we took the right steps to move the company forward. We focused on ways to generate higher returns sooner. We took aggressive steps to enhance our profitability, improve our return on invested capital, and grow our core analog business for the benefit of all shareholders. We are proud of our employees, and we believe that this positive story will continue to unfold in 2004 and continue to point to a bright future.

Sincerely,

Brian L. Halla
Chairman of the Board, President and CEO
National Semiconductor Corporation