<PAGE>
________________________________________________________________________________
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES
EXCHANGE ACT OF 1934
For the quarter ended June 30, 1996 OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________ to __________
Commission file number 0-21126
S3 INCORPORATED
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 77-0204341
-------------- --------------
[State or other jurisdiction of [I.R.S. Employer Identification No.]
incorporation or organization]
2770 San Tomas Expressway
Santa Clara, California 95051-0968
------------------------- -----------
[Address of principal executive [Zip Code]
offices]
Registrant's telephone number, including area code: (408)980-5400
Indicate by check mark whether the Registrant (1) has filed
all reports required to be filed by Section 13 or 15(d) of
the Securities Exchange Act of 1934 during the preceding 12
months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days.
Yes [X] No [ ]
The number of shares of the Registrant's Common Stock, $.0001 par value,
outstanding at July 26, 1996 was 47,517,589
___________________________________________________________________________
<PAGE>
S3 INCORPORATED
FORM 10-Q
INDEX
<TABLE>
<CAPTION>
<S> <C>
PAGE
PART I. CONSOLIDATED CONDENSED FINANCIAL INFORMATION
Item 1. Consolidated Condensed Financial Statements:
Consolidated Condensed Balance Sheets
June 30, 1996 and December 31, 1995 3
Consolidated Condensed Statements of Operations
Three months ended and six months
ended June 30, 1996 and 1995 4
Consolidated Condensed Statements of Cash Flows
Six months ended June 30, 1996 and 1995 5
Notes to Unaudited Consolidated Condensed Financial 6-8
Statements
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 9-14
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 15
Item 2. Changes in Securities Not Applicable
Item 3. Defaults Upon Senior Securities Not Applicable
Item 4. Submission of Matters to a Vote of
Security Holders 15-16
Item 5. Other Information Not Applicable
Item 6. Exhibits and Reports on Form 8-K 16
Signatures 17
</TABLE>
Page 2 of 17
<PAGE>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
S3 INCORPORATED
CONSOLIDATED CONDENSED BALANCE SHEETS
(Dollars in thousands, except par value data)
(Unaudited)
<TABLE>
<CAPTION> June 30, December
1996 31, 1995
--------- ---------
<S> <C> <C>
ASSETS
Current assets:
Cash and equivalents $ 69,226 $ 69,289
Short-term investments 15,162 24,630
Accounts receivable (net of allowances of
$1,680 in 1996 and $1,614 in 1995) 91,330 84,210
Inventories, net 51,973 43,293
Prepaid expenses and other 17,773 14,216
--------- ---------
Total current assets 245,464 235,638
Property and equipment, net 25,405 20,678
Production capacity rights 24,000 24,000
Investment in joint venture 36,425 36,425
Other assets 9,554 4,902
--------- ---------
Total $ 340,848 $ 321,643
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 45,186 $ 62,081
Notes payable 15,700 9,200
Accrued liabilitie 17,016 13,461
Income taxes payabe 5,860 6,276
--------- ---------
Total current liabilities 83,762 91,018
Notes payable 24,000 24,000
Other liabilities 3,688 761
--------- ---------
Total liabilities 111,450 115,779
--------- ---------
Commitments and contingencies (Notes 4 and 5)
Stockholders' equity:
Common stock, $.0001 par value; 70,000,000
shares authorized; 47,471,360 and 46,797,327
shares outstanding in 1996 and 1995 158,867 156,474
Unrealized gain on investments 55 14
Retained earnings 70,476 49,376
--------- ---------
Total stockholders' equity 229,398 205,864
--------- ---------
Total $ 340,848 $ 321,643
========= =========
</TABLE>
See accompanying notes to consolidated condensed financial
statements.
Page 3 of 17
<PAGE>
S3 INCORPORATED
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June June 30, June 30,
1996 30,1995 1996 1995
-------- ------- -------- --------
<S> <C> <C> <C> <C>
Net sales $103,825 $70,558 $213,897 $127,980
Cost of sales 64,357 42,601 130,867 77,395
-------- ------- -------- --------
Gross margin 39,468 27,957 83,030 50,585
Operating expenses:
Research and development 15,057 8,902 29,778 15,837
Selling, marketing and 11,587 7,688 22,501 14,314
administrative
-------- ------- -------- --------
Total operating expenses 26,644 16,590 52,279 30,151
-------- ------- -------- --------
Income from operations 12,824 11,367 30,751 20,434
Other income, net 703 1,283 1,709 1,717
-------- ------- -------- --------
Income before income taxes 13,527 12,650 32,460 22,151
Provision for income taxes 4,735 4,680 11,360 8,096
-------- ------- -------- --------
Net income $ 8,792 $ 7,970 $21,100 $14,055
======== ======= ======== ========
Net income per share $0.18 $0.17 $0.42 $0.32
======== ======= ======== ========
Common and equivalent shares
used in computing net income
per share 50,114 46,074 50,081 43,614
======== ======= ======== ========
</TABLE>
See accompanying notes to consolidated condensed financial
statements.
Page 4 of 17
<PAGE>
S3 INCORPORATED
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
<TABLE>
<CAPTION> Six Months Ended
----------------------
June 30, June 30,
1996 1995
-------- --------
<S> <C> <C>
Operating activities:
Net income $ 21,100 $ 14,055
Adjustments to reconcile net income to net
cash provided by used for) operating
activities:
Deferred income taxes (557) 52
Depreciation and amortization 4,690 3,009
Provision for doubtful accounts receivable 66 192
Deferred rent (50) 69
Changes in assets and liabilities:
Accounts receivable (7,186) (18,172)
Inventories (8,680) (6,204)
Prepaid expenses and other (5,551) 110
Accounts payable (16,895) 10,812
Accrued liabilities and other 6,533 2,725
Income taxes payable (416) 4,980
-------- --------
Net cash provided by (used for) operating (6,946) 11,628
activities
-------- --------
Investing activities:
Property and equipment purchases, net (9,418) (7,467)
Investment in real estate partnership (2,100) -
Sales/maturities of short-term 9,509 3,355
investments, net
Other assets - (299)
-------- --------
Net cash used for investing activities (2,009) (4,411)
-------- --------
Financing activities:
Sale of common stock, net 2,392 92,013
Borrowings of notes payable 6,500 -
-------- --------
Net cash provided by financing activities 8,892 92,013
-------- --------
Net increase (decrease) in cash and (63) 99,230
equivalents
Cash and cash equivalents at beginning of 69,289 25,772
period
-------- --------
Cash and cash equivalents at end of period $69,226 $125,002
======== ========
</TABLE>
See accompanying notes to consolidated condensed financial
statements.
Page 5 of 17
<PAGE>
S3 INCORPORATED
NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL
STATEMENTS
1. Basis of Presentation:
The consolidated condensed financial statements have been prepared by S3
Incorporated, without audit, pursuant to the rules and regulations of the
Securities and Exchange Commission and include the accounts of S3
Incorporated and its wholly owned subsidiaries ("S3" or collectively the
"Company"). Certain information and footnote disclosures, normally included
in financial statements prepared in accordance with generally accepted
accounting principles, have been condensed or omitted pursuant to such rules
and regulations. In the opinion of the Company, the financial statements
reflect all adjustments, consisting only of normal recurring adjustments,
necessary for a fair presentation of the financial position at June 30, 1996
and December 31, 1995, and the operating results for the three and six months
ended June 30, 1996 and 1995. These financial statements and notes should be
read in conjunction with the Company's audited financial statements and notes
thereto for the year ended December 31, 1995, included in the Company's
Form 10-K filed with the Securities and Exchange Commission.
The results of operations for the three months and six months ended
June 30, 1996 are not necessarily indicative of the results that may be
expected for the year ending December 31, 1996.
Certain prior year amounts have been reclassified to conform to the current
year presentation.
2. Inventories:
Inventories consist of work in process and finished goods and are stated at
the lower of cost (first-in, first-out) or market.
<TABLE>
<CAPTION>
(In thousands)
June 30, December
1996 31,1995
--------- ---------
<S> <C> <C>
Inventories consist of:
Work in process $ 28,929 $ 23,469
Finished goods 23,044 19,824
--------- ---------
Total $ 51,973 $ 43,293
========= =========
</TABLE>
3. Net Income Per Share:
Net income per share is computed based on the weighted average number of
common shares and dilutive common equivalent shares outstanding. Common
equivalent shares include stock options and shares subscribed under the
employee stock purchase plan.
4. Wafer Supply Agreements and Commitments
In the third quarter of 1995, the Company entered into two long-term
manufacturing capacity arrangements. The Company entered into an agreement
with United Microelectronics Corporation (UMC) and Alliance Semiconductor
Corporation (Alliance) to form USC, a separate Taiwanese company, for the
purpose of building and managing a semiconductor manufacturing facility in
the Science-Based Industrial Park in Hsin Chu City, Taiwan. Pursuant to the
Page 6 of 17
<PAGE>
agreement, as initially executed, the Company invested $36.4 million in 1995
and committed to invest New Taiwanese Dollars (NTD) 1,500,000,000
(approximately $56.2 million) in the second half of 1996 for a 25% equity
interest in USC. In June 1996, the Company amended its agreement with UMC and
Alliance to provide that the Company would pay NTD 688,000,000 (approximately
$26.0 million) in July 1996 and would have the option, exercisable no later than
December 31, 1996, to pay NTD 687,000,000, plus 8.5% of such amount from
July 4, 1996, for a revised equity interest of 23.75% if the option was
exercised. The first installment of approximately $26.1 million was paid at the
beginning of July 1996. The facility is currently scheduled to begin
production utilizing advanced submicron semiconductor manufacturing processes in
late 1996, although there can be no assurance that production will begin on
schedule. The Company has the right to purchase up to 31.25% of the output from
the foundry. At June 30, 1996, the Company had forward exchange swap
agreements with a bank to hedge 1.375 billion NTD. Operations through
June 30, 1996 have consisted primarily of construction and other capitalizable
preproduction activities and, therefore, results of operations for the entity
have been immaterial. To the extent USC experiences operating losses during the
ramp up of production or thereafter, the Company will recognize its
proportionate share of such losses. There can be no assurance that such
operating losses will not continue after ramp up of production or that such
losses will not have a material adverse effect on the Company's consolidated
results of operations.
In June 1995, the Company expanded and formalized its relationship with
Taiwan Semiconductor Manufacturing Company (TSMC) to provide additional capacity
over the 1996 to 2000 timeframe. The agreement with TSMC requires the Company
to make certain annual advance payments to be applied against the following
year's capacity. The Company has signed promissory notes to secure these
payments over the term of the agreement. At June 30, 1996 the remaining advance
payments (and corresponding promissory notes to be paid through 2000) totaled
$31.2 million ($7.2 million in prepaid expenses and $24.0 million in production
capacity rights). On July 1, 1996, the Company paid $7.2 million to TSMC.
In the ordinary course of business, the Company places purchase orders with
its wafer suppliers based on its existing and anticipated customer orders for
its products. Should the Company experience a substantial unanticipated decline
in the selling price of its products and/or demand thereof, it could result in a
material loss on such purchase commitments.
During December 1995, the Company entered into a limited partnership
arrangement with a developer to obtain a ground lease and develop and operate
the Company`s future Santa Clara facilities. The facilities are currently
scheduled to be ready for occupancy in the first half of 1997. At
June 30, 1996, the Company had invested $2.1 million in the limited partnership.
5. Contingencies:
On October 2, 1995, Brooktree Corporation ("Brooktree") filed a complaint
against the Company in the United States District Court for the Southern
District of California (Action No. 952388R (AJB)). The complaint alleges that
S3's Trio64V+ product and other products with substantially equivalent
architecture infringes Brooktree`s United States Letters Patent No. 5,406,306
(the "'306 Patent"), which was issued on April 11, 1995. Brooktree has
indicated in its expert report and has informed the Company that it will assert
at trial that the Trio64V+, Trio64UV+, Trio64V2, Aurora64V+, ViRGE and ViRGE/VX,
comprising all of the Company`s current generation of products that have been
introduced to date, infringe the '306 Patent. Brooktree has alleged that such
infringement was willful and seeks a preliminary and permanent injunction
against S3 making, using or selling its Trio64V+ product or any other product
substantially equivalent thereto. In addition, Brooktree seeks damages, costs
and attorneys' fees and interest. On March 12, 1996, the Court ruled against
Brooktree in its request for a preliminary injunction. On July 2, 1996, the
Court ruled against S3 in its request for a summary judgment that the '306
Patent is unenforceable as a result of inequitable conduct before the United
States Patent and Trademark Office. A bench trial on the issue of inequitable
conduct is now set for August 6, 1996. In the event the '306 Patent is held to
be enforceable, the Court will hold a separate hearing to construe the scope of
the '306 Patent claims after which it will rule on S3`s motion for summary
judgment on the basis of non-infringement. If the Court were to deny this
summary judgment motion, the jury trial would immediately commence, where
Brooktree`s request for a permanent injunction and damages will be decided.
Page 7 of 17
<PAGE>
The Company has been advised by patent counsel that its Trio64V+,
Trio64UV+, Trio64V2, Aurora64V+, ViRGE and ViRGE/VX products do not infringe the
'306 Patent, and it plans to continue to defend the suit vigorously. The
Company believes that it has meritorious defenses, including that the '306
Patent is not valid and/or that the patent is unenforceable due to inequitable
conduct on the part of Brooktree in obtaining the patent. However, there can be
no assurance that the Company will be successful in the defense of such suit,
and even if successful, such litigation has resulted and will result in
substantial expense to the Company and diverted the efforts of the Company's
technical and management personnel. In addition, an adverse result in such
litigation, including substantial damages or an injunction, would have a
material adverse effect on the Company`s business and results of operations.
The semiconductor and software industries are characterized by frequent
litigation regarding patent and other intellectual property rights. The Company
is party to various claims of this nature. Although the ultimate outcome of
these matters and the Brooktree matter above is not presently determinable,
management currently believes that the resolution of all such pending matters
will not have a material adverse effect on the Company`s financial position or
results of operations. Accordingly, no liability that may occur has been
provided for in the accompanying financial statements. However, there can be no
assurance that an adverse result or settlement with respect to the Brooktree
lawsuit would not have a material adverse effect on the Company.
Page 8 of 17
<PAGE>
PART I. FINANCIAL INFORMATION
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations
When used in this discussion, the word "expects", "anticipates" and similar
expressions are intended to identify forward-looking statements. Such
statements are subject to risks and uncertainties that could cause actual
results to differ materially from those projected, including market conditions
in the PC industry, the impact of competitive products and pricing, the timely
development and market acceptance of new products and upgrades to existing
products, availability and cost of products from the Company's suppliers, the
factors discussed below and the factors discussed in Item 1 of the Company's
annual report on Form 10-K for the year ended December 31, 1995 under the
caption "Business-Factors that May Affect Results." These forward-looking
statements speak only as of the date hereof. The portions of the Form 10-K
referred to in this paragraph are expressly incorporated herein by reference.
The Company expressly disclaims any obligation or undertaking to release
publicly any updates or revisions to any forward-looking statement contained
herein to reflect any change in the Company's expectations with regard thereto
or any change in events, conditions or circumstances on which any such statement
is based.
Overview
The Company is a leading supplier of high performance multimedia
acceleration solutions for the PC market. The Company's accelerators are
designed to work cooperatively with a PC's central processing unit ("CPU"),
implementing functions best suited for a dedicated accelerator while allowing
the CPU to perform the more general purpose computing functions of today's
advanced graphical user interface ("GUI") environments and applications.
The following information should be read in conjunction with the
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" on pages 20 through 23 of the Company's 1995 Annual Report to
Stockholders, and with the section of the Company's annual report on Form 10-K
for the year ended December 31, 1995 entitled "Item 1. Business - Factors That
May Affect Results."
Results of Operations
The following table sets forth for the periods indicated certain financial data
as a percentage of net sales:
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June June June June
30, 30, 30, 30,
1996 1995 1996 1995
------ ------ ------ ------
<S> <C> <C> <C> <C>
Net sales 100.0% 100.0% 100.0% 100.0%
Cost of sales 62.0 60.4 61.2 60.5
------ ------ ------ -------
Gross margin 38.0 39.6 38.8 39.5
------ ------ ------ -------
Operating expenses:
Research and development 14.5 12.6 13.9 12.4
Selling, marketing and 11.2 10.9 10.5 11.1
administrative
------ ------ ------ -------
Total operating expenses 25.7 23.5 24.4 23.5
------ ------ ------ -------
Income from operations 12.3 16.1 14.4 16.0
Other income, net 0.7 1.8 0.8 1.3
------ ------ ------ -------
Income before income taxes 13.0 17.9 15.2 17.3
Provision for income taxes 4.5 6.6 5.3 6.3
------ ------ ------ -------
Net income 8.5% 11.3% 9.9% 11.0%
====== ====== ====== =======
</TABLE>
Page 9 of 17
<PAGE>
The Company's operating results have historically been, and will continue
to be, subject to quarterly and other fluctuations due to a variety of factors,
including changes in pricing policies by the Company, its competitors or its
suppliers, anticipated and unanticipated decreases in unit average selling
prices of the Company's products, availability and cost of products from the
Company's suppliers, changes in the mix of products sold and in the mix of sales
by distribution channels, the gain or loss of significant customers, new product
introductions by the Company or its competitors, market acceptance of new or
enhanced versions of the Company's products, seasonal customer demand, and the
timing of significant orders.
The Company's is continually developing new products to address changing
market needs, and its operating results may fluctuate from those in prior
quarters or may be adversely affected in quarters in which it is undergoing a
product line transition or in which existing products are under extreme price
pressures due to competitive factors. The Company also intends to add increased
functionality to its products, such as system logic, audio, communications or
other additional functions. If new products are not brought to market in a
timely manner or do not address market needs or achieve market acceptance, then
the Company's operating results will be adversely affected. As a result of the
foregoing, the Company's operating results and stock price may be subject to
significant volatility, particularly on a quarterly basis. Any shortfall in net
sales or net income from levels expected by securities analysts could have an
immediate and significant adverse effect on the trading price of the Company's
Common Stock.
Net Sales
The Company's net sales to date have been generated from the sale of its
graphic and multimedia accelerators. The Company's products are used in, and
its business is dependent on, the personal computer industry with sales
primarily in the U.S., Asia, and Europe. Net sales were $103.8 million for the
three months ended June 30, 1996, a 47% increase above the $70.6 million of net
sales for the three months ended June 30, 1995. Net sales were $213.9 million
for the six months ended June 30, 1996 or 67% above the $128.0 million of net
sales for the six months ended June 30, 1995. Net sales increased primarily as
a result of strong demand for the Company's 64-bit Trio and ViRGE products that
resulted in increased unit shipments. The increase in unit shipments was
partially offset by lower overall average selling prices. The Company's sales
in the three and six months ended June 30, 1996 consisted primarily of its
64-bit Trio family of integrated accelerators and its ViRGE family of multimedia
accelerators, which commenced shipment in volume in the three months ended
June 30, 1996. Sales in the three and six months ended June 30, 1995 consisted
primarily of its 64-bit Vision family and Trio family of integrated
accelerators. The Company expects that the percentage of its net sales
represented by any one product or type of product may change significantly from
period to period as new products are introduced and existing products reach the
end of their product life cycles. Due to competitive price pressures, the
Company's products experience declining unit average selling prices over time,
which at times can be substantial.
The pricing environment for 2D graphics accelerators, which accounted for a
majority of the Company's revenues in the first half of 1996, continues to
experience increasing pricing pressures due in part to the alleviation of supply
constraints that contributed to more stable pricing in 1995 and to aggressive
pricing from certain of the Company's competitors. In particular, the Company's
Trio family of integrated 2D accelerators has experienced significant decreases
in average selling prices in 1996. The Company expects that the graphics
accelerator market will transition from 2D acceleration to 3D acceleration, and
the Company has introduced its ViRGE family of 3D accelerators in response to
this expected transition. If the transition occurs slower that expected or if
the Company's 3D products do not achieve market acceptance, the Company's
operating results could be adversely affected.
Export sales accounted for 56% and 40% of net sales in the three months
ended June 30, 1996 and 1995, respectively. Export sales accounted for 56% and
41% of net sales in the six months ended June 30, 1996 and 1995, respectively.
Approximately 25% and 35% of export sales in the three and six months ended
June 30, 1996, respectively, were to affiliates of United States customers.
The Company expects that export sales will continue to represent a significant
portion of net sales, although there can be no assurance that export sales, as a
percentage of net sales, will remain at current levels. All sale transactions
are denominated in U.S. dollars.
Page 10 of 17
<PAGE>
One customer accounted for 24% and 17% of net sales in the three months and
six months ended June 30, 1996, respectively, and accounted for 17% and 19% of
net sales in the three months and six months ended June 30, 1995, respectively.
One additional customer accounted for 13% of net sales in the three months ended
June 30, 1996, and a different customer accounted for 10% of net sales in the
six months ended June 30, 1996. In comparison, only one additional customer
accounted for more than 10% of net sales in the comparable 1995 periods,
accounting for 12% of net sales in the three months ended June 10, 1995. The
Company expects a significant portion of its future sales to remain concentrated
within a limited number of strategic customers. There can be no assurance that
the Company will be able to retain its strategic customers or that such
customers will not cancel or reschedule orders or, in the event orders are
canceled, that such orders will be replaced by other sales. In addition, sales
to any particular customer may fluctuate significantly from quarter to quarter.
The occurrence of any such events or the loss of a strategic customer could have
a material adverse effect on the Company's operating results.
The occurrence of any supply problems for the Company's products may
adversely affect net sales. Net sales may also be adversely affected by delays
in the production ramp up of customers' new programs and systems which
incorporate the Company's products. In addition, the Company ships more
product in the third month of each quarter than in either of the first two
months of the quarter, with shipments in the third month higher at the end of
the month. This pattern, which is common in the semiconductor industry, is
likely to continue. The concentration of sales in the last month of the quarter
may cause the Company's quarterly results of operations to be more difficult to
predict. Moreover, a disruption in the Company's production or shipping near
the end of a quarter could materially reduce the Company's net sales for that
quarter. The Company's reliance on outside foundries and independent assembly
and testing houses reduces the Company's ability to control, among other things,
delivery schedules.
Gross Margin
Gross margin percentage decreased to 38.0% in the three months ended
June 30, 1996 from 39.6% in the three months ended June 30, 1995. Gross margin
percentage decreased to 38.8% in the six months ended June 30, 1996 from 39.5%
in the six months ended June 30, 1995. In the three and six months ended
June 30, 1996, the decrease resulted from the continuing decrease in overall
average selling prices of the 64-bit Trio family, partially offset by the
decrease in unit average costs resulting from the Company's foundries'
conversion to 8-inch wafers and 0.5 micron technology, and from initial volume
sales of ViRGE products.
In the future, the Company's gross margin percentages may be affected by
increased competition and related decreases in unit average selling prices
(particularly with respect to older generation products), timing of volume
shipments of new products, the availability and cost of products from the
Company's suppliers, changes in the mix of products sold, and further shifts in
sales from add-in card manufacturers to systems OEMs.
Because the Company must order products and build inventory substantially
in advance of product shipments and because the markets for the Company's
products are volatile and its products are subject to rapid technological and
price changes, there is a risk that the Company will forecast incorrectly and
produce excess or insufficient inventories of particular products. The
Company's customers' ability to reschedule or cancel orders without significant
penalty could adversely affect the Company's operating results, as the Company
may be unable to adjust its purchases from its independent foundries to match
such customers' changes and cancellations. The Company's foundry agreement
with Taiwan Semiconductor Manufacturing Company (TSMC) requires the Company,
under certain circumstances, to purchase certain committed capacity amounts or
to forfeit advance payments against such amounts. To the extent the Company
purchases excess or insufficient inventories of particular products, the
Company's operating results could be adversely affected.
Page 11 of 17
<PAGE>
Research and Development Expenses
The Company has made and intends to continue to make significant
investments in research and development to remain competitive by developing new
and enhanced products, which include products focused on the acceleration of
personal computer audio and communication functions and 3D multimedia
accelerators with enhanced features. Research and development expenses were
$15.1 million in the three months ended June 30, 1996, an increase of $6.2
million from $8.9 million in the three months ended June 30, 1995. Research and
development expenses were $29.8 million in the six months ended June 30, 1996,
an increase of $13.9 million from $15.8 million in the six months ended
June 30, 1995. Research and development spending increases reflect additions to
the Company's engineering staff and initial product verification expenses
related to the introduction of new products. Research and development spending
for the second half of 1996 is expected to continue to emphasize product
development activities currently underway for the business desktop, mobile and
home PC markets, with a focus on video, 3D, audio and communications.
Products in the Company's market typically have a life cycle of 12 to 24
months, with substantial reductions of unit average selling prices over the life
of a specific product. The successful development and commercialization of new
products required to replace or supplement existing products involve many risks,
including the identification of new product opportunities, the successful and
timely completion of the development process, and the selection of the Company's
products by leading systems suppliers and board manufacturers for design into
their products. There can be no assurance that the Company will successfully
identify new product opportunities and develop and bring to market in a timely
manner successful new products, that products or technologies developed by
others will not render the Company's products noncompetitive, or that the
Company's products will be selected for design into its customers' products. In
addition, it is possible that the Company's products may be found defective
after the Company has already shipped significant volume production. There can
be no assurance that the Company would be able to successfully correct such
problems or that such corrections would be acceptable to customers. The
occurrence of any such events would have a material adverse effect on the
Company's operating results.
Selling, Marketing and Administrative Expenses
Selling, marketing and administrative expenses were $11.6 million in the
three months ended June 30, 1996, an increase of $3.9 million from $7.7 million
in the three months ended June 30, 1995. Selling, marketing and administrative
expenses were $22.5 million in the six months ended June 30, 1996, an increase
of $8.2 million from $14.3 million in the six months ended June 30, 1995.
Selling and marketing costs have increased as a result of additional personnel,
increased commissions associated with higher sales levels, and increased
marketing costs associated with the introduction of new products, including the
consumer software licensing costs for the ViRGE 3D software. Administrative
costs increased due to the litigation costs in defending the Brooktree lawsuit
and the hiring of additional personnel necessary to support the increased level
of operations. The Company anticipates that selling, marketing, and
administrative expenses will increase in absolute dollars in 1996.
Other Income, Net
Other income, net decreased to $0.7 million in the three months ended
June 30, 1996 from $1.3 million in the three months ended June 30, 1995. The
current year decrease is due to the lower average amounts of cash and short-term
investments in the second quarter of 1996 compared to the same period in 1995.
Other income, net, remained at $1.7 million for the six months ended
June 30, 1996 and June 30,1995.
Income Taxes
The Company's effective tax rate for the three and six months ended
June 30, 1996 was 35%, compared to the effective rate for the three and six
months ended June 30, 1995 of 37.0% and 36.5%, respectively.
Page 12 of 17
<PAGE>
Liquidity and Capital Resources
Cash used for operating activities for the six months ended June 30, 1996
was $6.9 million. The Company experienced an increase from December 31, 1995 in
accounts receivable, inventory, prepaid expense and other, and accrued
liabilities. These increases were offset by decreases in accounts payable and
income taxes payable. The Company experienced an increase in accounts
receivable from the level at December 31, 1995 due to the substantial
concentration of sales in June 1996 resulting from the delivery schedules of the
Company's suppliers and increased shipments in the third month of that quarter
over either of the first two months of the quarter relative to what the Company
experienced in previous quarters. Inventory increased due to the absence of
capacity constraints and an increase in finished goods inventory to support
sales levels. During the six months ended June 30, 1996, the Company sold its
remaining inventory of its Vision family of integrated accelerators.
Investing activities for the six months ended June 30, 1996 and 1995
reflected property and equipment purchases of $9.4 million and $7.5 million,
respectively, sales and maturities of short-term investments and the 1996
investment in the real estate partnership of $2.1 million. Continued
expansion of the Company's business is likely to require higher levels of
accounts receivable, inventory, capital equipment purchases, foundry investments
and other payments to secure manufacturing capacity.
Financing activities provided cash of $8.9 million. Proceeds from the
issuance of common stock and equipment financing were the principal financing
activities generating cash.
Working capital at June 30, 1996 and December 31, 1995 was $161.7 and
$144.6 million, respectively. At June 30, 1996, the Company's principal sources
of liquidity included cash and equivalents of $69.2 million and $15.2 million
in short-term investments. In addition, the Company has available $25.0 million
under an unsecured revolving line of credit that expires June 1, 1997. The
Company had $2.0 million outstanding under this line of credit at June 30, 1996.
In addition the Company has available two separate secured equipment lines of
credit totaling $10.0 million. The Company had $6.5 million outstanding under
these secured equipment lines of credit at June 30, 1996. The Company believes
that these available funds and anticipated funds from operations will satisfy
the Company's projected working capital, existing foundry supply agreement and
capital expenditure requirements for at least the next 12 months, other than
possible expenditures for future manufacturing agreements. The Company believes
that success in its industry requires substantial capital in order to, among
other things, maintain the flexibility to take advantage of opportunities as
they may arise. Depending upon market conditions, the Company may seek to raise
additional funds through equity or debt financings. The sale of additional
equity or convertible debt securities could result in additional dilution to the
Company's stockholders.
In connection with the Company's investment in the real estate partnership,
the Company (together with the developer) is subject to recourse provisions of
the construction financing loan for up to $24.0 million. Permanent nonrecourse
financing has been secured, conditioned upon completion of the construction and
satisfaction of certain criteria of the lender.
In order to obtain an adequate supply of wafers, especially wafers
manufactured using advanced process technologies, the Company has entered into
and will continue to consider various possible transactions, including the use
of "take or pay" contracts that commit the Company to purchase specified
quantities of wafers over extended periods, equity investments in, advances or
issuances of equity securities to wafer manufacturing companies in exchange for
guaranteed production or the formation of joint ventures to own and operate or
construct wafer fabrication facilities. Manufacturing arrangements such as
these may require substantial capital investments, which may require the Company
to seek additional equity or debt financing. There can be no assurance that
such additional financing, if required, will be available when needed or, if
available, will be on satisfactory terms. In addition, the Company may, from
time to time, as business conditions warrant, invest in or acquire businesses,
technology or products that complement the business of the Company.
Page 13 of 17
<PAGE>
In the third quarter of 1995, the Company entered into two long-term
manufacturing capacity arrangements. The Company entered into an agreement with
United Microelectronics Corporation (UMC) and Alliance Semiconductor Corporation
(Alliance) to form USC, a separate Taiwanese company, for the purpose of
building and managing a semiconductor manufacturing facility in the Science-
Based Industrial Park in Hsin Chu City, Taiwan. Pursuant to the agreement, as
initially executed, the Company invested $36.4 million in 1995 and committed to
invest New Taiwanese Dollars (NTD) 1,500,000,000 (approximately $56.2 million)
in the second half of 1996 for a 25% equity interest in USC. In June 1996, the
Company amended its agreement with UMC and Alliance to provide that the Company
would pay NTD 688,000,000 (approximately $26.0 million) in July 1996 and would
have the option, exercisable no later than December 31, 1996, to pay
NTD 687,000,000, plus 8.5% of such amount from July 4, 1996, for a revised
equity interest of 23.75% if the option was exercised. The first installment of
approximately $26.1 million was paid at the beginning of July 1996. The
facility is currently scheduled to begin production utilizing advanced submicron
semiconductor manufacturing processes in late 1996, although there can be
no assurance that production will begin on schedule. The Company has the right
to purchase up to 31.25% of the output from the foundry. At June 30, 1996, the
Company had forward exchange swap agreements with a bank to hedge
1.375 billion NTD. Operations through June 30, 1996 have consisted primarily of
construction and other capitalizable preproduction activities and, therefore,
results of operations for the entity have been immaterial. To the extent USC
experiences operating losses during the ramp up of production or thereafter, the
Company will recognize its proportionate share of such losses. There can be no
assurance that such operating losses will not continue after ramp up of
production or that such losses will not have a material adverse effect on the
Company's consolidated results of operations.
In June 1995, the Company expanded and formalized its relationship with
TSMC to provide additional capacity over the 1996 to 2000 timeframe. The
agreement with TSMC requires the Company to make certain annual advance payments
to be applied against the following year's capacity. The Company has signed
promissory notes to secure these payments over the term of the agreement. At
June 30, 1996 the remaining advance payments (and corresponding promissory notes
to be paid through 2000) totaled $31.2 million ($7.2 million in prepaid expenses
and $24.0 million in production capacity rights). On July 1, 1996, the Company
paid $7.2 million to TSMC.
The cyclical nature of the semiconductor industry periodically results in
shortages of advanced process wafer fabrication capacity such as the Company
experiences from time to time. The Company's ability to maintain adequate
levels of inventory is primarily dependent upon the Company obtaining sufficient
supply of products to meet future demand, and any inability of the Company to
maintain adequate inventory levels may adversely affect its relations with its
customers. In addition, because the Company must order products and build
inventory substantially in advance of product shipments, there is a risk that
the Company will forecast incorrectly and produce excess or insufficient
inventories of particular products because the Company's products are volatile
and subject to rapid technology and price change. This inventory risk is
heightened because certain of the Company's key customers place orders with
short lead times. The Company's customers' ability to reschedule or cancel
orders without significant penalty could adversely affect the Company's
liquidity, as the Company may be unable to adjust its purchases from its
independent foundries to match such customer changes and cancellations. To the
extent the Company purchases excess or insufficient inventories of particular
products, the Company's operating results could be adversely affected.
In October 1995, a complaint was filed by Brooktree Corporation against the
Company alleging patent infringement. The costs of defending such suit have
been and will be substantial and an adverse result in such litigation would
materially and adversely affect the Company's liquidity and capital resources.
See Part II, Item 1. "Legal Proceedings."
Page 14 of 17
<PAGE>
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
On October 2, 1995, Brooktree Corporation ("Brooktree") filed a complaint
against the Company in the United States District Court for the Southern
District of California (Action No. 952388R (AJB)). The complaint alleges that
S3's Trio64V+ product and other products with substantially equivalent
architecture infringes Brooktree's United States Letters Patent No. 5,406,306
(the "'306 Patent"), which was issued on April 11, 1995. Brooktree has
indicated in its expert report and has informed the Company that it will assert
at trial that the Trio64V+, Trio64UV+, Trio64V2, Aurora64V+, ViRGE and ViRGE/VX,
comprising all of the Company's current generation of products that have been
introduced to date, infringe the '306 Patent. Brooktree has alleged that such
infringement was willful and seeks a preliminary and permanent injunction
against S3 making, using or selling its Trio64V+ product or any other product
substantially equivalent thereto. In addition, Brooktree seeks damages, costs
and attorneys' fees and interest. On March 12, 1996, the Court ruled against
Brooktree in its request for a preliminary injunction. On July 2, 1996, the
Court ruled against S3 in its request for a summary judgment that the '306
Patent is unenforceable as a result of inequitable conduct before the United
States Patent and Trademark Office. A bench trial on the issue of inequitable
conduct is now set for August 6, 1996. In the event the '306 Patent is held to
be enforceable, the Court will hold a separate hearing to construe the scope of
the '306 Patent claims after which it will rule on S3's motion for summary
judgment on the basis of non-infringement. If the Court were to deny this
summary judgment motion, the jury trial would immediately commence, where
Brooktree's request for a permanent injunction and damages will be decided.
The Company has been advised by patent counsel that its Trio64V+,
Trio64UV+, Trio64V2, Aurora64V+, ViRGE and ViRGE/VX products do not infringe the
'306 Patent, and it plans to continue to defend the suit vigorously. The
Company believes that it has meritorious defenses, including that the '306
Patent is not valid and/or that the patent is unenforceable due to inequitable
conduct on the part of Brooktree in obtaining the patent. However, there can be
no assurance that the Company will be successful in the defense of such suit,
and even if successful, such litigation has resulted and will result in
substantial expense to the Company and diverted the efforts of the Company's
technical and management personnel. In addition, an adverse result in such
litigation, including substantial damages or an injunction, would have a
material adverse effect on the Company's business and results of operations.
Item 4. Submission of Matters to a Vote of Security Holders
a) The Annual Meeting of Stockholders was held on May 8, 1996.
b) The following directors were elected at the meeting to serve one year
terms:
Diosdado P. Banatao
Terry N. Holdt
Carmelo J. Santoro
John C. Colligan
Dr. Robert P. Lee
Ronald T. Yara
Page 15 of 17
<PAGE>
C) The matters voted upon at the meeting and results of the voting with
respect to those matters were as follows:
<TABLE>
<CAPTION>
For Abstain
--- -------
<S> <C> <C> <C>
(1) Election of Directors:
Diosdado P. Banatao 42,988,793 176,689
Terry N. Holdt 42,981,701 183,781
Dr. Carmelo J. Santoro 42,988,450 177,032
John C. Colligan 42,922,085 173,397
Dr. Robert P. Lee 42,989,236 176,246
Ronald T. Yara 42,988,175 177,307
For Against Abstain
--- ------- -------
(2) Resolution for the
approval of the amendments
to the 1989 Stock Plan
(Proposal 2). 14,240,736 11,043,749 358,736
(3) Resolution for the approval
of the amendments to the
1989 Stock Plan
(Proposal 3). 12,923,142 12,347,386 372,693
(4) Approval on amendment to
the Employee Stock
Purchase Plan. 26,398,446 1,117,163 178,815
(5) Approval on amendment and
restatement of the
Executive Bonus Plan. 38,401,720 1,609,317 332,923
(6) Ratification of Deloitte &
Touche LLP as the Company's
independent auditors for
fiscal year 1996. 42,889,594 131,548 144,340
</TABLE>
The foregoing matters are described in detail in the Registrant's definitive
proxy statement dated March 29, 1996, for the Annual Meeting of Stockholders
held on May 8, 1996.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
27 Financial Data Schedule (filed only with the electronic submission of
Form 10-Q in accordance with the Edgar requirements)
(b) Reports on Form 8-K
No reports on Form 8-K were filed by the Company during the three months
ended June 30, 1996.
Page 16 of 17
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act
of 1934, the Registrant has duly caused this report to be
signed on its behalf by the undersigned thereunto duly
authorized.
S3 INCORPORATED
(Registrant)
/S/GEORGE A. HERVEY
GEORGE A. HERVEY
Senior Vice President, Finance
and Chief Financial Officer
(Principal Financial and Accounting Officer)
August 5, 1996
Page 17 of 17
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from S3
Incorporated Condensed Consolidated Financial Statements for the period ended
June 30, 1996 and is qualified in its entirety by reference to such 10-Q
filing.
</LEGEND>
<CIK> 0000850519
<NAME> S3 INCORPORATED
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<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1995
<PERIOD-START> APR-01-1996
<PERIOD-END> JUN-30-1996
<EXCHANGE-RATE> 1
<CASH> 69,226
<SECURITIES> 15,162
<RECEIVABLES> 91,330
<ALLOWANCES> 1,680
<INVENTORY> 51,973
<CURRENT-ASSETS> 245,464
<PP&E> 41,201
<DEPRECIATION> 15,796
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<CURRENT-LIABILITIES> 83,762
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0
0
<COMMON> 158,867
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<TOTAL-LIABILITY-AND-EQUITY> 340,848
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