<PAGE> 1
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 March 31, 1998 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 (I.R.S. Employer
of incorporation or organization) Identification No.)
2801 Mission College Boulevard
Santa Clara, California 95052-8058
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (408) 588-8000
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 April 30, 1998 was 51,024,825
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S3 INCORPORATED
FORM 10-Q
INDEX
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
PART I. CONDENSED CONSOLIDATED FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements:
Condensed Consolidated Balance Sheets
March 31, 1998 and December 31, 1997 3
Condensed Consolidated Statements of Income
Three months ended March 31, 1998 and 1997 4
Condensed Consolidated Statements of Cash Flows
Three months ended March 31, 1998 and 1997 5
Notes to Unaudited Condensed Consolidated Financial
Statements 6-8
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 8-19
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 19
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 Not Applicable
Item 5. Other Information Not Applicable
Item 6. Exhibits and Reports on Form 8-K 20
Signatures 21
</TABLE>
2
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
S3 INCORPORATED
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except shares and per share data)
(Unaudited)
<TABLE>
<CAPTION>
MARCH 31, DECEMBER 31
1998 1997
---------------------------
<S> <C> <C>
ASSETS
Current assets:
Cash and equivalents $ 87,172 $ 90,484
Short-term investments 59,032 27,186
Accounts receivable (net of allowances
of $7,346 in 1998 and $5,664 in 1997) 48,562 60,713
Inventories 37,642 71,882
Prepaid expenses and other 44,701 51,172
---------------------------
Total current assets 277,109 301,437
Property and equipment, net 43,620 46,628
Production capacity rights 4,800 4,800
Investment in joint venture 74,545 104,465
Other assets 66,195 35,524
---------------------------
Total $ 466,269 $ 492,854
===========================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 20,746 $ 42,819
Notes payable 15,549 26,717
Accrued liabilities 11,413 10,987
Deferred revenue 4,382 10,921
---------------------------
Total current liabilities 52,090 91,444
Notes payable 4,800 4,800
Other liabilities 26,059 23,684
Convertible subordinated notes 103,500 103,500
Commitments and contingencies
(Notes 5 and 6)
Stockholders' equity:
Common stock, $.0001 par value;
70,000,000 shares authorized; 50,720,758
and 50,549,279, shares outstanding in 1998 and 1997 187,916 187,276
Unrealized gain 2,282 2,252
Accumulated translation adjustment (14,344) (19,944)
Retained earnings 103,966 99,842
---------------------------
Total stockholders' equity 279,820 269,426
---------------------------
Total $ 466,269 $ 492,854
===========================
</TABLE>
See accompanying notes to the unaudited condensed
consolidated financial statements.
3
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S3 INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share amounts)
(Unaudited)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31, MARCH 31,
1998 1997
-------------------------
<S> <C> <C>
Net sales $ 82,507 $130,255
Cost of sales 66,829 79,820
-------------------------
Gross margin 15,678 50,435
Operating expenses:
Research and development 22,033 18,942
Selling, marketing and administrative 12,494 12,630
Write-off of acquired
in-process technology 8,000 --
-------------------------
Total operating expenses 42,527 31,572
-------------------------
Income (loss) from operations (26,849) 18,863
Gain on sale of joint venture 26,561 --
Other income, net 8 8
-------------------------
Income (loss) before income taxes and equity
in net income of joint venture (280) 18,871
Provision (benefit) for income taxes (751) 7,068
-------------------------
Income before equity in net income of
joint venture 471 11,803
Equity in net income of joint venture
(net of tax) 3,650 2,579
-------------------------
Net income $ 4,121 $ 14,382
=========================
Per share amounts:
Basic $ 0.08 $ 0.30
Diluted $ 0.08 $ 0.27
Shares used in computing per share amounts:
Basic 50,601 48,672
Diluted 52,148 57,503
</TABLE>
See accompanying notes to the unaudited condensed
consolidated financial statements.
4
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S3 INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31, MARCH 31,
1998 1997
-------------------------
<S> <C> <C>
Operating activities:
Net income $ 4,121 $ 14,382
Adjustments to reconcile net income to net
cash provided by operating activities:
Deferred income taxes 2,293 2,308
Depreciation and amortization 4,114 3,697
Write-off of acquired in-process technology 9,000 --
Gain on sale of joint venture (26,561) --
Equity in net income of joint venture (5,944) (4,201)
Changes in assets and liabilities:
Accounts receivable 12,151 (20,763)
Inventories 34,240 150
Prepaid expenses and other 921 (1,726)
Accounts payable (22,073) (1,486)
Accrued liabilities and other 1,976 5,247
Deferred revenue (6,539) 1,984
Income taxes payable 5,550 2,747
-------------------------
Net cash provided by operating activities 13,249 2,339
-------------------------
Investing activities:
Property and equipment purchases, net (1,106) (8,375)
Sale of joint venture 68,025 --
Sales/maturities (purchase) of short-term investments, net (31,796) (1,743)
Other assets 329 (11,855)
Purchase of technology (40,000) --
-------------------------
Net cash used for investing activities (4,548) (21,973)
-------------------------
Financing activities:
Sale of common stock, net 643 2,182
Net borrowings (repayments) of equipment financing (2,656) --
Net borrowings (repayments) of notes payable (10,000) 5,000
-------------------------
Net cash provided by (used for) financing activities (12,013) 7,182
-------------------------
Net decrease in cash and equivalents (3,312) (12,452)
Cash and cash equivalents at beginning of period 90,484 94,616
-------------------------
Cash and cash equivalents at end of period $ 87,172 $ 82,164
=========================
</TABLE>
See accompanying notes to the unaudited
condensed consolidated financial statements.
5
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S3 INCORPORATED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of Presentation:
The condensed consolidated 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"). All
significant inter-company balances and transactions have been eliminated.
Investments in entities in which the Company does not have control, but has the
ability to exercise significant influence over operating and financial policies
are accounted for by the equity method. 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 March 31, 1998 and December 31, 1997, and the operating results and
cash flows for the three months ended March 31, 1998 and 1997. 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, 1997,
included in the Company's Form 10-K filed with the Securities and Exchange
Commission.
The results of operations for the three months ended March 31, 1998 are not
necessarily indicative of the results that may be expected for the future
quarters or the year ending December 31, 1998.
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>
MARCH 31, DECEMBER 31,
INVENTORIES CONSIST OF: 1998 1997
-----------------------
(IN THOUSANDS)
<S> <C> <C>
Work in process $13,445 $28,392
Finished goods 24,197 43,490
----------------------
Total $37,642 $71,882
======================
</TABLE>
3. Technology Exchange:
In January 1998, the Company entered into a $40 million technology
exchange with Cirrus Logic, Inc. to obtain graphic functionality technologies.
As a result of the exchange, the Company acquired the technology covered by 10
graphic patents and 25 graphic patent applications, as well as cross-licensed
Cirrus Logic's remaining patents. Under the terms of the cross-licensing
provisions, the Company and Cirrus Logic have a perpetual license to each
other's graphic patents and additional licenses with respect to the other
party's patents for agreed upon periods of time.
The Company wrote-off $8 million of the acquired technologies not
utilized in current products as in-process technology in the first quarter of
1998. The remaining $32 million will be amortized to cost of sales based on the
lives of the currently utilized core technologies, which is generally five
years.
4. Earnings per share:
Basic earnings per share (EPS) is computed by dividing income available to
common stockholders by the weighted average number of common shares outstanding
for the period. Diluted EPS reflects the potential dilution that would occur
from any instrument or options which could result in additional common shares
being issued.
6
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The following table sets forth the computation of basic and diluted earnings
per share:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31, MARCH 31,
1998 1997
-------------------------
(IN THOUSANDS, EXCEPT PER
SHARE AMOUNTS)
<S> <C> <C>
NUMERATOR
Net Income
Basic $ 4,121 $14,382
Interest expense on subordinated debt -- 1,071
------- -------
Diluted $ 4,121 $15,453
======= =======
DENOMINATOR
Denominator for basic earnings per share 50,601 48,672
Common stock equivalents 1,547 3,446
Subordinated debt -- 5,385
------- -------
Denominator for diluted earnings per share 52,148 57,503
======= =======
Basic earnings per share $ 0.08 $ 0.30
Diluted earnings per share $ 0.08 $ 0.27
</TABLE>
5. Wafer supply agreements and commitments
During 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 to form United
Semiconductor Corporation (USC), a separate Taiwanese company, for the purpose
of building and managing a semiconductor manufacturing facility in Taiwan,
Republic of China. The Company invested a total of $89.4 million for its equity
interest of 23.75%. On December 31, 1997, the Company entered into an agreement
with UMC to sell to UMC 80 million shares of stock of USC for a purchase price
of 2.4 billion New Taiwan dollars. The Company received the purchase price
(approximately $68 million in cash) in January 1998 upon closing. As a result of
the January 1998 sale to UMC, S3's percentage ownership in USC decreased to
15.75%. The Company has the right to purchase up to 31.25% of the output from
the foundry.
In addition, in 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 March 31, 1998, the remaining
advance payments (and corresponding promissory notes) totaled $14.4 million
($9.6 million in prepaid expenses and $4.8 million in production capacity
rights).
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.
6. Contingencies
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 is not presently determinable, management 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.
7. Recently Issued Accounting Standard
As of January 1, 1998, the Company adopted Statement 130, Reporting
Comprehensive Income. Statement 130 establishes new rules for the reporting and
display of comprehensive income and its components; however, the adoption of
this Statement had no impact on the Company's net income or shareholders'
equity. Statement 130 requires unrealized gains or losses on the Company's
available-for-sale securities and foreign currency translation adjustments,
which prior to adoption were reported separately in
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stockholders' equity to be included in other comprehensive income. Prior year
financial statements have been reclassified to conform to the requirements of
Statement 130.
During the first quarter of 1998 and 1997, total comprehensive income
amounted to $3.1 million and $14.3 million, respectively.
PART I. FINANCIAL INFORMATION
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
When used in this discussion, the words "expects," "anticipates," "estimates"
and similar expressions are intended to identify forward-looking statements.
Such statements, which include statements concerning the timing of availability
and functionality of products under development, product mix, trends in average
selling prices, trends in the PC market, the percentage of export sales and
sales to strategic customers and the availability and cost of products from the
Company's suppliers, are subject to risks and uncertainties, including those set
forth below under "Factors That May Affect Results," that could cause actual
results to differ materially from those projected. These forward-looking
statements speak only as of the date hereof. The Company expressly disclaims any
obligation or undertaking to release publicly any updates or revisions to any
forward-looking statements 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 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 environment and applications.
8
<PAGE> 9
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
MARCH 31, MARCH 31,
1998 1997
-------------------------
<S> <C> <C>
Net sales 100.0% 100.0%
Cost of sales 81.0 61.3
-------------------------
Gross margin 19.0 38.7
Operating expenses:
Research and development 26.7 14.5
Selling, marketing and administrative 15.1 9.7
Write-off of acquired in-process technology 9.7 --
-------------------------
Total operating expenses 51.5 24.2
-------------------------
Income (loss) from operations (32.5) 14.5
Gain on sale of joint venture 32.2 --
-------------------------
Income (loss) before income taxes and equity
in net income of joint venture (0.3) 14.5
Provision (benefit) for income taxes (0.9) 5.4
Equity in net income from joint venture 4.4 1.9
-------------------------
Net income 5.0% 11.0%
=========================
</TABLE>
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, marketing acceptance of new or
enhanced versions of the Company's products, seasonal customer demand, the
timing of significant orders, and operating results of USC, the Company's
manufacturing joint venture.
The Company's 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 in which production and sales of new products are ramping up and in
which existing products are under extreme price pressures due to competitive
factors. If new products are not brought to market in a timely manner or do not
address market needs or performance requirements, 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
graphics 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 $82.5 million for the
three months ended March 31, 1998, a 36.7% decrease from the $130.3 million of
net sales for the three months ended March 31, 1997. Net sales decreased
primarily as a result of declining unit average selling prices due to aggressive
pricing from certain of the Company's competitors, the sale of older generation
products at lower prices, as well as a decrease in number of units sold. Net
sales for the three months ended March 31, 1998 consisted primarily of the
Company's ViRGE family of integrated accelerators while sales for the three
months ended March 31, 1997 consisted primarily of the ViRGE and Trio families
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. Net sales for the three months ended March
31, 1998 were also adversely affected by the economic downturn in Asia.
The pricing environment for graphics accelerators has recently experienced
and is expected to continue to experience increasing pricing pressures due in
part to aggressive pricing from certain of the Company's competitors as well as
the sale of older generation products. In particular, the Company's Virge family
of 2D/3D accelerators experienced decreases in average selling prices over the
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<PAGE> 10
past few quarters which continued in the first quarter of 1998. The graphics
accelerator market is transitioning from 2D acceleration to 3D acceleration, and
the Company introduced its ViRGE family of 2D/3D accelerators in response to
this transition. As a result of the entry of competitors into the 3D
acceleration market, the Company has experienced and anticipates that it may
continue to experience increased pricing pressures on average selling prices for
the ViRGE family of 2D/3D accelerators. If the Company is unable to introduce
and successfully market higher performance products, if the Company's products
do not achieve market acceptance, or if the pricing pressures increase above
normal anticipated levels, the Company's operating results could be adversely
affected.
Export sales accounted for 81% and 61% of net sales for the three months
ended March 31, 1998 and 1997, respectively. Approximately 21% of export sales
for the three months ended March 31, 1998 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 sales
transactions were denominated in U.S. dollars.
Three customers accounted for 33%, 13% and 13% of net sales for the three
months ended March 31, 1998. Three customers accounted for 17%, 15% and 12% of
net sales for the three months ended March 31, 1997. 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
otherwise cancel or reschedule orders, or in the event of canceled orders, that
such orders will be replaced by other sales. In addition, sales to any
particular customer may fluctuate significantly from quarter to quarter. The
Company's largest customer in the first quarter of 1998 was the Company's
largest Asian distributor, and a substantial percentage of the Company's first
quarter net sales were made through distributors. 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 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 19.0% for the three months ended March
31, 1998 from 38.7% for the three months ended March 31, 1997. The decrease was
impacted by decreases in overall average selling prices of the ViRGE family of
accelerators, which resulted in part from the increased proportion of the
Company's export sales to Asian customers and the substantial price competition
experienced in the Asian market. In addition, the Company does not currently
offer products addressing the high performance 3D acceleration market, which
adversely affects the Company's gross margin. The Company recently announced the
Savage3D, which is designed to address the high performance 3D acceleration
market and is scheduled to be in volume production in the third quarter of 1998.
There can be no assurance that the Savage3D can be successfully marketed or can
enter volume production in a timely manner or that the Company's gross margin
will be positively affected. The Company's gross margin was impacted in the
current quarter by license fees and will continue to be impacted in future
quarters by license fees. See "Technology Exchange" note.
In the future, the Company's gross margin percentages may be affected by
increased competition and related decreases in the 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, the extent to which
the Company forfeits or utilizes its production capacity rights with TSMC, the
extent to which the Company will incur additional licensing fees and shifts in
sales mix between add-in card and motherboard manufacturers and systems OEMs.
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. Research and development expenses were $22.0 million for the three
months ended March 31, 1998, an increase of $3.1 million from $18.9 million for
the three months ended March 31, 1997. The increase was due to engineering costs
associated with the discontinued audio and communications products line.
10
<PAGE> 11
Products in the Company's market typically have a life cycle of 12 to 18
months. 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 motherboard and add-in card
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 the 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 $12.5 million for the
three months ended March 31, 1998, a decrease of $0.1 million from $12.6 million
for the three months ended March 31, 1997. Selling, marketing and administrative
expenses consist primarily of salaries, commissions and marketing costs
associated with the introduction of new products.
WRITE-OFF OF ACQUIRED IN-PROCESS TECHNOLOGY
In January 1998, the Company entered into a $40 million technology
exchange with Cirrus Logic, Inc. to obtain graphic functionality technologies.
As a result of the exchange, the Company acquired the technology covered by 10
graphic patents and 25 graphic patent applications, as well as cross-licensed
Cirrus Logic's remaining patents. Under the terms of the cross-licensing
provisions, the Company and Cirrus Logic have a perpetual license to each
other's graphic patents and additional licenses with respect to the other
party's patents for agreed upon periods of time.
The Company wrote-off $8 million of the acquired technologies not
utilized in current products as in-process technology in the first quarter of
1998. The remaining $32 million will be amortized to cost of sales based on the
lives of the currently utilized core technologies, which is generally five
years.
GAIN ON SALE OF JOINT VENTURE
On December 31, 1997, the Company entered into an agreement with UMC to
sell to UMC 80 million shares of stock of USC for a purchase price of 2.4
billion New Taiwan dollars. The Company received the purchase price
(approximately $68 million in cash) in January 1998 upon closing. The gain on
the sale of stock of USC was $26.6 million.
INCOME TAXES
The Company's effective tax rate for the three months ended March 31, 1998 is
42% excluding the gain on sale of joint venture and the write-off of acquired in
process technology (for which an effective tax rate of 38.5% was applied)
compared to the 38% effective tax rate for the three months ended March 31,
1997. The effective tax rate for the three months ended March 31, 1998 differs
from the statutory rate primarily because of research credits.
EQUITY IN NET INCOME OF JOINT VENTURE
As discussed in "Liquidity and Capital Resources", the Company entered into
an agreement with other parties to form a separate Taiwanese company, USC. This
investment is accounted for under the equity method of accounting in reporting
the Company's share of results for the entity. Equity in net income of joint
venture reflects the Company's share of income earned by USC for the current
quarter. The Company reported $3.7 million of equity in net income of joint
venture, net of tax for the three months ended March 31, 1998 and $2.6 million
for the three months ended March 31, 1997.
LIQUIDITY AND CAPITAL RESOURCES
11
<PAGE> 12
Cash provided by operating activities for the three months ended March 31, 1998
was $13.2 million, as compared to $2.3 million for the three months ended March
31, 1997. The increase for the three months ended March 31, 1998 was due to a
decrease in accounts receivable and inventories. These increases were partially
offset by a decrease due to lower net income, the gain on sale of joint venture
and decreased accounts payable. The decrease in accounts receivable was a result
of lower sales in the first quarter of 1998 as compared to the fourth quarter of
1997. The decrease in inventory and accounts payable is attributable to
reductions in inventory procurement resulting from softening demand and the
Company's efforts to reduce inventory balances in its distribution channel.
Investing activities for the three months ended March 31, 1998 consisted
primarily of the cash received from the sale of USC shares, offset by cash used
in the technology exchange with Cirrus Logic, Inc. and the purchase of short
term investments, net. Future expansion of the Company's business may require
higher levels of capital equipment purchases, technology investments, foundry
investments and other payments to secure manufacturing capacity.
Financing activities used cash of $12.0 million and provided cash of $7.2
million for the three months ended March 31, 1998 and 1997 respectively.
Repayment on the line of credit and equipment financing were the principal
financing activities that used cash for the three months ended March 31, 1998.
Borrowings on the line of credit and the issuance of common stock were the
principal financing activities that provided cash for the three months ended
March 31, 1997.
In 1995, the Company entered into two long-term manufacturing capacity
arrangements. The Company entered into an agreement with UMC and Alliance
Semiconductor Corporation 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, Republic of China. The
Company invested $53.0 million in 1996 and $36.4 million in 1995 for its 23.75%
equity interest. In January 1998, the Company reduced its equity interest to
15.75% through the sale of a portion of its USC shares, and received
approximately $68.0 million in cash. Under the terms of the agreement, if at any
time a "Liquidity Event" occurs, S3 will be entitled to receive, in addition to
the initial payment of 2.4 billion New Taiwan dollars, a contingent payment of
up to 19 New Taiwan dollars per share, or up to an additional 1.5 billion New
Taiwan dollars (approximately U.S. $46.0 million at exchange rates prevailing on
March 31, 1998). A "Liquidity Event" is defined as any event by which UMC, or
its successor, will have the opportunity to receive value from transfer of its
ownership of shares of stock in USC in an arms-length transaction other than by
way of transfer to employees for incentives, whether or not UMC or its
successor, in fact, participates in such opportunity. A Liquidity Event will
include, for example, completion of a public offering of USC securities on a
recognized securities exchange; a sale of USC stock owned by UMC (or by a UMC
successor) in an arms-length transaction; or a sale of all or substantially all
of the assets of USC. The facility commenced production utilizing advanced
submicron semiconductor manufacturing processes in late 1996. The Company has
the right to purchase up to 31.25% of the output from the foundry. In addition,
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. At March 31, 1998, the remaining advance
payments (and corresponding promissory notes) totaled $14.4 million ($9.6
million in prepaid expenses and $4.8 million in production capacity rights).
Working capital at March 31, 1998 and December 31, 1997 was $225.0 million
and $210.0 million, respectively. At March 31, 1998, the Company's principal
sources of liquidity included cash and equivalents of $87.2 million and $59.0
million in short-term investments. In addition, the Company has a $75.0 million
unsecured revolving line of credit that expires September 26, 1999. The Company
had no amounts outstanding under the line of credit as of March 31, 1998. The
Company was not in compliance with one financial covenant at March 31, 1998.
Accordingly, the bank is not required to fund requested borrowing. The Company
is currently seeking to obtain either a waiver of such non-compliance or an
amendment to the line of credit agreement. In addition, the Company has one
secured equipment line of credit totaling $6.5 million. The Company had $3.0
million outstanding under this secured equipment line of credit at March 31,
1998. The Company believes that its available funds will satisfy the Company's
projected working capital and capital expenditure requirements for at least the
next 12 months, other than expenditures for future potential manufacturing
agreements.
In January 1998, the Company entered into patent purchase and
cross-licensing agreements with Cirrus Logic, Inc. to enable a patent portfolio
exchange between the two companies for $40 million.
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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.
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 produces excess or
insufficient inventories of particular products, the Company's operating results
could be adversely affected.
Since November 1997, a number of complaints have been filed in federal and
state courts seeking an unspecified amount of damages on behalf of an alleged
class of persons who purchased shares of the Company's Common Stock at various
times between April 17, 1996 and November 3, 1997. The complaints name as
defendants the Company, certain of its officers and former officers and certain
directors of the Company, asserting that they violated federal and state
securities laws by misrepresenting and failing to disclose certain information
about the Company's business. The plaintiffs in the federal class actions have
moved to dismiss those cases and scheduled a June 5 hearing for court approval.
In addition, certain stockholders have filed derivative actions seeking recovery
on behalf of the Company, alleging, among other things, breach of fiduciary
duties by such individual defendants. The Company has not yet formally responded
to these complaints. While management intends to defend the actions against
the Company vigorously, there can be no assurance that an adverse result or
settlement with regards to these lawsuits would not have a material adverse
effect on the Company's financial condition or results of operations.
The Company has received from the United States Securities and Exchange
Commission a request for information relating to the Company's recent
restatement announcement in November 1997. The Company has responded and intends
to continue to respond to such requests.
FACTORS THAT MAY AFFECT RESULTS
Fluctuations in Quarterly Operating Results
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, the
timing of significant orders, and operating results of USC, the Company's
manufacturing joint venture. Operating results could also be adversely affected
by general economic and other conditions affecting the timing of customer orders
and capital spending, a downturn in the market for PCs, order cancellations or
rescheduling and the other factors discussed below. These factors could
adversely affect demand for the Company's products. In addition, the pricing
environment for graphics accelerators has recently experienced increasing
pricing pressures and is expected to continue to experience pricing pressures,
due in part to aggressive pricing from certain of the Company's competitors. The
graphics accelerator market is
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transitioning from 2D acceleration to 3D acceleration, and the Company does not
currently offer products addressing the high performance 3D acceleration market,
which adversely affects the Company's gross margin and profitability. As a
result of the entry of competitors into the 3D acceleration market, the Company
has experienced and anticipates that it may continue to experience increased
pricing pressures on average selling prices for its ViRGE family of 2D/3D
accelerators. The Company recently announced the Savage3D, which is designed to
address the high performance 3D acceleration market and is scheduled to be in
volume production in the third quarter of 1998. There can be no assurance that
the Savage3D can be successfully marketed or can enter volume production in a
timely manner or that the Company's gross margin will be positively affected. If
the Company is unable to introduce and successfully market higher performance
products, if the Company's products do not achieve market acceptance, or if
pricing pressures increase above normal anticipated levels, the Company's
operating results could be adversely affected. Furthermore, because the Company
is continuing to increase its operating expenses for personnel and new product
development, the Company's operating results would be adversely affected if such
budgeted sales levels were not achieved. PC graphics and multimedia subsystems
include, in addition to the Company's products, a number of other components
which are supplied by third-party manufacturers. Any shortage of such components
in the future could adversely affect the Company's business and operating
results. Furthermore, it is possible that the Company's products may be found to
be 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 defects or that such corrections would be acceptable
to customers, and the occurrence of such events could have a material adverse
effect on the Company's business and operating results.
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 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. In addition, the Company's
customers may change delivery schedules or cancel orders without significant
penalty. To the extent the Company produces excess or insufficient inventories
of particular products, the Company's operating results could be adversely
affected.
The Company generally 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.
Due to the foregoing factors, it is likely that in some future quarter or
quarters the Company's operating results may be below the expectations of public
market analysts and investors. In such event, the price of the Company's Common
Stock would likely be materially and adversely affected.
Importance of New Products; Rapid Technological Change
The PC industry in general, and the market for the Company's products in
particular, is characterized by rapidly changing technology, evolving industry
standards, frequent new product introductions and significant price competition,
resulting in short product life cycles and regular reductions of unit average
selling prices over the life of a specific product. Products in the Company's
market typically have a life cycle of 12 to 18 months, with regular 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 add-in card and motherboard 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 or technologies noncompetitive, or
that the Company's products will be selected for design into its customers'
products. The Company has not offered products addressing the high performance
3D acceleration market, which has adversely affected the Company's business and
operating results. The Company is continually developing new products, such as
the Savage3D, 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 transition or in which existing products are
under price pressures due to competitive factors. Market acceptance of the
Company's products will also depend upon acceptance of other components, such as
memory, that the Company's products are
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designed to work with. For example, the Company has recently introduced
accelerators designed to work with synchronous graphics RAM ("SGRAM") and/or
synchronous DRAM ("SDRAM") which the Company believes offer better performance
for its price than the more expensive video RAM ("VRAM"). However, there can be
no assurance that other memory technologies, such as Rambus DRAM, will not
achieve a greater degree of market acceptance than SGRAMs or SDRAMs.
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. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations."
Dependence on Foundries and Other Third Parties
The Company currently relies on several independent foundries to manufacture
its products either in finished form or wafer form. The Company currently has
long-term supply arrangements with two of its foundries, a "take or pay"
contract with Taiwan Semiconductor Manufacturing Company ("TSMC") and a joint
venture foundry, United Semiconductor Corporation ("USC"). In 1995, the Company
expanded and formalized its relationship with TSMC to provide additional
capacity over the 1996 to 2000 timeframe. The foundry agreement with TSMC
requires the Company to make certain annual advance payments to purchase certain
committed capacity amounts to be applied against the following year's capacity
or forfeit advance payments against such amounts. In addition, the Company,
together with United Microelectronics Corporation ("UMC") and Alliance
Semiconductor Corporation, owns USC. The Company currently owns 15.75% of USC
and maintains the right to purchase up to 31.25% of USC's output. To the extent
the Company purchases excess inventories of particular products or chooses to
forfeit advance payments, the Company's operating results could be adversely
affected. To the extent USC experiences operating losses, the Company will
recognize its proportionate share of such losses and may be required to
contribute additional capital. The Company believes that a number of
manufacturers are expanding or planning to expand their fabrication capacity
over the next several years, which could lead to over-capacity in the market and
resulting decreases in costs of finished wafers. If the wafers produced by USC
cannot be produced at competitive prices, USC could sustain operating losses.
There can be no assurance that such operating losses will not have a material
adverse effect on the Company's results of operations.
The Company conducts business with its other current foundries by delivering
written purchase orders specifying the particular product ordered, quantity,
price, delivery date and shipping terms and, therefore, such foundries are
generally not obligated to supply products to the Company for any specific
period, in any specific quantity or at any specified price, except as may be
provided in a particular purchase order. To the extent a foundry terminates its
relationship with the Company or should the Company's supply from a foundry be
interrupted or terminated for any other reason, such as a natural disaster or an
injunction arising from alleged violations of third party intellectual property
rights, the Company may not have a sufficient amount of time to replace the
supply of products manufactured by that foundry. There can be no assurance that
the Company will obtain sufficient advanced process technology foundry capacity
to meet customer demand in the future. The Company is continuously evaluating
potential new sources of supply. However, the qualification process and the
production ramp-up for additional foundries has in the past taken, and could in
the future take, longer than anticipated, and there can be no assurance that
such sources will be able or willing to satisfy the Company's requirements on a
timely basis or at acceptable quality or per unit prices.
Two of the Company's principal foundries, TSMC and UMC, and the Company's
foundry joint venture, USC, are located in the Science-Based Industrial Park in
Hsin Chu City, Taiwan. The Company currently expects these three foundries to
supply the substantial portion of the Company's products in 1998. Disruption of
operations at these foundries for any reason, including work stoppages, fire,
earthquakes or other natural disasters, would cause delays in shipments of the
Company's products, and could have a material adverse effect on the Company's
results of operations. In addition, as a result of the rapid growth of the
semiconductor industry based in the Science-Based Industrial Park, severe
constraints have been placed on the water and electricity supply in that region.
Any shortages of water or electricity could adversely affect the Company's
foundries' ability to supply the Company's products, which could have a material
adverse effect on the Company's results of operations.
The Company is using multiple sources for certain of its products, which may
require the Company's customers to perform separate product qualifications. The
Company has not, however, developed alternate sources of supply for certain
other products, and its newly introduced products are typically produced
initially by a single foundry until alternate sources can be qualified. The
requirement that a customer perform separate product qualifications or a
customer's inability to obtain a sufficient supply of products
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from the Company may cause that customer to satisfy its product requirements
from the Company's competitors, which would adversely affect the Company's
results of operations.
The Company's products are assembled and tested by a variety of independent
subcontractors. The Company's reliance on independent assembly and testing
houses to provide these services involves a number of risks, including the
absence of adequate availability of certain packaging technologies, the absence
of guaranteed capacity and reduced control over delivery schedules, quality
assurance and costs. The Company also is subject to the risks of shortages and
increases in the cost of raw materials used in the manufacture or assembly of
the Company's products.
Constraints or delays in the supply of the Company's products, whether
because of capacity constraints, unexpected disruptions at the foundries or
assembly or testing houses, delays in obtaining additional production at
existing foundries or in obtaining production from new foundries, shortages of
raw materials, or other reasons, could result in the loss of customers and other
material adverse effects on the Company's operating results, including effects
that may result should the Company be forced to purchase products from higher
cost foundries or pay expediting charges to obtain additional supply.
Dependence on Accelerator Product Line
S3's products are designed to improve the graphics and multimedia performance
of Pentium-based PCs and Microsoft Windows, Windows NT and IBM OS/2 operating
systems, the predominant standards in today's PC market. Any shift away from
such standards would require the Company to develop new products. The Company
expects that additional specialized graphics processing and general purpose
computing capabilities will be integrated into future versions of Intel and
other Pentium-based microprocessors and that standard multimedia accelerators in
the future will likely integrate memory, system logic, audio, communications or
other additional functions. In particular, Intel and other manufactures have
announced plans to develop chips that integrate graphics and processor functions
to serve the lower cost PC market. A substantial portion of the Company's 1997
sales were derived from products addressing the lower cost PC market, and the
Company anticipates that a substantial portion of its 1998 sales will also be
derived from products addressing this market. The Company has not previously
offered either single function or integrated accelerator products that provide
these functions, which have traditionally been provided by separate single
function chips or chipsets. The Company has been and will continue to be
required to expand the scope of its research and development efforts to provide
these functions, which will require the hiring of engineers skilled in the
respective areas and additional management and coordination among the Company's
design and engineering groups. Alternatively, the Company may find it necessary
or desirable to license or acquire technology to enable the Company to provide
these functions, and there can be no assurance that any such technology will be
available for license or purchase on terms acceptable to the Company.
Furthermore, there is a limited amount of space on PC motherboards, and
companies that offer solutions that provide the greatest amount of functionality
within this limited space may have a competitive advantage. While the Company's
strategy is to develop new and enhanced graphics and multimedia accelerator
products that will be complementary to present and future versions of Intel and
other Pentium-based microprocessors and integrate additional functionality,
there can be no assurance that the Company will be able to develop such new or
enhanced products in a timely manner or correctly anticipate the additional
functionality that will be required to compete effectively in this market. The
Company's initial product containing a number of these functions, Plato/PX, has
been discontinued. In addition, in 1997 the Company wrote off approximately
$17.2 million of intangible assets including certain licenses, patents and other
technology as a result of management's decision to focus on the core graphics
business. In the first quarter of 1998, the Company discontinued its audio and
communication products line. There can be no assurance that, if developed, the
Company's new or enhanced products that incorporate these functions will achieve
market acceptance. There also can be no assurance that the market for graphics
and multimedia accelerators will continue to grow in the future or that new
technological developments or changes in standards will not result in decreased
demand for graphics and multimedia accelerators or for the Company's products
that are not compatible with such changed standards. For example, in 1996, there
was an absence of an industry standard 3D graphics API. As a result, the Company
developed and promoted its proprietary API. Microsoft has since introduced its
Direct3D API and Silicon Graphics has introduced OpenGL, which has emerged as
the standard APIs for 3D acceleration. While the Company's 3D accelerators
currently support the Company's proprietary API, Microsoft's Direct 3D API and
OpenGL, there can be no assurance that another API will emerge as an industry
standard that the Company's accelerators will not support. Also, due to the
widespread industry acceptance of Intel's microprocessor architecture and
interface architecture, including its AGP bus, Intel exercises significant
influence over the PC industry generally, and the inability of the Company to
develop successfully products that are compatible with the AGP technology, Intel
microprocessors or other aspects of the PC microprocessor architecture, whether
the need for compatibility results from significant modifications by Intel to
its existing technology, architecture or standards, would have a material
adverse effect on the Company's business, financial condition and results of
operations. Any delay in the public release of information relating to any such
modifications could also have a material adverse
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effect on the Company's business, financial condition and results of operations.
While the PC industry in recent periods has been characterized by substantial
demand, such demand has historically been cyclical, and there can be no
assurance that this demand will continue in future periods or that demand for
the Company's products will continue.
Substantial Competition
The market for the Company's products is extremely competitive and is
characterized by declining selling prices over the life of a particular product
and rapid technological changes. The Company's principal competitors for
graphics accelerators include ATI Technologies, Inc., Matrox Graphics Inc., and
Trident Microsystems, Inc. The Company's principal competitors in the multimedia
market include the companies named in the preceding sentence and a number of
smaller companies which may have greater flexibility to address specific market
needs. Potential competitors in these markets include both large and emerging
domestic and foreign semiconductor companies. In particular, there is a
significant number of established and emerging companies that have developed,
are developing or have announced plans to develop 3D graphics chips. These
include Intel, which recently commenced shipments of the Intel740 3D graphics
processor and Texas Instruments Incorporated, which has announced a development
and marketing agreement with 3Dlabs Inc., Ltd. In addition, Intel has acquired
Chips and Technologies, Inc., a leading provider of accelerators for the mobile
PC market, and has announced a collaboration with 3Dlabs, Inc., Ltd. to develop
a graphics processor targeting the high end workstation market. To the extent
that Intel's initiatives in the graphics sector are successful, the Company's
business, financial condition and results of operations could be materially and
adversely affected. There can be no assurance that the Company's product
offerings to address the demand for the next generation of 2D/3D accelerators
will be competitive, and if such product offerings are not competitive, the
Company's results of operations in 1998 and future periods could be materially
and adversely affected. The Company's current products do not address the high
performance segment of the market, which has resulted in substantial pricing and
margin pressures on the Company's products and adversely affected the Company's
recent results of operations. There can be no assurance that the Company's
recently introduced Savage3D accelerator, which is designed to address the high
performance 3D acceleration market, will achieve market acceptance, and there is
a significant number of companies, including Intel, that offer products
addressing this market segment. The entry of additional competitors into the
2D/3D accelerator market has resulted in and is expected to continue to result
in pricing pressures on average selling prices of the Company's products. To the
extent the Company expands its product line to add products with additional
functionality, it will encounter substantial competition from established
semiconductor companies and may experience competition from companies designing
chips based on different technologies. Furthermore, the need of PC manufacturers
to rapidly introduce a variety of products aimed at different segments of the PC
market may lead to the shift by such system OEMs to the purchase of graphics and
multimedia add-in cards provided by others. Certain of the Company's competitors
supply both add-in cards and accelerator chips, which may provide those
competitors with an advantage over suppliers such as the Company that supply
only accelerator chips, which may provide those competitors with an advantage
over suppliers such as the companies that supply only accelerator chips. In
addition, certain of the Company's potential competitors that supply add-in
cards and/or motherboards, such as Intel, may seek to use their card/board
business to leverage the startup of their graphics accelerator business. Certain
of the Company's current and potential competitors have greater technical,
manufacturing, financial and marketing resources than the Company. The Company
believes that its ability to compete successfully depends upon a number of
factors both within and outside of its control, including product performance,
product features, product availability, price, quality, timing of new product
introductions by the Company and its competitors, the emergence of new graphics
and PC standards, customer support, and industry and general economic trends.
There can be no assurance that the Company will have the financial resources,
technical expertise, or marketing, distribution and support capabilities to
compete successfully. The Company's future success will be highly dependent upon
the successful development and introduction of new products that are responsive
to market needs. There can be no assurance that the Company will be able to
successfully develop or market any such products.
Customer Concentration
The Company expects a significant portion of its future sales to remain
concentrated within a limited number of strategic customers. Three customers
accounted for 33%, 13% and 13% of net sales for the three months ended
March 31, 1998. Three customers accounted for 17%, 15% and 12% of net sales for
the three months ended March 31, 1997. 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 otherwise cancel or
reschedule orders, or in the event of canceled orders, that such orders will be
replaced by other sales. In addition, sales to any particular customer may
fluctuate significantly from quarter to quarter. The Company's distributors are
permitted to return to the Company the products purchased by them, and the
Company provides its distributors with price protection in the event that the
Company reduces the prices
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of its products. The Company's largest customer in the first quarter of 1998, is
the Company's largest Asian distributor, and a substantial percentage of the
Company's first quarter net sales were made through distributors.
Management of Growth; Dependence on Key Personnel
Since its inception, the Company has experienced significant growth in the
number of its employees and in the scope of its operating and financial systems,
resulting in increased responsibilities for the Company's management. To manage
future growth effectively, the Company will need to continue to improve its
operational, financial and management information systems, procedures and
controls, and expand, train, motivate, retain and manage its employee base. Any
problems encountered in the implementation of such a system could adversely
affect the Company's operations. There can be no assurance that the Company will
be able to manage its growth effectively, and failure to do so could have a
material adverse effect on the Company's operating results.
The Company's future success depends in part on the continued service of its
key engineering, sales, marketing and executive personnel, including highly
skilled semiconductor design personnel and software developers, and its ability
to identify and hire additional personnel. Competition for such personnel is
intense and there can be no assurance that the Company can retain and recruit
necessary personnel to operate its business and support its future growth. In
August 1997, Walter D. Amaral joined the Company as Senior Vice President and
Chief Financial Officer. In December 1997, Terry N. Holdt returned to the
Company as its Chief Executive Officer and President and Chairman of the Board.
The Company's co-founder, Diosdado Banatao, resigned as Chairman of the Board
but continues to serve as a member of the Board of Directors. There can be no
assurance as to the effects of this management transition on the Company's
business and operating results. The loss of key personnel could have a material
adverse effect on the Company's business and operating results. The Company does
not maintain key man insurance on any of its employees.
Importance of Intellectual Property; Litigation Involving Intellectual Property
The Company's ability to compete will be affected by its ability to protect
its proprietary information. The Company has filed several United States and
foreign patent applications and to date has a number of issued United States
patents. The Company relies primarily on its trade secrets and technological
know-how in the conduct of its business. There can be no assurance that the
steps taken by the Company to protect its intellectual property will be adequate
to prevent misappropriation of its technology or that the Company's competitors
will not independently develop technologies that are substantially equivalent or
superior to the Company's technology. The semiconductor and software industries
are characterized by frequent claims and related 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 is not presently
determinable, management presently believes that the resolution of all such
pending matters will not have a material adverse effect on the Company's
operating results. There can be no assurance that third parties will not assert
additional claims or initiate litigation against the Company, its foundries, or
its customers with respect to existing or future products. In addition, the
Company may initiate claims or litigation against third parties for infringement
of the Company's proprietary rights or to determine the scope and validity of
the proprietary rights of the Company or others. Litigation by or against the
Company has in the past resulted in, and could in the future result in,
substantial expense to the Company and diversion of the efforts of the Company's
technical and management personnel, whether or not litigation is determined in
favor of the Company. In the event of an adverse result in any such litigation,
the Company could be required to pay substantial damages, cease the manufacture,
use, sale, offer for sale and importation of infringing products, expend
significant resources to develop or obtain non-infringing technology,
discontinue the use of certain processes or obtain licenses to the technology
which is the subject of the litigation. There can be no assurance that the
Company would be successful in such development or acquisition or that any such
licenses, if available, would be available on commercially reasonable terms, and
any such development or acquisition could require expenditures by the Company of
substantial time and other resources. Any such litigation or adverse result
therefrom could have a material adverse effect on the Company's operating
results.
In October 1995, Brooktree filed a complaint against the Company in the
United States District Court for the Southern District of California, alleging
that certain of the Company's products infringed a Brooktree patent. Such a
lawsuit resulted in substantial expense to the Company to defend the action and
diverted the efforts of the Company's technical and management personnel. In
August 1996, the Company and Brooktree entered into a settlement and license
agreement pursuant to which all claims and counterclaims between the parties
were dismissed and the Company agreed to pay to Brooktree a license fee and
royalties related to certain product revenues over a five-year period.
International Operations
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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. In addition,
a substantial proportion of the Company's products are manufactured, assembled
and tested by independent third parties in Asia. Due to its export sales and
independent third party manufacturing, assembly and testing operations, and its
joint venture foundry, the Company is subject to the risks of conducting
business internationally, including unexpected changes in, or impositions of,
legislative or regulatory requirements, fluctuations in the U.S. dollar, which
could increase the sales price in local currencies of the Company's products in
foreign markets or increase the cost of wafers purchased by the Company, delays
resulting from difficulty in obtaining export licenses for certain technology,
tariffs and other barriers and restrictions, potentially longer payment cycles,
greater difficulty in accounts receivable collection, potentially adverse taxes,
and the burdens of complying with a variety of foreign laws. The Company has
experienced an adverse impact associated with the economic downturn in Asia and
there can be no assurance that the volatility in the Asian economy will not
continue to adversely affect the Company's business, financial condition and
results of operations. In addition, the Company is subject to general
geopolitical risks, such as political and economic instability and changes in
diplomatic and trade relationships, in connection with its international
operations. Two of the Company's independent foundries, UMC and TSMC, and the
Company's joint venture foundry, USC, are located in Taiwan. The Company
currently expects these three foundries to supply the substantial portion of the
Company's products in 1998. The People's Republic of China and Taiwan at times
experienced strained relations in 1995 and 1996, and the worsening of relations
or the development of hostilities between the two parties could have a material
adverse effect on the Company. Although the Company has to date not experienced
any material adverse effect on its operations as a result of such regulatory,
geopolitical, economic and other factors, there can be no assurance that such
factors will not adversely impact the Company's operations in the future or
require the Company to modify its current business practices. In addition, the
laws of certain foreign countries may not protect the Company's intellectual
property rights to the same extent as do the laws of the United States.
Transactions to Obtain Manufacturing Capacity; Future Capital Needs
In order to obtain an adequate supply of wafers, especially wafers
manufactured using advanced process technologies, the Company has entered into
and may consider in the future various 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 or advances or issuances of
equity securities to wafer manufacturing companies in exchange for guaranteed
production capacity, or the formation of joint ventures to own and operate or
construct foundries or to develop certain products. Any of such transactions
would involve financial risk to the Company and could require the Company to
commit substantial capital or provide technology licenses in return for
guaranteed production capacity. In particular, the Company has entered into a
"take or pay" contract with TSMC and has entered into the USC joint venture. The
need to commit substantial capital may require the Company to seek additional
equity or debt financing. Although the Company currently believes that the need
for such additional capital is minimal for the next two years, if such capital
is needed, the sale or issuance of additional equity or convertible debt
securities could result in additional dilution to the Company's stockholders.
There can be no assurance that such additional financing, if required, will be
available when needed or, if available, will be on terms acceptable to the
Company.
Volatility of Stock Price
The market price of the shares of the Company's common stock, like that of
the common stock of many other semiconductor companies, has been and is likely
to be highly volatile, and the market has from time to time experienced
significant price and volume fluctuations that are unrelated to the operating
performance of particular companies. The market price of the Company's common
stock could be subject to significant fluctuations in response to
quarter-to-quarter variations in the Company's anticipated or actual operating
results, announcements of new products, technological innovations or setbacks by
the Company or its competitors, conditions in the semiconductor and PC
industries, the commencement of, developments in or outcome of litigation,
changes in or the failure by the Company to meet earnings estimates by
securities analysts, market conditions for high technology stocks in general,
and other events or factors.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
19
<PAGE> 20
Since November 1997, a number of complaints have been filed in federal and
state courts seeking an unspecified amount of damages on behalf of an alleged
class of persons who purchased shares of the Company's common stock at various
times between April 17, 1996 and November 3, 1997. The complaints name as
defendants the Company, certain of its officers and former officers and certain
directors of the Company, asserting that they violated federal and state
securities laws by misrepresenting and failing to disclose certain information
about the Company's business. The plaintiffs in the federal class actions have
moved to dismiss those cases and scheduled a June 5 hearing for court approval.
In addition, certain stockholders have filed derivative actions seeking recovery
on behalf of the Company, alleging, among other things, breach of fiduciary
duties by such individual defendants. The Company has not yet formally responded
to these complaints. While management intends to defend the actions against
the Company vigorously, there can be no assurance that an adverse result or
settlement with regards to these lawsuits would not have a material adverse
effect on the Company's financial condition or results of operations.
The Company has received from the United States Securities and Exchange
Commission a request for information relating to the Company's restatement
announcement in November 1997. The Company has responded and intends to continue
to respond to such requests.
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:
The following reports on Form 8-K were filed during the quarter for which
this report is filed:
A current report on Form 8-K, dated December 31, 1997, was filed by the
Registrant on January 2, 1998. This report announced the sale by the Registrant
of a portion of its USC shares.
A current report on Form 8-K, dated January 26, 1998, was filed by the
Registrant on January 28, 1998. This report announced the $40 million patent
purchase agreement with Cirrus Logic, Inc.
20
<PAGE> 21
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/ WALTER D. AMARAL
WALTER D. AMARAL
Senior Vice President Finance
and Chief Financial Officer
(Principal Financial and Accounting Officer)
May 14, 1998
21
<PAGE> 22
INDEX TO EXHIBITS
EXHIBIT
NUMBER EXHIBITS
------ --------
27 Financial Data Schedule
22
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<FISCAL-YEAR-END> DEC-31-1998
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