<PAGE> 1
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
FORM 10-Q/A
AMENDMENT NO. 1 TO
(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, 1997 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 of other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
2801 Mission College Boulevard
P.O. Box 58058
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 July 30, 1997 was 49,615,803
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<PAGE> 2
S3 INCORPORATED
FORM 10-Q/A
This report on Form 10-Q/A constitutes Amendment No. 1 to the Registrant's Form
10-Q for the quarter ended June 30, 1997. This report is intended to amend
certain information contained in Part I, Items 1 and 2, and Part II, Item 1, 2
and 6. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations" for a discussion of the basis for such amendments.
INDEX
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
PART I. CONDENSED CONSOLIDATED FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements:
Condensed Consolidated Balance Sheets
June 30, 1997 and December 31, 1996 3
Condensed Consolidated Statements of Operations
Three months ended and six months
ended June 30, 1997 and 1996 4
Condensed Consolidated Statements of Cash Flows
Six months ended June 30, 1997 and 1996 5
Notes to Unaudited Condensed Consolidated Financial Statements 6-9
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 10-22
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 23
Item 2. Changes in Securities 23
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 24
Signatures 24
</TABLE>
Page 2 of 24
<PAGE> 3
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
S3 INCORPORATED
CONDENSED CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except share data)
(Unaudited)
<TABLE>
<CAPTION>
June 30, December 31,
1997 1996
------------- -------------
(As Restated) (As Restated)
<S> <C> <C>
ASSETS
Current assets:
Cash and equivalents $ 67,416 $ 94,616
Short-term investments 55,851 62,768
Accounts receivable (net of allowances of $2,329 in 1997
and $2,648 in 1996) 104,997 76,120
Inventories, net 46,615 53,466
Prepaid expenses and other 41,664 39,079
-------- --------
Total current assets 316,543 326,049
Property and equipment, net 47,578 34,047
Production capacity rights 14,400 14,400
Investment in joint venture 104,708 93,430
Other assets 33,303 17,246
-------- --------
Total $516,532 $485,172
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 50,796 $ 51,160
Notes payable 22,230 17,802
Accrued liabilities 16,011 12,063
Deferred revenue 20,599 12,113
Income taxes payable 2,837 7,361
-------- --------
Total current liabilities 112,473 100,499
Notes payable 14,400 14,400
Other liabilities 8,892 6,452
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; 49,440,104
and 48,331,794 shares outstanding in 1997 and 1996 173,700 169,411
Unrealized loss on short-term investments (14) (54)
Retained earnings 103,581 90,964
-------- --------
Total stockholders' equity 277,267 260,321
-------- --------
Total $516,532 $485,172
======== ========
</TABLE>
See accompanying notes to the unaudited condensed
consolidated financial statements.
Page 3 of 24
<PAGE> 4
S3 INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
---------------------------- ----------------------------
June 30, June 30, June 30, June 30,
1997 1996 1997 1996
------------- ------------- ------------- --------------
(As Restated) (As Restated) (As Restated) (As Restated)
<S> <C> <C> <C> <C>
Net sales $84,589 $99,122 $214,844 $201,242
Cost of sales 52,628 61,485 128,248 123,312
------- ------- -------- --------
Gross margin 31,961 37,637 86,596 77,930
Operating expenses:
Research and development 21,029 15,057 39,971 29,778
Selling, marketing and administrative 13,502 11,587 26,132 22,501
------- ------- -------- --------
Total operating expenses 34,531 26,644 66,103 52,279
------- ------- -------- --------
Income from operations (2,570) 10,993 20,493 25,651
Other income (expense), net (279) 703 (271) 1,709
------- ------- -------- --------
Income before income taxes (2,849) 11,696 20,222 27,360
Provision for income taxes (1,083) 3,984 7,606 9,269
------- ------- -------- --------
Net income $(1,766) $ 7,712 12,616 $ 18,091
======= ======= ======== ========
Net income per common and
equivalent share:
Primary $ (0.04) $ 0.15 $ 0.25 $ 0.36
======= ======= ======== ========
Assuming full dilution $ (0.04) $ 0.15 $ 0.25 $ 0.36
======= ======= ======== ========
Shares used in computing net income
per common and equivalent share:
Primary 49,199 50,114 50,658 50,081
======= ======= ======== ========
Assuming full dilution 49,199 50,114 53,340 50,081
======= ======= ======== ========
</TABLE>
See accompanying notes to the unaudited condensed
consolidated financial statements.
Page 4 of 24
<PAGE> 5
S3 INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
(Unaudited)
<TABLE>
<CAPTION>
Six Months Ended
-------------------------------
June 30, June 30,
1997 1996
------------ --------------
(As Restated) (As Restated)
<S> <C> <C>
Operating activities:
Net income $ 12,616 $ 18,091
Adjustments to reconcile net income to net cash used for
operating activities:
Deferred income taxes (312) (2,648)
Depreciation and amortization 8,222 4,690
Equity in income from joint venture (11,278) --
Changes in assets and liabilities:
Accounts receivable (28,877) (7,120)
Inventories 6,851 (8,680)
Prepaid expenses and other (919) (5,551)
Accounts payable (364) (16,895)
Accrued liabilities 4,271 5,753
Deferred revenue 8,486 5,829
Income taxes payable (4,524) (415)
-------- --------
Net cash used for operating activities (5,828) (6,946)
-------- --------
Investing activities:
Property and equipment purchases, net (20,212) (9,418)
Investment in real estate partnership -- (2,100)
Sales/maturities of short-term investments, net 6,957 9,509
Technology investment (5,000) --
Other assets (12,063) --
-------- --------
Net cash used for investing activities (30,318) (2,009)
-------- --------
Financing activities:
Sale of common stock, net 4,288 2,392
Net borrowings of notes payable 4,658 6,500
-------- --------
Net cash provided by financing activities 8,946 8,892
-------- --------
Net decrease in cash and equivalents (27,200) (63)
Cash and cash equivalents at beginning of period 94,616 69,289
-------- --------
Cash and cash equivalents at end of period $ 67,416 $ 69,226
======== ========
</TABLE>
See accompanying notes to the unaudited condensed
consolidated financial statements.
Page 5 of 24
<PAGE> 6
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"). 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, 1997 and December 31, 1996, and the operating
results and cash flows for the three and six months ended June 30, 1997 and
1996. 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, 1996, 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, 1997 are not necessarily indicative of the results that may be expected for
the future quarters or the year ending December 31, 1997. Certain
reclassifications of 1996 amounts were made in order to conform to the 1997
presentation.
Page 6 of 24
<PAGE> 7
2. Restatement of Quarterly Financial Statements
Subsequent to the issuance of the Company's Form 10-Q for the quarter ended June
30, 1997, the Company discovered that its accounting policies with respect to
revenue recognition for international sales had not been fully followed. The
Company's policy is to defer recognition of revenue on all sales to distributors
until the product is sold by each distributor to its customers. Based on its
review of this matter, the Company determined that in certain instances, revenue
was recognized prematurely, prior to sale by the Company's distributors.
Accordingly, the accompanying consolidated condensed financial statements have
been restated to properly defer revenue recognition on products shipped to
certain distributors.
The effects of such restatement are summarized as follows in thousands except
per share amounts:
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
------------------------ -----------------------
June 30, June 30, June 30, June 30,
1997 1996 1997 1996
------------------------ -----------------------
<S> <C> <C> <C> <C>
Net sales before restatement $ 108,892 $ 103,825 $ 247,058 $ 213,897
Net sales after restatement $ 84,589 $ 99,122 $ 214,844 $ 201,242
Cost of sales before restatement $ 70,429 $ 64,357 $ 151,352 $ 130,867
Cost of sales after restatement $ 52,628 $ 61,485 $ 128,248 $ 123,312
Net income before restatement $ 2,265 $ 8,792 $ 18,186 $ 21,100
Net income after restatement $ (1,766) $ 7,712 $ 12,616 $ 18,091
Net income per common and equivalent
share before restatement $ 0.05 $ 0.18 $ 0.36 $ 0.42
Net income per common and equivalent
share after restatement $ (0.04) $ 0.15 $ 0.25 $ 0.36
</TABLE>
<TABLE>
<CAPTION>
At June 30, At December 31,
1997 1996
----------- ---------------
<S> <C> <C>
Deferred revenue before restatement $ -- $ 624
Deferred revenue after restatement $ 20,599 $ 12,113
Total stockholders' equity before restatement $289,615 $267,100
Total stockholders' equity after restatement $277,267 $260,321
</TABLE>
Page 7 of 24
<PAGE> 8
3. 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>
June 30, December 31,
1997 1996
-------- ------------
(in thousands)
<S> <C> <C>
Inventories consist of:
Work in process $28,129 $22,556
Finished goods 18,486 30,910
------- -------
Total $46,615 $53,466
======= =======
</TABLE>
4. Net income per share:
Primary per share data is computed based on the weighted average number of
common and dilutive common equivalent shares outstanding. Common equivalent
shares include stock options and shares subscribed under the employee stock
purchase plan (computed using the treasury stock method). Fully diluted per
share data is computed using the most dilutive assumptions and by adjusting the
primary per share data and net income for the effect of the conversion of the 5
3/4% Convertible Subordinated Notes outstanding during the period and the
elimination of the related interest and amortization of issue costs, net of
income taxes.
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 has invested a total of $89.4 million for its
equity interest of 23.75%. 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 years capacity. The Company has signed promissory notes to secure
these payments over the term of the agreement. At June 30, 1997, the remaining
advance payments (and corresponding promissory notes) totaled $24.0 million
($9.6 million in prepaid expenses and $14.4 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
has been and can be in the future 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 litigation will not
have a material adverse effect on the Company's financial position or results of
operations.
Page 8 of 24
<PAGE> 9
7. Recently Issued Accounting Standard
In February 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 128, "Earnings per Share" (SFAS 128). The
Company is required to adopt SFAS 128 in the fourth quarter of fiscal 1997 and
will restate at that time earnings per share (EPS) data for prior periods to
conform with SFAS 128. Earlier application is not permitted.
SFAS 128 will replace current EPS reporting requirements and requires a
dual presentation of basic and diluted EPS. Basic EPS excludes dilution and is
computed by dividing net income available to common shareholders by the weighted
average of common shares outstanding for the period. Diluted EPS reflects the
potential dilution that could occur if securities or other contracts to issue
common stock were exercised or converted into common stock.
If SFAS 128 had been in effect during the current and prior year periods,
basic EPS would have been $(0.04) and $0.16 for the three months ended June 30,
1997 and 1996 respectively. Basic EPS would have been $0.26 and $0.38 for the
six months ended June 30, 1997 and 1996 respectively. Diluted EPS under SFAS 128
would have been $(0.04) and $0.15 for the three months ended and $0.26 and $0.36
for the six months ended June 30, 1997 and 1996 respectively.
In June 1997, the Financial Accounting Standards Board adopted Statements
of Financial Accounting Standards No. 130 (Reporting Comprehensive Income),
which requires that an enterprise report, by major components and as a single
total, the change in its net assets during the period from nonowner sources; and
No. 131 (Disclosures about Segments of an Enterprise and Related Information),
which establishes annual and interim reporting standards for an enterprise's
business segments and related disclosures about its products, services,
geographic areas, and major customers. Adoption of these statements will not
impact the Company's consolidated financial position, results of operations or
cash flows. Both statements are effective for fiscal years beginning after
December 15, 1997, with earlier application permitted.
8. Subsequent Events
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 January 1, 1995 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. In addition, certain shareholders 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 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 such 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. The Company has responded and intends to continue to
respond to such requests.
Page 9 of 24
<PAGE> 10
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 multimedia acceleration hardware and
its associated software 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") environment and applications.
Subsequent to the filing of the Company's Form 10-K for the quarter ended
June 30, 1997, the Company discovered that its accounting policies with respect
to revenue recognition for international sales had not been fully followed. The
Company's policy is to defer recognition of revenue on all sales to distributors
until the period the product is sold by each distributor to its customers. Based
on its review of this matter, the Company determined that in certain instances,
revenue was recognized prematurely, prior to sale by the Company's distributors.
The Company's review of this matter has been supervised by the Audit Committee
of the Board of Directors. The Company's accompanying quarterly financial
statements have been restated from the amounts previously reported to defer the
recognition of revenue until the time of sale by the distributor to the
customer. See note 2 of notes to unaudited condensed consolidated financial
statements.
Page 10 of 24
<PAGE> 11
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 30, June 30, June 30, June 30,
1997 1996 1997 1996
------------- ------------ ------------ -------------
(As Restated) (As Restated) (As Restated) (As Restated)
<S> <C> <C> <C> <C>
Net sales 100.0% 100.0% 100.0% 100.0%
Cost of sales 62.2 62.0 59.7 61.3
----- ----- ----- -----
Gross margin 37.8 38.0 40.3 38.7
----- ----- ----- -----
Operating expenses:
Research and development 24.9 15.2 18.6 14.8
Selling, marketing and administrative 15.9 11.7 12.2 11.2
----- ----- ----- -----
Total operating expenses 40.8 26.9 30.8 26.0
----- ----- ----- -----
Income (loss) from operations (3.0) 11.1 9.5 12.7
Other income (expense), net (0.3) 0.7 (0.1) 0.9
----- ----- ----- -----
Income before income taxes (3.3) 11.8 9.4 13.6
Provision for income taxes (1.2) 4.0 3.5 4.6
----- ----- ----- -----
Net income (loss) (2.1)% 7.8% 5.9% 9.0%
===== ===== ===== =====
</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, and the
timing of significant orders.
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 $84.6 million for the
three months ended June 30, 1997, a 14.6% decrease from the $99.1 million of net
sales for the three months ended June 30, 1996. Net sales were $214.8 million
for the six months ended June 30, 1997 or 6.8% above the $201.2 million of new
sales for the six months ended June 30, 1996. Net sales increased primarily as a
result of an increase in unit volumes offset by lower overall average selling
due to aggressive pricing from certain of the Company's competitors.
Page 11 of 24
<PAGE> 12
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 net sales in 1996, has recently
experienced and is expected to continue to experience increasing pricing
pressures due to aggressive pricing from certain of the Company's competitors.
In particular, the Company's Trio family of integrated 2D accelerators
experienced significant decreases in average selling prices in 1996 which
continued in the first half of 1997. The graphics accelerator market is making a
transition 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. The Company experienced significant price competition for its
products in the three and six months ended June 30, 1997. The Company currently
anticipates price declines to return to a more normalized environment and
traditional demand to rise in the third quarter. 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. If the
transition occurs slower than expected, if the Company's graphic products do not
achieve market acceptance, or if the pricing pressures increase or continue in
the manner experienced in the first half of 1997, then the Company's operating
results could be adversely affected.
Export sales accounted for 69% and 57% of net sales for the three months
ended June 30, 1997 and 1996, respectively. Export sales accounted for 64% and
54% of net sales in the six months ended June 30, 1997 and 1996 respectively.
Approximately 35% and 30% of export sales for the three and six months ended
June 30, 1997 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.
One customer accounted for 34% and 24% of net sales for the three and six
months ended June 30, 1997 respectively, and 14% and 10% of net sales for the
three and six months ended June 30, 1996, respectively. Another customer
accounted for 18% and 10% of net sales for the three and six months ended June
30, 1997 respectively, and another customer accounted for 15% and 13% of net
sales for the same periods. A different customer accounted for 15% of net sales
for the three months ended June 30, 1997 while a different customer accounted
for 18% of net sales for the three and six months ended June 30, 1996. A
different customer accounted for 11% of net sales for the six months ended June
30, 1996. 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 the rate of growth in 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.
Page 12 of 24
<PAGE> 13
GROSS MARGIN
Gross margin percentage decreased to 37.8% for the three months ended June
30, 1997 from 38.0% for the three months ended June 30, 1996. The decrease was
due to decreases in overall average selling prices. Gross margin percentage
increased to 40.3% for the six months ended June 30, 1997 from 38.7% for the six
months ended June 30, 1996. The Company currently expects its gross margin
percentage for the three months ending September 30, 1997 to decrease from
current levels as unit average selling prices decrease.
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, the profitability of
the USC joint venture (the Company recognizes its proportionate share of USC
profits and losses), 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 to 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 $21.0 million for
the three months ended June 30, 1997, an increase of $5.9 million from $15.1
million for the three months ended June 30, 1996. Research and development
expenses were $40.0 million for the six months ended June 30, 1997, an increase
of $10.2 million from $29.8 million for the six months ended June 30, 1996.
Research and development spending increases reflect additions to the Company's
engineering staff and nonrecurring engineering and initial product verification
expenses related to the expected introduction of new products. Research and
development spending is expected to increase in absolute dollars in 1997 as a
result of the product development activities currently underway for the desktop,
mobile and home PC markets with a focus on full motion video, 3D, and audio.
Products in the Company's market typically have a life cycle of 12 to 24
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 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 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 $13.5 million for the
three months ended June 30, 1997, an increase of $1.9 million from $11.6 million
for the three months ended June 30, 1996. Selling, marketing and administrative
expenses were $26.1 million for the six months ended June 30, 1997 an increase
of $3.6 million from $22.5 million in the six months ended June 30, 1996.
Selling and marketing costs increased as a result of additional personnel,
increased commissions and increased marketing costs associated with the expected
Page 13 of 24
<PAGE> 14
increased due to 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 1997.
OTHER INCOME (EXPENSE), NET
Other expense, decreased to $0.3 million for the three months ended June
30, 1997, from $0.7 million of interest income for the three months ended June
30, 1996. Other expense decreased to $0.3 million for the six months ended June
30, 1997, from $1.7 million of interest income for the six months ended June 30,
1996. The decrease is attributable to the interest expense incurred on $103.5
million aggregate principal amount of convertible subordinated notes, which were
issued by the Company in September 1996. The interest expense is partially
offset by the interest income due to the higher average amounts of cash and
short-term investments as a result of the net proceeds of approximately $100.1
million from the sale of the convertible subordinated notes.
INCOME TAXES
The Company's effective tax rate for the six months ended June 30, 1997 is
38%, compared to the 34% effective rate for the three months and six months
ended June 30, 1996. The increased tax rate is primarily attributable to the
expiration of the federal research and development credit as of May 31, 1997.
LIQUIDITY AND CAPITAL RESOURCES
Cash used for operating activities for the six months ended June 30, 1997
was $5.8 million, as compared to $6.9 million for the six months ended June 30,
1996. The Company experienced an increase from December 31, 1996 in accounts
receivable, prepaid expenses, other assets, accrued liabilities, deferred
revenue and other liabilities. These increases were partially offset by
decreases in inventories, and income taxes payable. The Company experienced an
increase in accounts receivable from the level at December 31, 1996 due to the
substantial concentration of sales in June 1997 resulting from increased
shipments in the third month of the second quarter over either of the first two
months of the quarter relative to what the Company experienced in previous
quarters.
Investing activities for the six months ended June 30, 1997 and 1996
reflected property and equipment purchases, net, of $20.2 million and $9.4
million, respectively, short term investments, and deferred royalties related to
the Brooktree license agreement. Continued 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. In June 1997, the Company made a $5.0 million equity investment in
Faroudja Laboratories, Inc. ("Faroudja"). The Company and Faroudja are working
jointly, pursuant to a license agreement, to develop integrated circuits
incorporating Faroudja's video processing technology for use in PC's.
Financing activities provided cash of $8.9 million in the six months ended
June 30, 1997 and 1996. Borrowings on the line of credit and proceeds from the
issuance of common stock were the principal financing activities that generated
cash in these periods.
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. The facility commenced production
Page 14 of 24
<PAGE> 15
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 years capacity. The Company has signed
promissory notes to secure these payments, which total $24.0 million as of June
30, 1997, over the term of the agreement.
Working capital at June 30, 1997 and December 31, 1996 was $204.1 million
and $225.6 million, respectively. At June 30, 1997, the Company's principal
sources of liquidity included cash and equivalents of $67.4 million and $55.9
million in short-term investments. In addition, the Company has a $25.0 million
unsecured revolving line of credit that expires September 1, 1997. The Company
is currently in the process of renewing the line of credit. The Company had $5.0
million outstanding under the line of credit as of June 30, 1997. In addition,
the Company has a separate secured equipment line of credit totaling $3.5
million. The Company had $2.4 million outstanding under this secured equipment
line of credit at June 30, 1997. The Company believes that its available funds
and its 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 expenditures for future
potential manufacturing agreements.
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
issuance 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.
Page 15 of 24
<PAGE> 16
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, and the
timing of significant orders. 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. In
particular, the Company's Trio family of integrated 2D accelerators, which
accounted for a majority of the Company's revenues in 1996, experienced
significant decreases in average selling prices in 1997. The graphics
accelerator market is making a transition from 2D acceleration to 3D
acceleration, and the Company has 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
transition occurs slower than expected, if the Company's 2D/3D products do not
achieve market acceptance, or if pricing pressures increase above normal
anticipated levels, the Company's operating results could be adversely affected.
Further, 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 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.
Page 16 of 24
<PAGE> 17
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 24 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 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 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 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 could 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
entered into an agreement with United Microelectronics Corporation ("UMC") and
Alliance Semiconductor Corporation to form a separate Taiwanese company, USC,
for the purpose of building and managing a semiconductor manufacturing facility.
The Company invested $53.0 million in 1996 and $36.4 million in 1995 for its
23.75% equity interest. 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. 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 overcapacity 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.
Page 17 of 24
<PAGE> 18
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. Until 1996, due to worldwide
semiconductor supply constraints, especially with respect to advanced process
technologies required by the Company's products, the Company was unable to
obtain a sufficient supply of products to enable it to meet demand and was
required to allocate available supply of its products among its customers. 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 1997. 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 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.
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 introduction of new products. Administrative costs have
Page 18 of 24
<PAGE> 19
periods, equity investments in or advances or issuance 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. 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.
Dependence on Accelerator Product Line
S3's products are designed to improve the graphics and multimedia
performance of x86-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 x86-based microprocessors and that standard multimedia accelerators in
the future will likely integrate memory, system logic, audio, communications or
other additional functions. 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 x86-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. 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, which has emerged as the standard API for
3D acceleration. While the Company's 3D accelerators currently support the
Company's proprietary API and Microsoft's Direct 3D API, there can be no
assurance that another API will emerge as an industry standard that the
Company's accelerators will not support. 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. The occurrence
of any such events would have a material adverse effect on the Company's
operating results.
Page 19 of 24
<PAGE> 20
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., Cirrus Logic, 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, including Intel Corporation and Lockheed Martin
Corporation, which have announced that they are jointly developing such chips,
which are currently expected to become available in the second half of 1997, and
Texas Instruments Incorporated, which has announced a development and marketing
agreement with 3Dlabs Inc., Ltd. Microsoft is working with a number of
companies, including Cirrus Logic, Inc., Samsung Electronics Co., Ltd., Philips
N.V. and Fujitsu Ltd., to implement this architecture. In addition, Intel
Corporation has entered into a definitive agreement to acquire Chips and
Technologies, Inc., a leading provider of accelerators for the mobile PC market.
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 1997 and future periods could be materially and adversely affected. 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, such
as software-centric multimedia processors. Further, 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. In addition, certain of the Company's potential
competitors that supply add-in cards and/or motherboards, such as Intel
Corporation, 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. 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 occurrence of any such events could have a material
adverse effect on the Company's operating results.
Page 20 of 24
<PAGE> 21
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. The
Company is in the final stage of implementing a new management information
system. Any problems encountered with the new 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 1996, the Company appointed a new President and Chief Executive Officer
to replace Terry N. Holdt, who retired, and in March 1997, the Company's Chief
Financial Officer resigned, and 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 has been and can be in the
future 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, in the case of the
Brooktree Corporation ("Brooktree") litigation, resulted 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 litigation to determine the
validity of any third-party claims, such litigation could result in significant
expense to the Company and divert 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 the Company's current products infringe a Brooktree patent. Such a
Page 21 of 24
<PAGE> 22
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. See Part
II, Item 1. Legal Proceedings.
International Operations
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. 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 1997. 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 not to date 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.
Volatility of Stock Price
The market price of the shares of 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 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.
Page 22 of 24
<PAGE> 23
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
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 January 1, 1995 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. In addition, certain shareholders 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 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 such 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. The Company has responded and intends to continue to
respond to such requests.
Item 2. Changes in Securities
On May 14, 1997, the Board of Directors of the Company adopted a
Stockholder Rights Plan. Under the terms of the Rights Plan, stockholders of
record as of June 1, 1997 received a dividend of one Preferred Stock Purchase
Right for each share of Common Stock held on that date. The Rights will expire
10 years after issuance, and will be exercisable only if a person or group
becomes the beneficial owner of 15% or more of the Common Stock (such person or
group, a "15% holder") or commences a tender or exchange offer which would
result in the offeror beneficially owning 15% or more of the Common Stock. Each
Right will entitle stockholders to buy one one-thousandth of a share of Series A
Preferred Stock of the Company at an exercise price of $85.00, subject to
certain antidilution adjustments.
If a person or group accumulates 15% or more of the Common Stock, each
Right (other than Rights held by a 15% holder and certain related parties, which
will be voided) will be adjusted so that upon exercise the holder will have the
right to receive that number of shares of Common Stock or in certain
circumstances, a combination of securities and/or assets) having a value of
twice the exercise price of the Right. In addition, if following the public
announcement of the existence of a 15% holder the Company is involved in a
merger or business combination or a sale of 50% or more of the Company's assets
or earning power, each Right (other than Rights held by a 15% holder and certain
related parties, which will be voided) will represent the right to purchase, at
the exercise price, common stock of the acquiring entity having a value of twice
the exercise price at the time. The Board of Directors will also have the right,
following the public announcement of the existence of a 15% holder, to cause
each Right (other than rights held by the 15% holder) to be exchanged for one
share of Common Stock.
The Board of Directors is entitled to redeem the Rights at $.01 per Right
at any time prior to the public announcement of the existence of a 15% holder.
Item 6. Exhibits and Reports on Form 10K
27 Financial Data Schedule (filed only with the electronic submission of
Form 10-Q in accordance with the Edgar requirements)
Page 23 of 24
<PAGE> 24
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 V.P. Finance & Chief Financial Officer
(Principal Financial and Accounting Officer)
February 25, 1998
Page 24 of 24
<PAGE> 25
INDEX TO EXHIBITS
Exhibit
Number Exhibits
- ------- --------
27 Financial Data Schedule
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM (A)
S3 INCORPORATED CONDENSED CONSOLIDATED BALANCE SHEET AS OF JUNE 30,
1997 AND CONDENSED CONSOLIDATED STATEMENTS OF INCOME FOR THE THREE AND
SIX MONTHS ENDED JUNE 30, 1997, AND IS QUALIFIED IN ITS ENTIRETY
BY REFERENCE TO SUCH (B) FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> APR-01-1997
<PERIOD-END> JUN-30-1997
<CASH> 67,416
<SECURITIES> 55,851
<RECEIVABLES> 107,326
<ALLOWANCES> 2,329
<INVENTORY> 46,615
<CURRENT-ASSETS> 316,543
<PP&E> 73,300
<DEPRECIATION> 25,722
<TOTAL-ASSETS> 516,532
<CURRENT-LIABILITIES> 112,473
<BONDS> 0
0
0
<COMMON> 173,700
<OTHER-SE> 103,567
<TOTAL-LIABILITY-AND-EQUITY> 516,532
<SALES> 214,844
<TOTAL-REVENUES> 214,844
<CGS> 128,248
<TOTAL-COSTS> 128,248
<OTHER-EXPENSES> 66,103
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 3,244
<INCOME-PRETAX> 20,222
<INCOME-TAX> 7,606
<INCOME-CONTINUING> 12,616
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 12,616
<EPS-PRIMARY> 0.25
<EPS-DILUTED> 0.25
</TABLE>
