<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 September 30, 2000 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.)
2841 Mission College Boulevard
Santa Clara, California 95054
(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 October 19, 2000 was 92,515,920.
<PAGE> 2
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 at September 30, 2000 and December 31, 1999 3
Condensed Consolidated Statements of Operations for the three and nine months ended
September 30, 2000 and 1999 4
Condensed Consolidated Statements of Cash Flows for the nine months ended
September 30, 2000 and 1999 5
Notes to Unaudited Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 13
Item 3. Quantitative and Qualitative Disclosures About Market Risk 31
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 32
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 33
Signatures 34
</TABLE>
2
<PAGE> 3
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
S3 INCORPORATED
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
2000 1999
------------ ------------
(UNAUDITED)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 27,303 $ 45,825
Investment - UMC 340,126 --
Other short-term investments 62,807 58,918
Accounts receivable (net of allowances
of $11,723 in 2000 and $19,298 in 1999) 81,194 78,312
Inventories, net 87,062 97,161
Deferred income taxes -- 15,486
Prepaid expenses and other 14,159 28,951
---------- ----------
Total current assets 612,651 324,653
Property and equipment, net 27,988 34,404
Investment - UMC 406,363 --
Other investments 32,483 92,763
Deferred taxes -- 56,458
Goodwill and intangible assets 171,195 199,139
Other assets 13,130 15,230
---------- ----------
Total $1,263,810 $ 722,647
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 86,155 $ 117,539
Notes payable 54,381 51,261
Accrued liabilities 59,669 45,751
Deferred taxes 39,014 --
Deferred revenue 7,882 9,953
---------- ----------
Total current liabilities 247,101 224,504
Long-term deferred taxes 106,796 --
Other liabilities 5,151 12,010
Convertible subordinated debentures 103,500 103,500
---------- ----------
Total liabilities 462,548 340,014
Stockholders' equity:
Common stock, $.0001 par value;
175,000,000 shares authorized;
92,367,142 and 78,139,745 shares
outstanding in 2000 and 1999 591,120 434,338
Accumulated other comprehensive loss (126,052) (7,563)
Retained earnings (accumulated deficit) 336,194 (44,142)
---------- ----------
Total stockholders' equity 801,262 382,633
---------- ----------
Total $1,263,810 $ 722,647
========== ==========
</TABLE>
See accompanying notes to the unaudited condensed
consolidated financial statements.
3
<PAGE> 4
S3 INCORPORATED
STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------- ---------------------------
2000 1999 2000 1999
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
Net sales $ 139,960 $ 70,484 $ 437,499 $ 172,037
Cost of sales 160,192 54,796 439,323 129,545
--------- --------- --------- ---------
Gross margin (20,232) 15,688 (1,824) 42,492
Operating expenses:
Research and development 21,677 17,075 63,708 52,562
Selling, marketing and administrative 31,028 9,401 88,102 25,732
Other operating expense -- 6,700 -- 6,700
Restructuring expense 8,981 -- 8,981
Amortization of goodwill and intangibles 11,795 895 33,354 895
--------- --------- --------- ---------
Total operating expenses 73,481 34,071 194,145 85,889
--------- --------- --------- ---------
Loss from operations (93,713) (18,383) (195,969) (43,397)
Gain on sale of manufacturing joint venture -- 7,466 14,738 14,673
Gain (loss) on UMC investment (6,419) -- 873,749 --
Gain on other investment -- -- 5,917 --
Other income (expense), net (3,211) (181) (2,539) 259
--------- --------- --------- ---------
Income (loss) before income taxes and equity
in income of manufacturing joint venture
and minority interest in RioPort.com, Inc. (103,343) (11,098) 695,894 (28,465)
Income taxes expense (benefit) (30,688) -- 306,183 --
--------- --------- --------- ---------
Income (loss) before equity in income of
manufacturing joint venture and minority
interest in RioPort.com, Inc. (72,655) (11,098) 389,711 (28,465)
Equity in income from manufacturing joint -- -- -- 4,588
venture
Minority interest in RioPort.com, Inc. (2,993) -- (9,374) --
--------- --------- --------- ---------
Net income (loss) $ (75,648) $ (11,098) $ 380,337 $ (23,877)
========= ========= ========= =========
Per share amounts:
Basic $ (0.82) $ (0.20) $ 4.25 $ (0.45)
Diluted $ (0.82) $ (0.20) $ 3.79 $ (0.45)
Shares used in computing per share amounts:
Basic 92,573 55,419 89,416 53,284
Diluted 92,573 55,419 101,179 53,284
</TABLE>
See accompanying notes to the unaudited condensed
consolidated financial statements.
4
<PAGE> 5
S3 INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
---------------------------
2000 1999
--------- ---------
<S> <C> <C>
Operating activities:
Net income (loss) $ 380,337 $ (23,877)
Adjustments to reconcile net income (loss) to net
cash provided by (used for) operating activities:
Deferred income taxes 221,926 81
Depreciation 17,848 13,315
Amortization 34,410 895
Write-off of acquired in-process research & -- 6,700
development
Gain on sale of manufacturing joint venture (14,738) (14,673)
Gain on UMC investment (873,747) --
Gain on other investments (5,917) --
Equity in income of joint venture -- (4,588)
Other Investments 6,381 --
Changes in assets and liabilities:
Accounts receivable (2,882) (16,177)
Inventories 10,098 (7,362)
Prepaid expenses and other 10,621 21,647
Accounts payable (31,384) 20,396
Accrued liabilities and other liabilities 1,220 12,561
Deferred revenue (2,071) (147)
--------- ---------
Net cash provided by (used for) operating activities (247,898) 8,771
--------- ---------
Investing activities:
Property and equipment purchases, net (8,971) (5,491)
Sale (purchase) of short-term investments, net 100,592 22,219
Sale of manufacturing joint venture 14,738 14,673
Gain on other investments (502) --
Sale of investment in real estate partnership -- 7,812
Acquisition of Diamond Multimedia, net of cash -- (22,114)
acquired
Investment in technologies (49,441) (10,869)
Issuance of notes receivable -- --
Other assets 13,076 (1,378)
--------- ---------
Net cash used for investing activities 69,492 4,852
--------- ---------
Financing activities:
Sale of common stock, net 156,782 36,925
Sale of warrant -- 990
Repayments of notes payable 3,120 (9,764)
--------- ---------
Net cash provided by financing activities 159,902 28,151
--------- ---------
Effect of exchange rate changes (18) --
--------- ---------
Net increase (decrease) in cash and equivalents (18,522) 41,774
Cash and cash equivalents at beginning of period 45,825 31,022
--------- ---------
Cash and cash equivalents at end of period $ 27,303 $ 72,796
========= =========
</TABLE>
See accompanying notes to the unaudited condensed
consolidated financial statements.
5
<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"). 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 principles and the rules and regulations of the Securities and
Exchange Commission. In the opinion of the Company, the financial statements
reflect all adjustments, consisting only of normal recurring adjustments with
the exception of the in-process research and development charge discussed in
Note 2, necessary for a fair presentation of the financial position at September
30, 2000 and December 31, 1999, and the operating results and cash flows for the
nine months ended September 30, 2000 and 1999. 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, 1999, included in
the Company's Form 10-K filed with the Securities and Exchange Commission.
The results of operations for the nine months ended September 30, 2000
are not necessarily indicative of the results that may be expected for the
future quarters or the year ending December 31, 2000. Certain reclassifications
of 1999 amounts were made in order to conform to the 2000 presentation.
This Quarterly Report on Form 10-Q contains forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933 and Section 21E
of the Securities Exchange Act of 1934. In particular, the assumptions set forth
in Note 2 and the Management's Discussion and Analysis section of this Quarterly
Report on Form 10-Q regarding revenue growth, gross margin increases, cost
decreases and cost of capital which underlie the Company's calculation of the
in-process research and development expenses contain forward-looking statements
and are qualified by the risks detailed in "Factors That May Affect Our Results"
and other risks detailed in the Company's Annual Report on Form 10-K for the
year ended December 31, 1999 and other reports filed by S3 with the Securities
and Exchange Commission from time to time. Actual results could differ
materially from those projected in these forward-looking statements as a result
of the risks described above as well as other risks set forth in S3's periodic
reports both previously and hereafter filed with the Securities and Exchange
Commission.
2. Business Combinations
Merger with Diamond
On September 24, 1999, the Company completed the acquisition of all of
the outstanding common stock of Diamond Multimedia Systems, Inc. ("Diamond").
Diamond designs, develops, manufactures and markets multimedia and connectivity
products for personal computers. The transaction was accounted for as a purchase
and, accordingly, the results of operations of Diamond and the estimated fair
value of assets acquired and liabilities assumed are included in the Company's
consolidated financial statements as of September 24, 1999, the effective date
of the purchase.
Pursuant to the merger agreement between S3 and Diamond, each share of
Diamond common stock was converted into the right to receive 0.52 shares of the
Company's common stock. No fractional shares were issued. Stockholders otherwise
entitled to a fractional share received cash. In addition, each option and right
to acquire Diamond common stock granted under Diamond's stock-based incentive
plans was converted into an option to purchase Company common stock.
Approximately 18.7 million common shares of S3 stock were issued to Diamond
stockholders and approximately 1.3 million options were assumed.
The purchase price of $218.3 million includes $172.2 million of stock
issued at fair value (fair value being determined as the average price of the S3
stock for a period three days before and after the announcement of the merger),
$11.7 million in Diamond stock option costs (being determined under both the
Black-Scholes formula and in accordance with the Merger Agreement), cash paid to
Diamond of $20.0 million and $14.4 million in estimated expenses of the
transaction. The purchase price was allocated as follows: $0.8 million to the
estimated fair value of Diamond net liabilities assumed (as of September 24,
1999), $6.7 million to purchased in-process research and development, $6.8
million to purchased existing technology, $11.4 million to tradenames, $5.5
million to workforce-in-place, $12.5 million to Diamond distribution channel
relationships and $174.6 million to goodwill. Goodwill is recorded as a result
of consideration paid in excess of the fair value of net tangible and intangible
assets acquired. Goodwill and identified
6
<PAGE> 7
acquisition related intangible assets are amortized on a straight-line basis
over the periods indicated below. The allocation of the purchase price to
intangibles was based upon management's estimates. The purchase price and the
related allocation are subject to further refinement and change over the initial
year of combined operations.
Management has completed its integration plans related to Diamond. The
integration plans include initiatives to combine the operations of Diamond and
S3 and consolidate duplicative operations. Areas where management estimates may
be revised primarily relate to employee severance and relocation costs and other
exit costs. Adjustments to accrued integration costs related to Diamond will be
recorded as adjustments to the fair value of net assets in the purchase price
allocation. Accrued integration charges included $3.8 million related to
involuntary employee separation and relocation benefits for employees and $2.2
million in other exit costs primarily relating to the closing or consolidation
of facilities and the termination of certain contractual relationships. The
accruals recorded related to the integration of Diamond are based upon
management's current estimate of integration costs.
The intangible assets and goodwill acquired have estimated useful lives
and estimated first year amortization, as follows (dollars in thousands):
<TABLE>
<CAPTION>
CALCULATED
ESTIMATED FIRST YEAR
AMOUNT USEFUL LIFE AMORTIZATION
------ ----------- ------------
<S> <C> <C> <C>
Purchased existing technology $6,800 2-5 years $2,708
Tradenames 11,400 7 years 1,629
Workforce-in-place 5,500 4 years 1,375
Diamond distribution channel 12,500 5 years 2,500
relationships
Goodwill 174,563 5 years 34,913
</TABLE>
The value assigned and written off as purchased in-process research and
development ("IPR&D") of $6.7 million was determined by identifying research
projects in areas for which technological feasibility had not been established.
The value was determined by estimating the expected cash flows from the projects
once commercially viable, discounting the net cash flows back to their present
value and then applying a percentage of completion to the calculated value.
The discount rate used in discounting the net cash flows from IPR&D
ranged from 25% to 35%. Relatively high discount rates were used to reflect the
inherent uncertainties surrounding the successful development of the IPR&D,
market acceptance of the technology, the useful life of such technology and the
uncertainty of technological advances which could potentially impact the
estimates described above.
The percentage of completion for each project was determined using costs
incurred to date on each project as compared to the remaining research and
development to be completed to bring each project to technological feasibility.
The percentage of completion varied by individual project ranging from 20% to
60%.
If the projects discussed above are not successfully developed, the
sales and profitability of the combined company may be adversely affected in
future periods.
Purchase of Assets of Number Nine
On February 1, 2000, the Company completed the acquisition of all of the
assets of Number Nine Visual Technology Corporation ("Number Nine"). The
purchase price of $5.3 million includes $5.1 million of cash and $0.2 million in
estimated expenses of the transaction. The purchase price was allocated as
follows: $0.7 million to the estimated fair value of Number Nine net assets (as
of February 1, 2000), $0.5 million to workforce-in-place and $4.1 million to
goodwill. Goodwill is recorded as a result of consideration paid in excess of
the fair value of net tangible and intangible assets acquired. Goodwill and
identified acquisition related intangible assets are amortized on a
straight-line basis over five years. The allocation of the purchase price to
intangibles was based upon management's estimates. The purchase price and the
related allocation are subject to further refinement and change over the initial
year of combined operations.
3. Inventories
Inventories are stated at the lower of cost (determined on a first-in,
first-out basis) or market. Inventories consisted of:
7
<PAGE> 8
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
2000 1999
------------ -----------
(IN THOUSANDS)
<S> <C> <C>
Raw materials $37,635 $40,132
Work in process 13,881 10,418
Finished goods 35,546 46,611
------- -------
Total $87,062 $97,161
======= =======
</TABLE>
4. Investments
Investment in USC (UMC)
In June 1999, the Company announced that it would receive $42.0 million
for a patent license and release associated with the sale of 80 million shares
its stock of United Semiconductor Corporation ("USC") in January 1998. Payments
will be received over five fiscal quarters beginning in the quarter ended
September 30, 1999. Under the terms of the agreement, S3 will license to United
Microelectronics Corporation ("UMC") 29 patents covering multimedia products and
integrated circuit manufacturing technology for use in products manufactured by
UMC.
In June 1999, UMC announced a foundry consolidation plan whereby USC,
United Integrated Circuits Corporation, United Silicon Incorporated and UTEK
Semiconductor Corporation would be merged into UMC. Under the terms of the
consolidation plan, each of the Company's shares in the USC joint venture would
be exchanged for one share of UMC. On January 4, 2000, the Company's 252 million
shares of USC were exchanged for 252 million shares of UMC stock. The Company
recorded a gain on the transfer of the shares of $880.2 million to recognize the
difference in the carrying value of its investment in USC and the fair market
value of the UMC shares on the date of the transfer. Approximately half of the
shares received are subject to sale restrictions and are carried at market value
as of January 4, 2000 as long-term assets in the accompanying balance sheet at
September 30, 2000. As the remaining shares are publicly traded, the investment
is adjusted to fair market value in accordance with SFAS 115 and classified as
short-term investments.
The Company received a 20% stock dividend, or approximately 50.4 million
shares of UMC stock, in a transaction which was approved by the UMC's
shareholders at its Annual Shareholders Meeting on April 7, 2000. With the stock
dividend, the Company's investment holdings in UMC have increased to
approximately 302 million shares of UMC stock. The Company sold 10 million
shares of UMC stock in August 2000 on the Taiwan Stock Exchange receiving net
proceeds of $25.1 million. At September 30, 2000, approximately 166 million
shares are classified as a current asset with approximately 126 millions shares
as a long-term asset.
Interest in Partnership
In 1995, the Company entered into a limited partnership arrangement (the
"partnership") with a developer to obtain a ground lease and develop and operate
the Company's current Santa Clara facilities. The Company invested $2.1 million
for a 50% limited partnership interest. On June 29, 1999, the Company entered
into an agreement to assign to the general partner the Company's entire interest
in the partnership for $7.8 million. The gain on the assignment of the Company's
partnership interest is being recognized over the term of the facilities lease,
which expires in 2008.
Investment in OneStep, LLC and RioPort.com, Inc.
In July 1999, Diamond acquired OneStep, LLC, a software development
company that supplies the Rio Audio Manager to RioPort.com, Inc. ("RioPort"),
for $10.9 million in cash. RioPort is developing an integrated platform for
acquiring, managing and experiencing music and spoken audio programming from the
Internet. The Rio Audio Manager is designed to allow audio enthusiasts to easily
acquire, create, organize and playback music or spoken audio programming in one
simple application.
In October 1999, S3 caused RioPort, which was a wholly owned subsidiary,
to sell shares of its preferred stock to third party investors. As a result of
the preferred stock sales, the Company retains a minority investment in RioPort
and accounts for its investment using the equity method of accounting. In
addition, in November 1999, the Company received $10.9 million for the sale of
OneStep, LLC to RioPort.
In June 2000, RioPort sold additional preferred stock to third party
investors. As part of this financing, the Company invested an additional $10.7
million in RioPort, maintaining its percentage ownership of RioPort.
8
<PAGE> 9
Investment in S3-VIA, Inc.
In November 1999, the Company established a joint venture with VIA
Technologies, Inc. ("VIA") to bring high-performance integrated graphics and
core logic chip sets to the volume OEM desktop and notebook PC markets. The
newly formed S3-VIA, Inc. will have joint funding, exclusive access to both
companies' technology and distribution rights for developed products between S3
and VIA. The Company owns 50.1% of the voting common stock of the joint venture.
Accordingly, the Company consolidates the accounts of S3-VIA, Inc. in its
consolidated financial statements.
5. Notes Payable
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. The notes bear interest at 10% per annum commencing
on the individual note's maturity dates if such notes are not paid. In July
2000, the Company terminated the "take and pay" contract with Taiwan
Semiconductor Manufacturing Company ("TSMC") and a foundry relationship with
United Microelectronics Corporation ("UMC"). The Company's agreement with TSMC
provided capacity through 2002 and requires the Company to make annual advance
payments to purchase specified capacity to be applied against the following
year's capacity or to forfeit advance payments against those amounts. The
Company received a refund of approximately $4.8 million and the notes payable
were cancelled.
At September 30, 2000, the Company had a $50.0 million domestic bank
facility permitting borrowings at the prime rate. This bank facility expires in
January 2001. The covenants covering this debt agreement pertain to minimum
levels of collateral coverage and tangible net worth, quarterly profitability
and minimum levels of liquidity. As of September 30, 2000, the Company is in
compliance with all loan covenants. Additionally, the Company has credit
facilities under foreign lines of credit. The Company has a foreign line of
credit of 10 million Deutsche Marks (approximately $4.5 million at September 30,
2000). The Company also has a foreign line of credit of 400,000 British Pounds
(approximately $.6 million at September 30, 2000). There were no borrowings
under these foreign credit facilities at September 30, 2000.
As of September 30, 2000, the Company's future payments on debt related
to notes payable, lines of credit and capital lease obligations are due in 2000,
therefore all amounts have been classified as current.
6. Earnings (Loss) Per Share
Basic earnings (loss) 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.
When computing earnings (loss) per share, the Company includes only
potential common shares that are dilutive. Exercise of options and conversion of
convertible debt in the three months ended September 30, 2000, three months
ended September 30, 1999 and nine months ended September 30, 1999 are not
assumed because the result would have been anti-dilutive.
The following table sets forth the computation of basic and diluted
earnings (loss) per share:
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------- ------------------------
2000 1999 2000 1999
-------- -------- -------- --------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
NUMERATOR
Net income (loss)
Basic $(75,648) $(11,098) $380,337 $(23,877)
Interest expense on subordinated debt -- -- 2,898 --
-------- -------- -------- --------
Diluted $(75,648) $(11,098) $383,235 $(23,877)
======== ======== ======== ========
DENOMINATOR
Denominator for basic earnings (loss) per 92,573 55,419 89,416 53,284
share
Common stock equivalents -- -- 6,378 --
Subordinated debt -- -- 5,385 --
-------- -------- -------- --------
Denominator for diluted earnings (loss) 92,573 55,419 101,179 53,284
per share
======== ======== ======== ========
Basic earnings (loss) per share $ (0.82) $ 0.20 $ 4.25 $ (0.45)
Diluted earnings (loss) per share $ (0.82) $ 0.20 $ 3.79 $ (0.45)
</TABLE>
9
<PAGE> 10
7. Comprehensive Income (Loss)
The Company's available-for-sale securities and foreign currency
translation adjustments are included in other comprehensive income (loss).
The following are the components of accumulated other comprehensive
loss, net of tax:
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
2000 1999
------------ -----------
(IN THOUSANDS)
<S> <C> <C>
Unrealized gain (loss) on investments $(117,668) $ 803
Foreign currency translation (8,384) (8,366)
--------- ---------
adjustments
Accumulated other comprehensive loss $(126,052) $ (7,563)
========= =========
</TABLE>
The following schedule of other comprehensive loss shows the gross
current-period gain (loss) and the reclassification adjustment:
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------- ---------------------------
2000 1999 2000 1999
--------- --------- --------- ---------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
Unrealized gain on investments:
Unrealized (loss)on available-for-sale $ (71,340) $ 392 $(118,471) $ (158)
securities
Less: reclassification adjustment for (gain)
loss realized in net income 1,996 (11) -- 56
--------- --------- --------- ---------
Net unrealized loss on investments (69,944) 381 (118,471) (102)
Foreign currency translation adjustments (9) 26 (18) (1,552)
--------- --------- --------- ---------
Other comprehensive income (loss) $ (47,497) $ 407 $(118,489) $ (1,654)
========= ========= ========= =========
</TABLE>
8. Contingencies
The semiconductor and personal computing products industries are
characterized by frequent litigation, including litigation regarding patent and
other intellectual property rights. The Company is party to various legal
proceedings that arise in the ordinary course of business. 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.
Since November 1997, a number of complaints have been filed in federal
and state courts seeking unspecified damages on behalf of an alleged class of
persons who purchased shares of the Company's common stock at various times
between April 18, 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. In addition, certain stockholders have filed derivative
actions in the state courts of California and Delaware seeking recovery on
behalf of the Company, alleging, among other things, breach of fiduciary duties
by such individual defendants. The plaintiffs in the derivative action in
Delaware have not taken any steps to pursue their case. The derivative cases in
California State court have been consolidated, and plaintiffs have filed a
consolidated amended complaint. The court has entered a stipulated order in
those derivative cases suspending court proceedings and coordinating discovery
in them with discovery in the class actions in California State courts. On
plaintiffs' motion, the federal court has dismissed the federal class actions
without prejudice. The class actions in California State court have been
consolidated, and plaintiffs have filed a consolidated amended complaint. The
Company has answered that complaint. Discovery is pending. While management
intends to defend the actions against the Company vigorously, there can be no
assurance that an adverse result or settlement with regard 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 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.
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The Company has been defending several putative class action lawsuits
naming Diamond, which were filed in June and July 1996 and June 1997 in the
California Superior Court for Santa Clara County and the U.S. District Court for
the Northern District of California. Certain former executive officers and
directors of Diamond are also named as defendants. The plaintiffs purport to
represent a class of all persons who purchased Diamond's Common Stock between
October 18, 1995 and June 20, 1996 (the "Class Period"). The complaints allege
claims under the federal securities laws and California law. The plaintiffs
allege that Diamond and the other defendants made various material
misrepresentations and omissions during the Class Period. The complaints do not
specify the amount of damages sought. On March 24, 2000, the District Court for
the Northern District of California dismissed the federal action without
prejudice. The parties have tentatively agreed to settle this matter, subject
to final documentation and court approval, for a payment of $15.0 million. The
Company funded $4.5 million of the settlement on November 1, 2000. The Company
previously accrued this amount in connection with the merger with Diamond. The
Company believes that Diamond's insurance covers the remaining $10.5 million of
the settlement and Diamond's insurers have paid that amount into the
settlement.
Sega initiated a claim for arbitration in Tokyo, Japan against Diamond
in December 1998. The claim arises out of an agreement entered into between Sega
and Diamond in September 1995, in which Sega agreed to provide Diamond with Sega
game software that Diamond would bundle with its 3-D graphics board "The Edge."
Sega claims that Diamond breached the parties' agreement by failing to pay Sega
a contractual minimum royalty fee for the games as set forth in the agreement.
Sega claims as damages $3,800,000 in unpaid royalties and pre-judgment interest.
On May 28, 1999, Diamond responded to Sega's claims by filing an answer in which
it denied the material allegations of Sega's claims. The parties have filed
additional briefs in support of their claims and defenses. An evidentiary
hearing on this action has not yet been scheduled. The Company contests the
material allegations of Sega's claims. In addition, the Company has pleaded that
Sega's failure to provide it with 3-D optimized game software on a timely basis
adversely affected sales of The Edge. The Company claims that these lost sales
and profits should provide an offset to Sega's claims in the arbitration and
intends to defend the suit vigorously.
C3 Sales, Inc. ("C3") filed suit against S3 on October 6, 1999 in the
Harris County (Houston), Texas District Court. The petition sought a judicial
declaration that a Sales Representative Agreement entered into between C3 and S3
on May 19, 1999 was a valid contract that governed the relationship between the
two parties. On November 8, 1999, S3 answered acknowledging that the May 19,
1999 agreement was a contract between the two parties. C3 failed to respond to
informal requests by S3 to dismiss the declaratory relief action on grounds that
no justifiable controversy existed between the parties. On December 3, 1999, S3
filed a summary judgment motion seeking judgment against C3 on the grounds that
no issues of material fact remain to be determined regarding the declaratory
judgment sought by C3. C3 responded by filing an amended petition raising new
matters. Specifically, C3's new claims allege that the Sales Representative
Agreement applies to Diamond products, and that certain commissions due under
the agreement have not been paid. S3 intends to defend this action vigorously.
On January 6, 2000, PhoneTel Communications, Inc. ("PhoneTel") filed a
complaint for patent infringement against a group of defendants, including
Diamond, in the United States District Court for the Northern District of Texas.
PhoneTel generally alleges that Diamond and the other defendants are infringing
its two patents by making, using, selling, offering to sell and/or importing
digital synthesizers, personal computers, sound cards, or console game systems.
PhoneTel does not specify which Diamond products allegedly infringe its patents.
S3 filed Diamond's answer to the complaint on March 28, 2000. S3 believes that
the complaint is without merit and will vigorously defend itself against the
allegations made in the complaint.
The ultimate outcome of these actions cannot be presently determined.
Accordingly, no provision for any liability or loss that may result from
adjudication or settlement of the lawsuits has been made in the accompanying
condensed consolidated financial statements.
9. Proposed Joint Venture
The Company and VIA entered into an Investment Agreement dated as of
April 10, 2000 (the "Agreement"). Pursuant to the Agreement, the Company and VIA
will form a new joint venture (the "Joint Venture") for the purpose of
manufacturing and distributing graphics products and conducting related research
and development activities. On July 1, 2000, the Investment Commission of
Ministry of Economic Affairs of the Taiwan Government informed VIA that it would
not approve the transaction as proposed, but that VIA could reapply for
approval. In response the Company and VIA subsequently entered into an Amended
and Restated Investment Agreement dated as of August 28, 2000 (the "Restated
Agreement") that changes, adds to or eliminates some of the Agreement's terms.
At the closing of the transactions contemplated by the Restated Agreement, the
Company will transfer to the Joint Venture its graphics chip business in
exchange for 100,000,000 shares of Class A common stock of the Joint Venture. In
addition, the Restated Agreement provides that at the closing, VIA will deliver
to the Joint Venture $208 million in cash or a combination of cash or a
combination of cash and S3 equity securities, which in turn will be delivered by
the Joint Venture to the Company, in exchange for 30,000,000 hares of Class B
common stock of the Joint Venture. The S3 equity securities will be valued at
$16.00 per share of common stock. VIA has placed 6,000,000 shares of S3 common
stock into escrow to secure its payment obligations under the Restated
Agreement. The Joint Venture will assume certain
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liabilities of the Company totaling approximately $56.3 million at the time the
Restated Agreement was signed. At the closing, the Company will issue VIA a
warrant to purchase 2,000,000 shares of S3 common stock at an exercise price of
$10.00 per share.
The closing of the transactions contemplated by the Restated Agreement
is conditioned upon certain closing conditions, including the expiration or
early termination of the applicable waiting period under the Hart-Scott-Rodino
Antitrust Improvement Act and the approval of the government of Taiwan.
10. Subsequent Events
On November 1, 2000, the Company announced that it intends to change its
name to SONICblue Incorporated. The Company has filed an application to change
the ticker symbol for its common stock, which is quoted on the Nasdaq National
Market, to "SBLU". The Company expects the change of its name and ticker symbol
to become effective on November 15, 2000.
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PART I. CONDENSED CONSOLIDATED FINANCIAL INFORMATION
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
When used in this Report, 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 personal computer ("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 Our Results" and elsewhere in this report, 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
S3(R) Incorporated ("S3" or the "Company") designs, develops,
manufactures and distributes multimedia, connectivity and Internet appliance
products for the PC and consumer appliance markets. The Company's products
include the Rio line of digital music players, the Fire series of NT workstation
3D graphics accelerators, the HomeFree line of home networking products and the
Supra line of modems. The Company has been a leading supplier of graphics and
multimedia accelerator subsystems for PCs for over ten years.
In September 1999, S3 made a significant strategic shift by merging with
Diamond Multimedia Systems, Inc. ("Diamond"), an established original PC
equipment manufacturer ("OEM") and retail provider of communications and home
networking solutions, PC graphics and audio add-in boards, digital audio players
and Internet appliances. The transaction was accounted for as a purchase and,
accordingly, the results of operations of Diamond and the estimated fair value
of assets acquired and liabilities assumed are included in the Company's
consolidated financial statements as of September 24, 1999, the effective date
of the purchase.
In October 1999, S3 announced that it caused RioPort.com Inc., which was
a wholly owned subsidiary, to sell shares of its preferred stock to third party
venture capital and strategic investors. RioPort.com, Inc. is developing an
integrated platform for acquiring, managing and experiencing music and spoken
audio programming from the Internet. As a result of the preferred stock
financing, the Company retained a minority investment in RioPort.com, Inc. and
accounts for its investment using the equity method of accounting. In addition,
in November 1999, the Company received $10.9 million for the sale of OneStep,
LLC to RioPort.com, Inc. In June 2000, RioPort sold additional preferred stock
to third party investors. As part of this financing, the Company invested an
additional $10.7 million in RioPort, maintaining its percentage ownership of
RioPort.
In November 1999, the Company established a joint venture with VIA
Technologies, Inc. to bring high-performance integrated graphics and core logic
chip sets to the volume OEM desktop and notebook PC markets. The newly formed
S3-VIA Inc. will have joint funding, exclusive access to both companies'
technology and distribution rights for developed products between S3 and VIA.
The Company owns 50.1% of the voting common stock of the joint venture.
Accordingly, the Company consolidates the accounts of S3-VIA Inc. in its
consolidated financial statements.
The Company and VIA Technologies, Inc., a corporation organized under
the laws of Taiwan ("VIA"), entered into an Investment Agreement, dated as of
April 10, 2000. The Company and VIA subsequently entered into an Amended and
Restated Investment Agreement dated as of August 28, 2000. Pursuant to these
agreements, the Company and VIA will form a new joint venture (the "Joint
Venture") for the purposes of manufacturing and distributing graphics products
and conducting related research and development activities. See "Recent
Developments."
In August 2000, the Company began the shutdown of its Diamond
Multimedia-branded graphics add-in board business. The Company will continue to
supply and support its OEM customers, channel partners and end-users for the
existing line of Diamond Multimedia-branded PC graphics add-in cards, but will
cease development of follow-on products. The shutdown does not extend to the
Company's professional graphics division headquartered in Germany, which
continues to develop and market its Fire line of NT workstation 3D graphics
accelerators.
In September 2000, the Company announced the formation of frontpath, a
wholly owned subsidiary. frontpath plans to develop and market information
appliance products and services delivering personalized communication solutions.
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frontpath is developing its initial product, an approximately three-pound
broadband-based, wireless information appliance.
On November 1, 2000, the Company announced that it intends to change its
name to SONICblue Incorporated, effective November 15, 2000. See "Recent
Developments."
RESULTS OF OPERATIONS
The following table sets forth certain financial data for the periods
indicated as a percentage of net sales:
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------- ----------------------
2000 1999 2000 1999
------ ------ ------ ------
<S> <C> <C> <C> <C>
Net sales 100.0% 100.0% 100.0% 100.0%
Cost of sales 114.5 77.7 100.4 75.3
------ ------ ------ ------
Gross margin (14.5) 22.3 (0.4) 24.7
Operating expenses:
Research and development 15.5 24.2 14.6 30.6
Selling, marketing and administrative 22.2 13.3 20.1 15.0
Restructuring expense 6.4 -- 2.1 --
Other operating expense -- 9.5 -- 3.9
Amortization of goodwill and intangibles 8.4 1.3 7.6 0.5
------ ------ ------ ------
Total operating expenses 52.5 48.3 44.4 50.0
------ ------ ------ ------
Loss from operations (67.0) (26.0) (44.8) (25.3)
Gain on sale of manufacturing joint venture -- 10.6 3.4 8.5
Gain (loss) on UMC investment (4.6) -- 199.7 --
Gain on VIA investment -- -- 1.4 --
Other income (expense), net (2.3) (0.3) (0.6) 0.2
------ ------ ------ ------
Income (loss) before income taxes and equity
in income (loss) of manufacturing joint venture
and minority interest in RioPort.com, Inc. (73.8) (15.7) 159.1 (16.6)
Income tax expense (benefit) (21.9) -- 70.0 --
------ ------ ------ ------
Income (loss) before equity in income of manufacturing
joint venture and minority interest in (51.9) (15.7) 89.1 (16.5)
RioPort.com, Inc.
Equity in income from manufacturing joint venture -- -- -- 2.7
Minority interest in RioPort.com, Inc. (2.1) -- (2.1) --
------ ------ ------ ------
Net income (loss) (54.0)% (15.7)% 86.9% (13.9)%
====== ====== ====== ======
</TABLE>
NET SALES
The Company's net sales year to date have been generated from the sale
of its graphics and multimedia accelerators, connectivity products for the home
and products for acquiring, managing and experiencing music and spoken audio
programming from the Internet. The Company's products are used in, and its
business is dependent upon, the personal computer industry and growth of the
Internet with sales primarily in the U.S., Asia and Europe. Net sales were
$140.0 million for the three months ended September 30, 2000; a 98.6% increase
from the $70.5 million of net sales for the three months ended September 30,
1999. Net sales were $437.5 million for the nine months ended September 30,
2000; a 154.3% increase from the $172.0 million of net sales for the nine months
ended September 30, 1999. Sales increased from 1999 to 2000 because of the
acquisition of Diamond and the inclusion of the revenue of Diamond products in
the Company's financial results of operations in the three months ended
September 30, 2000 and nine months ended September 30, 2000. Net sales for the
three months ended September 30, 2000 and nine months ended September 30, 2000
consisted primarily of the Company's graphics chips, Diamond brand graphics
add-in cards, modem and communication products and Rio digital audio players
while net sales for the three months ended September 30, 1999 and nine months
ended September 30, 1999 consisted primarily of the Company's graphics chips.
The net sales for the three months and nine months ended September 30, 2000 for
the Company's graphics chips, excluding graphics chips integrated in the
Company's Diamond brand graphics add-in cards, were $18.9 million and $77.7
million respectively.
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.
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International sales accounted for 50% and 67% of net sales for the three
months ended September 30, 2000 and 1999, respectively. International sales
accounted for 53% and 58% of net sales for the nine months ended September 30,
2000 and 1999, respectively. Approximately 47% and 63% of international sales
for the three months ended September 30, 2000 and 1999, respectively, were to
affiliates of United States customers. Approximately 34% and 52% of
international sales for the nine months ended September 30, 2000 and 1999,
respectively, were to affiliates of United States customers. The shift in
international and domestic sales distribution in 2000 was primarily the result
of the inclusion of the acquired multimedia and communications products from the
Diamond acquisition. The Company expects that international sales will continue
to represent a significant portion of net sales, although there can be no
assurance that international 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 23% of net sales for the three months ended
September 30, 2000. Two customers accounted for 28% and 13% of net sales,
respectively, for the three months ended September 30, 1999. One customer
accounted for 20% of net sales for the nine months ended September 30, 2000. One
customer and one distributor accounted for 26% and 16% of net sales,
respectively, for the nine months ended September 30, 1999. 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 or the loss of a strategic customer could have a
material adverse effect on the Company's operating results.
GROSS MARGIN
Gross margin percentage decreased to (14.5)% for the three months ended
September 30, 2000 from 22.3% for the three months ended September 30, 1999.
Gross margin percentage decreased to (0.4)% for the nine months ended September
30, 2000 from 24.7% for the nine months ended September 30, 1999. The decrease
was primarily the result of inclusion of manufacturing costs for the Diamond
products and the write-down of inventory relating to the shutdown of its Diamond
Multimedia branded graphics add-in board business. Another factor resulting in
the decreased gross margin is the highly competitive pricing pressures in the
market for mainstream and entertainment graphics accelerators. This was
partially offset by improving margins on the Company's desktop chips and
communications products.
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 and the extent to which
the Company incurs additional licensing fees.
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 $21.7 million for
the three months ended September 30, 2000; a decrease of $2.1 million from $17.1
million for the three months ended September 30, 1999. This decrease was
primarily due to reduction in headcount and related personnel costs resulting
from the shutdown of the Company's Diamond Multimedia-branded graphics add-in
board business. Research and development expenses were $63.7 million for the
nine months ended September 30, 2000; an increase of $4.4 million from $59.3
million for the nine months ended September 30, 1999. This increase was due
primarily to inclusion of headcount and related expenses associated with the
Diamond acquisition partially offset by an increased focus on core technology
and products. Concentration of research and development efforts resulted in
lower overhead, headcount and related costs.
SELLING, MARKETING AND ADMINISTRATIVE EXPENSES
Selling, marketing and administrative expenses consist primarily of
salaries, related benefits and fees for professional services, such as legal and
accounting services. Selling, marketing and administrative expenses were $31.0
million for the three months ended September 30, 2000; an increase of $21.6
million from $9.4 million for the three months ended September 30, 1999.
Selling, marketing and administrative expenses were $88.1 million for the nine
months ended September 30, 2000; an increase of $62.4 million from $25.7 million
for the nine months ended September 30, 1999. Selling, marketing and
administrative expenses increased from the prior year due primarily to the
integration and combination of selling, marketing and administrative headcount
and related
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expenses due to the acquisition of Diamond. As a percentage of revenue, selling,
marketing and administrative expenses increased from 15.0% in 1999 to 20.1% in
2000.
RESTRUCTURING EXPENSE
In August 2000, the Company began the shutdown of its Diamond
Multimedia-branded add-in board business to reflect its long term strategy and
focus. Restructuring expenses of $9.0 million for the three months ended
September 30, 2000 related to the shutdown included write-off of intangibles,
inventory reserves and accrued facilities expenses. Expenses associated with
facilities shut down and personnel severance compensation and related expenses
were also incurred.
GAIN ON SALE OF MANUFACTURING JOINT VENTURE
In June 1999, the Company amended its agreements with UMC. Under the
terms of the amended agreements, UMC has agreed to pay the Company, subject to
certain conditions, 1.4 billion New Taiwan dollars (approximately $43.3 million
in cash) and the Company has agreed to release UMC from contingencies associated
with the sale in January 1988 of 80 million shares of stock of USC and to grant
a license to patents covering multimedia products and integrated circuit
manufacturing technology for use in products manufactured by UMC. Payments are
being received over five fiscal quarters beginning in the quarter ended
September 30, 1999. The gain on sale of manufacturing joint venture was $14.7
million for the nine months ended September 20, 2000.
GAIN (LOSS) ON UMC INVESTMENT
In June 1999, the Company announced that it would receive $42.0 million
for a patent license and release associated with the sale of 80 million shares
its stock of United Semiconductor Corporation ("USC") in January 1998. Payments
will be received over five fiscal quarters beginning in the quarter ended
September 30, 1999. Under the terms of the agreement, S3 will license to United
Microelectronics Corporation ("UMC") 29 patents covering multimedia products
and integrated circuit manufacturing technology for use in products
manufactured by UMC.
In June 1999, UMC announced a foundry consolidation plan whereby USC,
United Integrated Circuits Corporation, United Silicon Incorporated and UTEK
Semiconductor Corporation would be merged into UMC. Under the terms of the
consolidation plan, each of the Company's shares in the USC joint venture would
be exchanged for one share of UMC. On January 4, 2000, the Company's 252
million shares of USC were exchanged for 252 million shares of UMC stock. The
Company recorded a gain on the transfer of the shares of $880.2 million to
recognize the difference in the carrying value of its investment in USC and the
fair market value of the UMC shares on the date of the transfer. Approximately
half of the shares received are subject to sale restrictions and are carried at
market value as of January 4, 2000 as long-term assets in the accompanying
balance sheet at September 30, 2000. As the remaining shares are publicly
traded, the investment is adjusted to fair market value in accordance with SFAS
115 and classified as short-term investments.
The Company received a 20% stock dividend, or approximately 50.4
million shares of UMC stock, in a transaction which was approved by the UMC's
shareholders at its Annual Shareholders Meeting on April 7, 2000. With the
stock dividend, the Company's investment holdings in UMC have increased to
approximately 302 million shares of UMC stock. The Company sold 10 million
shares of UMC stock in August 2000 on the Taiwan Stock Exchange receiving net
proceeds of $25.1 million. At September 30, 2000, approximately 166 million
shares are classified as a current asset with approximately 126 million shares
as a long-term asset. The loss on UMC investment for the three months ended
September 30, 2000 was $6.4 million with a gain of $873.7 million for the nine
months ended September 30, 2000.
OTHER INCOME (EXPENSE), NET
Other expense was $3.2 million for the three months ended September 30,
2000; an increase of $3.0 million from other expense of $0.2 million for the
three months ended September 30, 1999. Other expense was $2.5 million for the
nine months ended September 30, 2000; a decrease of $2.8 million from other
income of $0.3 million for the nine months ended September 30, 1999. The
increase was due primarily to a decrease in interest expense associated with
repayment of a line of credit assumed in the merger with Diamond, partially
offset by foreign currency translation gains.
INCOME TAXES
The Company's effective tax rates for the three months and nine months
ended September 30, 2000 and 1999 are 41.6% and 0%, respectively. The effective
tax rate for 2000 reflects expected tax payment on the adjusted taxable income
at the federal, state and international statutory rates. The effective tax rate
for 1999 reflects net operating losses with no realized tax benefit.
LIQUIDITY AND CAPITAL RESOURCES
Cash used for operating activities for the nine months ended September
30, 2000 was $247.9 million, as compared to $8.8 million cash provided by
operating activities for the nine months ended September 30, 1999. The Company's
net income of $380.3 million for the nine months ended September 30, 2000
included a non-cash gain on UMC investment of $873.7 million, and non operating
gains on other investments of $5.9 million and the sale of manufacturing joint
venture of $14.7 million. Cash used for operations for the nine months ended
September 30, 2000 was unfavorably impacted by increases in accounts receivable,
accrued liabilities and other liabilities and decreases in deferred revenue. In
addition, cash used for operations for the nine months ended September 30, 2000
was favorably impacted by depreciation, amortization and decreases in inventory,
prepaid expenses and other and accounts payable. The Company's net loss of $23.9
million for the nine months ended September 30, 1999 was partially offset by
depreciation, amortization and write-off of acquired in-process research and
development. In addition, cash provided by operations for the nine months ended
September 30, 1999 was favorably impacted by decreases in prepaid taxes, prepaid
expenses and increases in accounts payable and accrued liabilities, partially
offset by increases in accounts receivable and inventories and decreases in
deferred revenue.
Investing activities provided cash of $69.5 million for the nine months
ended September 30, 2000 and consisted primarily of purchases of short-term
investments, net, investments made in a number of privately held companies with
which the Company has business relationships and other technology resulting from
strategic investments and purchases of property and equipment, partially offset
by cash received from sale of UMC shares, and the increases in other assets.
Investing activities provided cash of $4.9 million for the nine months ended
September 30, 1999 and consisted primarily of sales of short-term investments,
net, cash received from UMC related to the sale of shares and cash received from
the sale of investment in real estate partnership, offset by the acquisition of
OneStep, LLC, the acquisition of Diamond, net of cash acquired and purchases of
property and equipment, net.
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Financing activities provided cash of $159.9 million and $28.1 million
for the nine months ended September 30, 2000 and 1999, respectively. Sales of
common stock, including $145.5 million received from the sale of stock to VIA,
was the financing activity generating cash during the nine months ended
September 30, 2000 which was offset partially by repayments of notes payable.
Sales of common stock, net, including $23.4 million received from the sale of
stock to two foreign investors, and the sale of a warrant to Intel were the
financing activities generating cash during the nine months ended September 30,
1999.
Working capital at September 30, 2000 and December 31, 1999 was $365.6
million and $100.1 million, respectively. At September 30, 2000, the Company's
principal sources of liquidity included cash and equivalents of $27.3 million
and $62.8 million in short-term investments. In addition, the Company held
shares of UMC valued at $340.1 million at September 30, 2000 based upon then
existing New Taiwan dollar to U.S. dollar exchange rates and UMC's market prices
on the Taiwan Stock Exchange. The Company's principle sources of liquidity at
December 31, 1999 included cash and equivalents of $45.8 million and $58.9
million of short-term investments. As of September 30, 2000, the Company had
short-term lines of credit and bank credit facilities totaling $55.0 million. At
December 31, 1999, the Company was in default with its loan covenants regarding
liquidity. The Company obtained a waiver for this violation. 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.
The Company is currently a party to certain legal proceedings.
Litigation could result in substantial expense to the Company. See "Part II-
Item 1. Legal Proceedings."
RECENT DEVELOPMENTS
In February 2000, the Company purchased substantially all of the assets
of Number Nine Visual Technology Corporation ("Number Nine"). Number Nine was a
supplier of graphics accelerator subsystems for PCs using S3 graphics chips. The
acquisition of the assets of Number Nine, a supplier to IBM, allows S3 to
consolidate its graphics business with IBM into a single source distribution
model and furthers S3's strategy of becoming a single graphics solution provider
to the PC graphics market. The acquisition also adds skilled hardware and
software engineering resources to S3's existing teams.
In February 2000, VIA purchased from the Company 10,775,000 shares of
the Company's Common Stock for an aggregate purchase price of $145,462,500
pursuant to the terms of an agreement entered into in December 1999.
The Company and VIA, entered into an Investment Agreement dated as of
April 10, 2000 (the "Agreement"). Pursuant to the Agreement, the Company and VIA
will form a new joint venture (the "Joint Venture") for the purpose of
manufacturing and distributing graphics products and conducting related research
and development activities. On July 1, 2000, the Investment Commission of
Ministry of Economic Affairs of the Taiwan Government informed VIA that it would
not approve the transaction as proposed, but that VIA could reapply for
approval. In response the Company and VIA subsequently entered into an Amended
and Restated Investment Agreement dated as of August 28, 2000 (the "Restated
Agreement") that changes, adds to or eliminates some of the Agreement's terms.
At the closing of the transactions contemplated by the Restated Agreement, the
Company will transfer to the Joint Venture its graphics chip business in
exchange for 100,000,000 shares of Class A common stock of the Joint Venture. In
addition, the Restated Agreement provides that at the closing, VIA will deliver
to the Joint Venture $208 million in cash or a combination of cash or a
combination of cash and S3 equity securities, which in turn will be delivered by
the Joint Venture to the Company, in exchange for 30,000,000 shares of Class B
common stock of the Joint Venture. The S3 equity securities will be valued at
$16.00 per share of common stock. VIA has placed 6,000,000 shares of S3 common
stock into escrow to secure its payment obligations under the Restated
Agreement. The Joint Venture will assume certain liabilities of the Company
totaling approximately $56.3 million at the time the Restated Agreement was
signed. At the closing, the Company will issue VIA a warrant to purchase
2,000,000 shares of S3 common stock at an exercise price of $10.00 per share.
The closing of the transactions contemplated by the Restated Agreement is
conditioned upon certain closing conditions, including the expiration or early
termination of the applicable waiting period under the Hart-Scott-Rodino
Antitrust Improvement Act and the approval of the government of Taiwan.
In August 2000, the Company began the shutdown of its Diamond
Multimedia-branded graphics add-in board business. The Company will continue to
supply and support its OEM customers, channel partners and end-users for the
existing line of Diamond Multimedia-branded PC graphics add-in cards, but will
cease development of follow-on products. The shutdown does not extend to the
professional graphics division of S3 headquartered in Germany, which continues
to develop and market graphics, its FireGL lines of graphics cards.
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On November 1, 2000, the Company announced that it intends to change its
name to SONICblue Incorporated. The Company has filed an application the change
the ticker symbol for its common stock, which is quoted on the Nasdaq National
Market, to "SBLU". The Company expects the change of name and ticker symbol to
become effective on November 15, 2000.
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YEAR 2000 COMPLIANCE
The Company is not aware of any material problems resulting from Year
2000 issues, either with its products, its internal systems, or the products or
services of third parties. The Company will continue to monitor its critical
computer applications and those of its suppliers and vendors throughout the year
2000 to ensure that any latent Year 2000 issues that may arise are addressed
promptly.
FACTORS THAT MAY AFFECT OUR RESULTS
We have recently changed the focus of our business and may be unsuccessful or
experience difficulties in implementing this change. If this occurs, our net
losses could increase significantly.
In April 2000, we announced that we agreed to transfer our PC graphics
semiconductor business to a newly formed joint venture with VIA Technologies and
are in the process of realigning our resources to focus on our Internet-related
businesses. We have a limited operating history with our Internet-related
businesses and our shift in focus may prove to be unsuccessful. In addition, the
industry is new and continually evolving. Our Internet-related businesses
compete with larger, more established competitors, and we may be unable to
achieve market success. If we are unsuccessful in implementing this business
strategy, our net losses could increase significantly.
If we cannot complete the formation of our new joint venture with VIA
Technologies, we could incur substantial losses.
The formation of the VIA joint venture is subject to customary closing
conditions, including the receipt of antitrust and other regulatory approvals,
including the approval of the government of Taiwan. We cannot assure you that
these conditions will be satisfied. We may be required to pay substantial sums
to VIA if other conditions in the joint venture agreement are not satisfied. If
we are unable to complete the formation of the joint venture, our graphics chip
business could be severely harmed because, among other things, we would have to
bear the expenses of that business while we have refocused our sales and
marketing resources on our Internet-related business.
We may not be able to successfully manage the growth and expansion of our
business.
In the past year, and particularly following the merger with Diamond,
the Company has experienced a significant expansion in the overall level of its
business and the scope of its operations, including manufacturing, research and
development, marketing, technical support, customer service, sales and
logistics. This expansion in scope has resulted in a need for significant
investment in infrastructure, process development and information systems. This
requirement includes, without limitation: securing adequate financial resources
to successfully integrate and manage the growing businesses and acquired
companies; retention of key employees; integration of management information,
product data management, control, accounting, telecommunications and networking
systems; establishment of a significant worldwide web and e-commerce presence;
consolidation of geographically dispersed manufacturing and distribution
facilities; coordination of suppliers; rationalization of distribution channels;
establishment and documentation of business processes and procedures; and
integration of various functions and groups of employees. Each of these
requirements poses significant, material challenges.
The Company's future operating results will depend in large measure on
its success in implementing operating, manufacturing and financial procedures
and controls, improving communication and coordination among the different
operating functions, integrating certain functions such as sales, procurement
and operations, strengthening management information and telecommunications
systems, and continuing to hire additional qualified personnel in certain areas.
There can be no assurance that the Company will be able to manage these
activities and implement these additional systems, procedures and controls
successfully, and any failure to do so could have a material adverse effect upon
the Company's short-term and long-term operating results.
Our quarterly and annual operating results are subject to fluctuations caused by
many factors, which could result in failing to achieve our revenue or
profitability expectations, resulting in a drop in the price of our common
stock.
Our quarterly and annual results of operations have varied significantly
in the past and are likely to continue to vary in the future due to a number of
factors, many of which are beyond our control. Any one or more of the factors
listed below or other factors could cause us to fail to achieve our revenue or
profitability expectations. The failure to meet market expectations could cause
a drop in our stock price. These factors include:
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- our ability to develop, introduce and market successfully new or
enhanced products;
- our ability to introduce and market products in accordance with
specialized customer design requirements and short design cycles;
- changes in the relative volume of sales of various products with
sometimes significantly different margins;
- changes in demand for our products and our customers' products;
- rapid changes in electronic commerce on which we or our customers may
not capitalize or which erode our traditional business base;
- frequent gains or losses of significant customers or strategic
relationships;
- unpredictable volume and timing of customer orders;
- the availability, pricing and timeliness of delivery of components for
our products;
- the availability of manufacturing capacity, including wafer capacity
using advanced process technologies;
- the timing of new product announcements or introductions by us or by our
competitors;
- product obsolescence and the management of product transitions;
- production delays;
- decreases in the average selling prices of products;
- seasonal fluctuations in sales; and
- general economic conditions, including economic conditions in Asia and
Europe in particular, that could affect the timing of customer orders
and capital spending and result in order cancellations or rescheduling.
Some or all of these factors could adversely affect demand for our products and
our future operating results.
Most of our operating expenses are relatively fixed in the short term.
We may be unable to rapidly adjust spending to compensate for any unexpected
sales shortfall, which could harm our quarterly operating results. Because the
lead times of firm orders are typically short in the graphics industry, we do
not have the ability to predict future operating results with any certainty.
Therefore, sudden changes that are outside our control, such as general economic
conditions, the actions or inaction of competitors, customers, third-party
vendors of operating systems software, and independent software application
vendors, may materially and adversely affect our performance.
We generally ship more products in the third month of each quarter than
in either of the first two months of the quarter, with levels of shipment in the
third month being higher towards the end of the month. This pattern is likely to
continue and makes future quarterly operating results less predictable.
Because of the above factors, you should not rely on period-to-period
comparisons of results of operations as an indication of future performance.
We experienced a net loss for the last two years and we may continue to
experience net losses in the future.
We had a net loss of $30.8 million for 1999 and a net loss of $113.2
million for 1998. These results occurred primarily because we did not offer
competitive products in the high end of the graphics and multimedia accelerator
market. As a result, our sales consisted of primarily older generation and lower
price products that were sold into markets that had significant price
competition. Our ability to achieve profitability depends on our success in
refocusing our business resources and in executing our business plan for our
refocused business. We cannot assure you that we will be able to achieve or
maintain profitability.
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If we do not continue to develop and market new and enhanced products, we will
not be able to compete successfully in our markets.
The markets for which our products are designed are intensely
competitive and are characterized by short product life cycles, rapidly changing
technology, evolving industry standards and declining average selling prices. As
a result, we cannot succeed unless we consistently develop and market new
products that meet customer demands. We believe this will require expenditures
for research and development in the future consistent with our historical
research and development expenditures. To succeed in this environment, we must
anticipate the features and functionality that customers will demand. We must
then incorporate those features and functionality into products that meet the
design, performance, quality and pricing requirements of the personal computer
and other markets in which we compete and the timing requirements of PC OEMs and
retail selling seasons. For example, we have a joint venture with VIA
Technologies to bring integrated graphics and core logic chip sets to the OEM
desktop and notebook PC markets. There can be no assurance that the joint
venture will be successful or that our existing products will be compatible with
new products. We have in the past experienced delays in completing the
development and introduction of new products. We have also experienced
compatibility issues with integrated products. We cannot assure you that we will
not experience similar delays in the future. In the past, our business has been
seriously harmed when we developed products that failed to achieve significant
market acceptance and therefore were unable to compete successfully in our
markets. Such a failure could occur again in the future.
The demand for our products has historically been weaker in certain quarters.
Due to industry seasonality, demand for PCs and PC related products and
for consumer electronic products is strongest during the fourth quarter of each
year and is generally slower in the period from April through August. This
seasonality may become more pronounced and material in the future to the extent
that:
- a greater proportion of our sales consist of sales into the retail/mass
merchant channel;
- PCs become more consumer-oriented or entertainment-driven products; or
- our net revenue becomes increasingly based on entertainment-related
products, including our Internet-related products such as our Rio
digital music players.
Also, to the extent we expand our European sales, we may experience relatively
weak demand in the third calendar quarter due to historically weak summer sales
in Europe.
We operate in markets that are intensely and increasingly competitive.
The consumer Internet device, personal computer multimedia and
communications markets in which we compete are intensely competitive and are
likely to become more competitive in the future. Because of this competition, we
face a constant and increasing risk of losing customers to our competitors. The
competitive environment also creates downward pressure on prices and requires
higher spending to address the competition, both of which tend to keep profit
margins lower. We believe that the principal competitive factors for our
products are:
- performance and quality;
- conformity to industry standard application programming interfaces, or
APIs;
- access to customers and distribution channels;
- reputation for quality and strength of brand;
- manufacturing capabilities and cost of manufacturing;
- price;
- product support; and
- ability to bring new products to the market in a timely manner.
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Historically, the gross profit margins on Diamond's products have been
lower than the margins on our products. As a result of the Diamond merger, our
average gross margins have been lower than they were prior to the merger,
thereby decreasing our average gross margins.
Many of our current and potential competitors have substantially greater
financial, technical, manufacturing, marketing, distribution and other
resources. These competitors may also have greater name recognition and market
presence, longer operating histories, greater market power and product breadth,
lower cost structures and larger customer bases. As a result, these competitors
may be able to adapt more quickly to new or emerging technologies and changes in
customer requirements. In addition, some of our principal competitors offer a
single vendor solution because they maintain their own semiconductor foundries
and may therefore benefit from certain capacity, cost and technical advantages.
In some markets where we are a relatively new entrant, such as modems, home
networking, sound cards and consumer electronics, including Internet music
players, we face dominant competitors that include 3Com (home networking and
modems), Creative Technologies (sound cards, modems and Internet music players),
Intel (home networking) and Sony (consumer electronic music players). In
addition, the markets in which we compete are expected to become increasingly
competitive as PC products support increasingly more robust multimedia functions
and companies that previously supplied products providing distinct functions
(for example, companies today primarily in the sound, modem, microprocessor or
motherboard markets) emerge as competitors across broader or more integrated
product categories.
In addition to graphics board manufacturers, our competitors include
OEMs that internally produce graphics chips or integrate graphics chips on the
main computer processing board of their personal computers, commonly known as
the motherboard, and makers of other personal computer components and software
that are increasingly providing graphics or video processing capabilities.
We operate in markets that are rapidly changing, highly cyclical and vulnerable
to sharp declines in demand and average selling prices.
We operate in the personal computer, graphics/video chip, Internet
appliance, and home networking markets. These markets are constantly and rapidly
changing and have in the past, and may in the future, experience significant
downturns. These downturns are characterized by lower product demand and
accelerated product price reductions. In the event of a downturn, we would
likely experience significantly reduced demand for our products. Although are
changing our focus to concentrate on our Internet-related businesses,
substantially all of our revenues are currently derived from products sold for
use in or with personal computers. In the near term, we expect to continue to
derive almost all of our revenues from the sale of products for use in or with
personal computers. Changes in demand in the personal computer and
graphics/video chip markets could be large and sudden. Since graphics board and
personal computer manufacturers often build inventories during periods of
anticipated growth, they may be left with excess inventories if growth slows or
if they have incorrectly forecasted product transitions. In such cases, the
manufacturers may abruptly stop purchasing additional inventory from suppliers
like us until the excess inventory has been used. This suspension of purchases
or any reduction in demands for personal computers generally, or for particular
products that incorporate our products, would negatively impact our revenues and
financial results. We may experience substantial period-to-period fluctuations
in results of operations due to these general semiconductor industry conditions.
If we are unable to continue to develop and market new and enhanced products,
our average selling prices and gross profits will likely decline.
We must continue to develop new products in order to maintain average
selling prices and gross margins. As the markets for our products continue to
develop and competition increases, we anticipate that product life cycles will
shorten and average selling prices will decline. In particular, average selling
prices and, in some cases, gross margins, for each of our products will decline
as products mature. A decline in selling prices may cause the net sales in a
quarter to be lower than those of a preceding quarter or corresponding quarter
in a prior year, even if more units were sold during that quarter than in the
preceding or corresponding quarter of a prior year. To minimize that, we must
successfully identify new product opportunities and develop and bring new
higher-end and higher-margin products to market in time to meet market demand.
The availability of new products is typically restricted in volume early in a
product's life cycle. If customers choose to wait for the new version of a
product instead of purchasing the current version, our ability to procure
sufficient volumes of these new products to meet customer demand will be
limited. If this happens, our revenues and operating margins could be harmed.
Our products have short product life cycles, requiring us to manage product
transitions successfully in order to remain competitive.
Our products have short product life cycles. For example, the life
cycles of Diamond's graphics boards typically range from six to twelve months
and the life cycles of our graphic chips typically range from twelve to eighteen
months. If we fail to introduce new
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products successfully within a given time frame, our competitors could gain
market share, which could cause us to lose revenue. Further, continued failure
to introduce competitive new products on time could also damage our brand name,
reputation and relationships with our customers and cause longer-term harm to
our financial condition. Our major OEM customers typically introduce new
computer system configurations as often as twice a year. Short product life
cycles are the result of frequent transitions in the computer market and in the
consumer market in which products rapidly incorporate new features and
performance standards on an industry-wide basis. Our graphics products must be
able to support the new features and performance levels being required by
personal computer manufacturers at the beginning of these transitions.
Otherwise, we would likely lose business as well as the opportunity to compete
for new design contracts until the next product transition. Failing to develop
products with required features and performance levels or a delay as short as a
few months in bringing a new product to market could significantly reduce our
revenues for a substantial period.
We may face inventory risks that are increased by a combination of short product
life cycles and long component lead times.
The short product life cycles of our products also give rise to a number
of risks involving product and component inventories. These risks are heightened
by the long lead times that are necessary to acquire some components of our
products. We may not be able to reduce our production or inventory levels
quickly in response to unexpected shortfalls in sales. This could leave us with
significant and costly obsolete inventory. Long component lead times could cause
these inventory levels to be higher than they otherwise would be and may also
prevent us from quickly taking advantage of an unexpected new product cycle.
This can lead to costly lost sales opportunities and loss of market share, which
could result in a loss of revenues. For example, the timing and speed of the
PCI-to-AGP bus transition and the SGRAM-to-SDRAM memory transition led to an
excess inventory of PCI and SGRAM-based products at Diamond and in its
distribution channel, which in turn resulted in lower average selling prices,
lower gross margins, end-of-life inventory write-offs, and higher price
protection charges during the second and third quarters of 1998. Further,
declining demand for an excess supply of Monster 3D II and competitive 3D gaming
products in the channel during the third quarter of 1998 resulted in rapidly
declining revenue and prices vis-a-vis the second quarter of 1998, and resulted
in price protection charges for this class of product in the third quarter of
1998. Our Internet-related device sales could be affected in the future by the
availability of flash memory, which is a key component of our Rio digital music
players and is currently subject to high market demand and allocations from
suppliers. We estimate and accrue for potential inventory write-offs and price
protection charges, but we cannot assure you that these estimates and accruals
will be sufficient in future periods, or that additional inventory write-offs
and price protection charges will not be required. The impact of these charges
on Diamond's operating results in 1998 and the first quarter of 1999 was
material. Any similar occurrence in the future could materially and adversely
affect our operating results.
We have only recently started to offer products intended to address all
performance segments of the commercial and consumer PC market.
We recently commenced shipments of our Savage2000 product, which is
designed to compete in multiple performance segments of the commercial and
consumer PC markets and to satisfy multiple-function market needs, such as
graphics, video and DVD support. We do not know whether Savage2000 or future
products will be able to compete successfully in those segments. If we are not
able to introduce and successfully market higher performance products, our gross
margin and profitability could be negatively affected.
Demand for our personal computer products may decrease if the same capabilities
provided by our products become available in operating systems or embedded in
other personal computer components.
A majority of our net sales are derived from the sale of graphics boards
and multimedia accelerators for PC subsystems. However, there is a trend within
the industry for lower performance graphics and video functionality to migrate
from the graphics board to other personal computer components or into operating
systems. We expect 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 others
have announced plans to develop chips that integrate graphics and processor
functions to serve the lower-cost PC market. These could significantly reduce
the demand for our products. Graphics boards are usually used in higher-end
personal computers offering the latest technology and performance features.
However, as graphics functionality becomes technologically stable and widely
accepted by personal computer users, it typically migrates to the personal
computer motherboard. We expect this trend to continue, especially with respect
to low-end graphics boards. In this regard, the MMX instruction set from Intel
and the expanded capabilities provided by the DirectX applications programming
interface from Microsoft have increased the capability of Microsoft's operating
systems to control display features that have traditionally been performed by
graphics boards. As a result of these trends of technology migration, our
success largely depends on our ability to continue to develop products that
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incorporate new and rapidly evolving technologies that manufacturers have not
yet fully incorporated onto personal computer motherboards or into operating
systems.
Although our joint venture with VIA is intended to produce integrated
graphics/core logic accelerator products that provide these functions, we have
traditionally offered only single function graphics accelerator chips or
chipsets. We have and intend to continue to expand the scope of our research and
development efforts to provide integrated graphics/core logic accelerator
products, which will require that we hire engineers skilled in these areas and
promote additional coordination among our design and engineering groups.
Alternatively, we may find it necessary or desirable to license or acquire
technology to enable us to provide these functions, and we cannot assure you
that any such technology will be available for license or purchase on terms
acceptable to us.
We depend on third parties for the manufacture of our products.
We conduct business with one of our current foundries by delivering
written purchase orders specifying the particular product ordered, quantity,
price, delivery date and shipping terms. This foundry is therefore not obligated
to supply products to us for any specific period, in any specific quantity or at
any specific price, except as may be provided in a particular purchase order. To
the extent a foundry terminates its relationship with us or our supply from a
foundry is 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, we may not have a sufficient amount of time to
replace the supply of products manufactured by that foundry. We may be unable to
obtain sufficient advanced process technology foundry capacity to meet customer
demand in the future. From time to time, we may evaluate 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. Accordingly, there can be no assurance that such sources will
be able or willing to satisfy our requirements on a timely basis or at
acceptable quality or per unit prices.
TSMC and UMC are both located in the Science-Based Industrial Park in
Hsin Chu City, Taiwan. We currently expect these foundries to supply the
substantial portion of our graphics accelerator chips and S3-VIA joint venture
products in 2000 and 2001. Disruption of operations at these foundries for any
reason, including work stoppages, political or military conflicts, earthquakes
or other natural disasters, could cause delays in shipments of our products
which could have a material adverse effect on our operating results. For
example, in September 1999, Taiwan experienced a major earthquake. The
earthquake and its resulting aftershocks caused power outages and significant
damage to Taiwan's infrastructure. The result was delays of shipments of our
products from the TSMC and UMC foundries in Taiwan. Any such future delays could
have a material adverse effect on our operating results.
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 our foundries' ability to supply our
products, which could have a material adverse effect on operating results.
We rely on independent subcontractors to manufacture, assemble and/or
test certain of our products. We procure our components, assembly and test
services and assembled products through purchase orders and we do not have
specific volume purchase agreements with each of our subcontractors. Most of our
subcontractors could cease supplying the services, products or components at any
time with limited or no penalty. If we need to replace a key subcontractor, we
could incur significant manufacturing set-up costs and delays. Also, we may be
unable to find suitable replacement subcontractors. Our emphasis on maintaining
low internal and channel inventory levels may exacerbate the effects of any
shortage that may result from the use of sole-source subcontractors during
periods of tight supply or rapid order growth. Further, some of our
subcontractors are located outside the United States, which may present
heightened process control, quality control, political, infrastructure,
transportation, tariff, regulatory, legal, import, export, economic or supply
chain management risks.
We historically have had significant product concentration and significantly
depend on the health of the graphics and multimedia accelerator market, which
means that a decline in demand for a single product, or in the graphics and
multimedia accelerator market in general, could severely impact overall revenues
and financial results.
Our revenues have historically been dependent on the markets for
graphics/video chips for PCs and on our ability to compete in those markets. Our
business would be materially harmed if we are unsuccessful in selling these
graphic chips. We have agreed to transfer our PC graphics semiconductor business
to a newly formed joint venture with VIA Technologies but our remaining business
will continue to have significant product concentration after the transfer.
Historically, over 75% of the net sales of our subsidiary, Diamond, have come
from sales of graphics and video accelerator subsystems. Diamond has introduced
audio subsystems, has entered the PC modem and home networking markets, and has
entered the PC consumer electronics market with the Rio digital audio player,
but graphics and video accelerator subsystems are expected to continue to
account for a significant portion of our sales for the
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foreseeable future. A decline in demand or average selling prices for graphics
and video accelerator subsystems, digital audio players, PC modem and home
networking markets, whether as a result of new competitive product
introductions, price competition, excess supply, widespread cost reduction,
technological change, incorporation of the products' functionality onto personal
computer motherboards or otherwise, would have a material adverse effect on our
sales and operating results.
A significant portion of our sales are concentrated within a limited number of
customers.
We expect a significant portion of our future sales to remain
concentrated within a limited number of strategic customers. If we lose one or
more of these customers, our operating results would be harmed.
One customer accounted for 23% of net sales for the three months ended
September 30, 2000. Two customers accounted for 28% and 13% of net sales,
respectively, for the three months ended September 30, 1999. One customer
accounted for 20% of net sales for the nine months ended September 30, 2000. One
customer and one distributor accounted for 26% and 16% of net sales,
respectively, for the nine months ended September 30, 1999. 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 or the loss of a strategic customer could have a
material adverse effect on the Company's operating results.
The manufacturers on which we depend may experience manufacturing yield problems
that could increase our per unit costs and otherwise jeopardize the success of
our products.
Our primary products, graphics chips, are difficult to manufacture. The
production of graphic chips requires a complex and precise process that often
presents problems that are difficult to diagnose and time-consuming or expensive
to solve. As a result, companies like us often experience problems in achieving
acceptable wafer manufacturing yields. Our chips are manufactured from round
wafers made of silicon. During manufacturing, each wafer is processed to contain
numerous individual integrated circuits, or chips. We may reject or be unable to
sell a percentage of wafers or chips on a given wafer because of:
- minute impurities,
- difficulties in the fabrication process,
- defects in the masks used to print circuits on a wafer,
- electrical performance,
- wafer breakage, or
- other factors.
We refer to the proportion of final good chips that have been processed,
assembled and tested relative to the gross number of chips that could be
constructed from the raw materials as our manufacturing yields. These yields
reflect the quality of a particular wafer. Depending on the specific product, in
the past, we negotiated with our manufacturers to pay either an agreed upon
price for all wafers or a price that is typically higher for only wafers of
acceptable quality. If the payment terms for a specific product require us to
pay for all wafers, and if yields associated with that product are poor, we bear
the risk of those poor manufacturing yields.
Our products could have design defects.
Product components may contain undetected errors or "bugs" when first
supplied to the Company that, despite testing by the Company, are discovered
only after certain of the Company's products have been installed and used by
customers. There can be no assurance that errors will not be found in the
Company's products due to errors in such products' components, or that any such
errors will not impair the market acceptance of these products or require
significant product recalls. Problems encountered by customers or product
recalls could materially adversely affect the Company's business, financial
condition and results of operations. Further, the Company continues to upgrade
the firmware, software drivers and software utilities that are incorporated into
or included with its hardware products. The Company's software products, and its
hardware products incorporating such software, are extremely complex
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due to a number of factors, including the products' advanced functionality, the
diverse operating environments in which the products may be deployed, the rapid
pace of technology development and change in the Company's target product
categories, the need for interoperability, and the multiple versions of such
products that must be supported for diverse operating platforms, languages and
standards. These products may contain undetected errors or failures when first
introduced or as new versions are released. The Company's return policies for
its graphics chips and boards may permit OEMs to return these products for full
credit within thirty days after receipt of products that do not meet product
specifications. In addition, the Company generally provides warranties for its
retail products allowing the return or repair of defective products. There can
be no assurance that, despite testing by the Company, by its suppliers and by
current or potential customers, errors will not be found in new products after
commencement of commercial shipments, resulting in loss of or delay in market
acceptance or product acceptance or in warranty returns. Such loss or delay
would likely have a material adverse effect on the Company's business, financial
condition and results of operations.
Additionally, new versions or upgrades to operating systems, independent
software vendor titles or applications may require upgrades to the Company's
software products to maintain compatibility with such new versions or upgrades.
There can be no assurance that the Company will be successful in developing new
versions or enhancements to its software or that the Company will not experience
delays in the upgrade of its software products. In the event that the Company
experiences delays or is unable to maintain compatibility with operating systems
and independent software vendor titles or applications, the Company's business,
financial condition and results of operations could be materially adversely
affected.
We are subject to risks relating to product returns and price protection.
We often grant limited rights to customers to return unsold inventories
of our products in exchange for new purchases, also known as "stock rotation."
We also often grant price protection on unsold inventory, which allows customers
to receive a price adjustment on existing inventory when our published price is
reduced. Also, some of our retail customers will readily accept returned
products from their own retail customers. These returned products are then
returned to us for credit. We estimate returns and potential price protection on
unsold inventory in our distribution channel. We accrue reserves for estimated
returns, including warranty returns and price protection, and since the fourth
quarter of 1998, we reserve the gross margin associated with channel inventory
levels that exceed four weeks of demand. We may be faced with further
significant price protection charges as our competitors move to reduce channel
inventory levels of current products, such as our Monster Fusion, as new product
introductions are made.
We depend on sales through distributors. If relationships with or sales through
distributors decline, our operating results will be harmed.
We sell our products through a network of domestic and international
distributors, and directly to major retailers/mass merchants, value-added
resellers and OEM customers. Our future success is dependent on the continued
viability and financial stability of our customer base. Computer distribution
and retail channels historically have been characterized by rapid change,
including periods of widespread financial difficulties and consolidation and the
emergence of alternative sales channels, such as direct mail order, telephone
sales by PC manufacturers and electronic commerce on the worldwide web. The loss
of, or a reduction in, sales to certain of our key distribution customers as a
result of changing market conditions, competition or customer credit problems
could materially and adversely affect our operating results. Likewise, changes
in distribution channel patterns, such as:
- increased electronic commerce via the Internet,
- increased use of mail-order catalogues,
- increased use of consumer-electronics channels for personal computer
sales, or
- increased use of channel assembly to configure PC systems to fit
customers' requirements
could affect us in ways not yet known. For example, the rapid emergence of
Internet-based e-commerce, in which products are sold directly to consumers at
low prices, is putting substantial strain on some of our traditional
distribution channels.
Inventory levels of our products in the two-tier distribution channels
generally are maintained in a range of one to two months of customer demand.
These channel inventory levels tend toward the low end of the months-of-supply
range when demand is stronger, sales are higher and products are in short
supply. Conversely, during periods when demand is slower, sales are lower and
products are abundant, channel inventory levels tend toward the high end of the
months-of-supply range. Frequently, in these situations, we attempt to ensure
that distributors devote a greater degree of their working capital, sales and
logistics resources to our products instead of to
26
<PAGE> 27
our competitors. Similarly, our competitors attempt to ensure that their own
products are receiving a disproportionately higher share of the distributors'
working capital and logistics resources. In an environment of slower demand and
abundant supply of products, price declines and channel promotional expenses are
more likely to occur and, should they occur, are more likely to have a
significant impact on our operating results. Further, in an event like this,
high channel inventory levels may result in substantial price protection
charges. These price protection charges have the effect of reducing net sales
and gross profit. Consequently, in taking steps to bring our channel inventory
levels down to a more desirable level, we may cause a shortfall in net sales
during one or more accounting periods. These efforts to reduce channel inventory
might also result in price protection charges if prices are decreased to move
product out to final consumers, having a further adverse impact on operating
results. We accrue for potential price protection charges on unsold channel
inventory. We cannot assure you, however, that any estimates, reserves or
accruals will be sufficient or that any future price reductions will not
seriously harm our operating results.
We rely on intellectual property and other proprietary information that may not
be adequately protected and that may be expensive to protect.
The industry in which we compete is characterized by vigorous protection
and pursuit of intellectual property rights. We rely heavily on a combination of
patent, trademark, copyright, and trade secret laws, employee and third-party
nondisclosure agreements and licensing arrangements to protect our intellectual
property. If we are unable to adequately protect our intellectual property, our
business may suffer from the piracy of our technology and the associated loss of
sales. Also, the protection provided to our proprietary technology by the laws
of foreign jurisdictions, many of which offer less protection than the United
States, may not be sufficient to protect our technology. It is common in the
personal computer industry for companies to assert intellectual property
infringement claims against other companies. Therefore, our products may also
become the targets of infringement claims. These infringement claims or any
future claims could cause us to spend significant time and money to defend our
products, redesign our products or develop or license a substitute technology.
We may be unsuccessful in acquiring or developing substitute technology and any
required license may be unavailable on commercially reasonable terms, if at all.
In addition, an adverse result in litigation could require us to pay substantial
damages, cease the manufacture, use, sale, offer for sale and importation of
infringing products, or discontinue the use of certain processes. Any of those
events could materially harm our business. Litigation by or against us could
result in significant expense to us and could divert the efforts of our
technical and management personnel, regardless of the outcome of such
litigation. However, even if claims do not have merit, we may be required to
dedicate significant management time and expense to defending ourselves if we
are directly sued, or assisting our OEM customers in their defense of these or
other infringement claims pursuant to indemnity agreements. This could have a
negative effect on our financial results. For example, Intel Corporation is
currently in litigation with VIA, with whom we recently entered into a joint
venture to bring high-performance integrated graphics and core logic chip sets
to the volume OEM desktop and notebook PC markets and with whom we recently
agreed to form a new joint venture into which our graphics chip business would
be transferred. The result of such litigation could have an adverse effect on
us.
Our products depend upon third-party certifications, which may not be granted
for future products, resulting in product shipment delays and lost sales.
We submit most of our products for compatibility and performance testing
to the Microsoft Windows Hardware Quality Lab because our OEM customers
typically require our products to have this certification prior to making volume
purchases. This certification typically requires up to several weeks to complete
and entitles us to claim that a particular product is "Designed for Microsoft
Windows." We may not receive this certification for future products in a timely
fashion, or at all, which could result in product shipment delays and lost
sales.
We may not be able to retain or integrate key personnel, which may prevent us
from succeeding.
We may not be able to retain our key personnel or attract other
qualified personnel in the future. Our success will depend upon the continued
service of key management personnel. The loss of services of any of the key
members of our management team or our failure to attract and retain other key
personnel could disrupt our operations and have a negative effect on employee
productivity and morale, decreasing production and harming our financial
results. In addition, the competition to attract, retain and motivate qualified
technical, sales and operations personnel is intense. We have at times
experienced, and continue to experience, difficulty recruiting qualified
software and hardware development engineers.
We depend on a limited number of third party developers and publishers that
develop graphics software products that will operate with and fully utilize the
capabilities of our products to generate demand for our products.
27
<PAGE> 28
Only a limited number of software developers are capable of creating
high quality entertainment software. Because competition for these resources is
intense and is expected to increase, a sufficient number of high quality,
commercially successful software titles compatible with our products may not be
developed. We believe that the availability of numerous high quality,
commercially successful software entertainment titles and applications
significantly affects sales of multimedia hardware to the PC-based interactive
3D entertainment market. We depend on third party software developers and
publishers to create, produce and market software titles that will operate with
our 3D graphics accelerators. If a sufficient number of successful software
titles are not developed, our product sales and revenues could be negatively
impacted. In addition, the development and marketing of game titles that do not
fully demonstrate the technical capabilities of our products could create the
impression that our technology offers only marginal or no performance
improvements over competing products. Either of these effects could have an
adverse effect on our product sales and financial results.
We depend on a limited number of suppliers from whom we do not have a guarantee
of adequate supplies, increasing the risk that a loss of or problems with a
single supplier could result in impaired margins, reduced production volumes,
strained customer relations and loss of business.
We obtain several of the components used in our products from single or
limited sources. If component manufacturers do not allocate a sufficient supply
of components to meet our needs or if current suppliers do not provide
components of adequate quality or compatibility, we may have to obtain these
components from distributors or on the spot market at a higher cost. We rarely
have guaranteed supply arrangements with our suppliers, and suppliers may not be
able to meet our current or future component requirements. If we are forced to
use alternative suppliers of components, we may have to alter our product
designs to accommodate these components. Alteration of product designs to use
alternative components could cause significant delays and could require product
recertification by our OEM customers or reduce our production of the related
products. In addition, from time to time we have experienced difficulty meeting
certain product shipment dates to customers for various reasons. These reasons
include component delivery delays, component shortages, system compatibility
difficulties and component quality deficiencies. Delays in the delivery of
components, component shortages, system compatibility difficulties and supplier
product quality deficiencies will continue to occur in the future. These delays
or problems have in the past and could in the future result in impaired margins,
reduced production volumes, strained customer relations and loss of business.
For example, DRAM and flash memory components, which are used in our graphics
boards and Rio digital audio players, significantly increased in price in
September 1999 due in part to supply interruptions arising from the earthquake
in Taiwan. In addition, industry-wide demand for flash memory components has
increased dramatically, causing increases in price and shortages in supply.
These price increases may have an adverse impact on our gross margin in future
periods. Also, in an effort to avoid actual or perceived component shortages, we
may purchase more of certain components than we may otherwise require. Excess
inventory resulting from such over-purchases, obsolescence or a decline in the
market value of such inventory could result in inventory write-offs, which would
have a negative effect on our financial results as happened in the first and
second quarters of 1998. Similarly, Diamond's perception of component shortages
caused Diamond to over-purchase certain components and pay surcharges for
components that subsequently declined in value in the second, third and fourth
quarters of 1998. In addition, our inventory sell-offs or sell-offs by our
competitors could trigger channel price protection charges, further reducing our
gross margins and profitability, as occurred with the Monster 3D II product line
in the third and fourth quarters of 1998.
We may experience product delivery delays due to the inadequacy or
incompatibility of software drivers. Such delays could hurt our sales.
Some components of our products require software drivers in order for
those components to work properly in a PC. These software drivers are essential
to the performance of nearly all of our products and must be compatible with the
other components of the graphics board and PC in order for the product to work.
Some of these products that include software drivers are among those products
based on components, including software drivers, that are supplied by a limited
number of suppliers. From time to time, we have experienced product delivery
delays due to inadequacy or incompatibility of software drivers either provided
by component suppliers or developed internally by them. These delays could cause
us to lose sales, revenues and customers. Software driver problems will continue
to occur in the future, and those problems could negatively affect our operating
results.
We have significant exposure to international markets.
International sales accounted for 50% and 67% of net sales for the three
months ended September 30, 2000 and 1999, respectively. International sales
accounted for 53% and 58% of net sales for the nine months ended September 30,
2000 and 1999, respectively. Approximately 47% and 63% of international sales
for the three months ended September 30, 2000 and 1999, respectively, were to
affiliates of United States customers. Approximately 34% and 52% of
international sales for the nine months ended September 30, 2000 and 1999,
respectively, were to affiliates of United States customers. In addition, a
substantial proportion of our products are
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<PAGE> 29
manufactured, assembled and tested by independent third parties in Asia. As
a result, we are 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 price in local
currencies of our products in foreign markets or increase the cost of
wafers and components purchased by us;
- delays resulting from difficulty in obtaining export licenses for
certain technology;
- tariffs and other trade barriers and restrictions;
- potentially longer payment cycles;
- greater difficulty in accounts receivable collection;
- potentially adverse tax treatment; and
- the burdens of complying with a variety of foreign laws.
In the past, we have experienced an adverse impact associated with the
economic downturn in Asia that contributed to decreases in net sales. In
addition, our international operations are subject to general geopolitical
risks, such as political and economic instability and changes in diplomatic and
trade relationships. The People's Republic of China and Taiwan have in the past
experienced and are currently experiencing strained relations, and a worsening
of relations or the development of hostilities between them could disrupt
operations at our foundries and affect our Taiwanese customers.
We are dependent on a limited source of graphics chips and graphics boards
because S3 and Diamond are each suppliers to each other, resulting in heightened
risks because one company's suppliers may not meet the other company's
requirements.
As a result of the merger with Diamond, we have become significantly
dependent on our graphics chip design and development capabilities and
significantly dependent on Diamond's graphics board design, manufacturing and
marketing capabilities. This occurred because we are now more restricted in our
ability to select and use products produced by our competitors prior to the
merger. If either our graphics chips or Diamond's graphics boards fail to meet
the requirements of the market and our customers, our relationship with those
customers could be hurt, negatively affecting our financial performance. In
addition, we will be highly dependent on our ability to provide graphics chips
on a timely basis meeting the rigid scheduling and product specification
requirements of OEMs. If our graphics chips are not competitive or not provided
on a timely basis, we will most likely not be able to readily obtain suitable
alternative graphics chips, which would result in our loss of revenue and
customers.
We have a significant level of debt.
At September 30, 2000, we had total debt and other long-term liabilities
outstanding of $215.4 million. The degree to which we are leveraged could
adversely affect our ability to obtain additional financing for working capital
or other purposes and could make us more vulnerable to economic downturns and
competitive pressures. Our significant leverage could also adversely affect our
liquidity, as a substantial portion of available cash from operations may have
to be applied to meet debt service requirements. In the event of a cash
shortfall, we could be forced to reduce other expenditures to be able to meet
such debt service requirements.
Our stock price is highly volatile and we expect that our stock price will
continue to be highly volatile.
The market price of our common stock has been highly volatile, like that
of the common stock of many other semiconductor companies. We expect our common
stock to remain volatile. This volatility may result from:
- general market conditions and market conditions affecting technology and
semiconductor stocks generally;
- actual or anticipated fluctuations in our quarterly operating results;
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<PAGE> 30
- announcements of design wins, technological innovations, acquisitions,
investments or business alliances, by us or our competitors; and
- the commencement of, developments in or outcome of litigation.
The market price of our common stock also has been and is likely to
continue to be significantly affected by expectations of analysts and investors,
especially if our operating results do not meet those expectations. Reports and
statements of analysts do not necessarily reflect our views. The fact that we
have in the past met or exceeded analyst or investor expectations does not
necessarily mean that we will do so in the future.
In the past, following periods of volatility in the market price of a
particular company's securities, securities class action litigation has often
been brought. This litigation could result in substantial costs and a diversion
of our management's attention and resources. We are currently involved in
securities class action litigation and Diamond is also involved in similar
proceedings.
We are a party to legal proceedings alleging securities violations that could
have a negative financial impact on us.
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 our common stock at various
times between April 18, 1996 and November 3, 1997. The complaints name us as
defendants as well as certain of our officers and former officers and certain of
our directors, asserting that we and they violated federal and state securities
laws by misrepresenting and failing to disclose certain information about our
business. In addition, certain shareholders have filed derivative actions in the
state courts of California and Delaware seeking recovery on our behalf,
alleging, among other things, breach of fiduciary duties by such individual
defendants. The plaintiffs in the derivative action in Delaware have not taken
any steps to pursue their case. The derivative cases in California State court
have been consolidated, and plaintiffs have filed a consolidated amended
complaint. The court has entered a stipulated order in those derivative cases
suspending court proceedings and coordinating discovery in them with discovery
in the class actions in California State courts. On plaintiffs' motion, the
federal court has dismissed the federal class actions without prejudice. The
class actions in California State court have been consolidated, and plaintiffs
have filed a consolidated amended complaint. The Company has answered that
complaint. Discovery is pending. While our management intends to defend the
actions against us vigorously, there can be no assurance that an adverse result
or settlement with regard to these lawsuits would not have a material adverse
effect on our financial condition or results of operations.
We have been defending several putative class action lawsuits naming
Diamond which were filed in June and July 1996 and June 1997 in the California
Superior Court for Santa Clara County and the U.S. District Court for the
Northern District of California. Certain former executive officers and directors
of Diamond are also named as defendants. The plaintiffs purport to represent a
class of all persons who purchased Diamond's Common Stock between October 18,
1995 and June 20, 1996 (the "Class Period"). The complaints allege claims under
the federal securities laws and California law. The plaintiffs allege that
Diamond and the other defendants made various material misrepresentations and
omissions during the Class Period. The complaints do not specify the amount of
damages sought. On March 24, 2000, the District Court for the Northern District
of California dismissed the federal action without prejudice. The parties have
tentatively agreed to settle this matter, subject to final documentation and
court approval, for a payment of $15.0 million. The Company funded $4.5 million
of the settlement on November 1, 2000. The Company previously accrued this
amount in connection with the merger with Diamond. The Company believes that
Diamond's insurance covers the remaining $10.5 million of the settlement and
Diamond's insurers have paid that amount into the settlement.
We have also received from the SEC a request for information relating to
our financial restatement announcement in November 1997. We have responded and
intend to continue to respond to the SEC requests.
Sega initiated a claim for arbitration in Tokyo, Japan against Diamond
in December 1998. The claim arises out of an agreement entered into between Sega
and Diamond in September 1995, in which Sega agreed to provide Diamond with Sega
game software that Diamond would bundle with its 3-D graphics board "The Edge."
Sega claims that Diamond breached the parties' agreement by failing to pay Sega
a contractual minimum royalty fee for the games as set forth in the agreement.
Sega claims as damages $3,800,000 in unpaid royalties and pre-judgment interest.
On May 28, 1999, Diamond responded to Sega's claims by filing an answer in which
it denied the material allegations of Sega's claims. The parties have filed
additional briefs in support of their claims and defenses. An evidentiary
hearing on this action has not yet been scheduled. The Company contests the
material allegations of Sega's claims. In addition, the Company has pleaded that
Sega's failure to provide it with 3-D optimized game software on a timely basis
adversely affected sales of The Edge. The Company claims that these lost sales
and profits should provide an offset to Sega's claims in the arbitration and
intends to defend the suit vigorously.
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<PAGE> 31
C3 Sales, Inc. ("C3") filed suit against S3 on October 6, 1999 in the
Harris County (Houston), Texas District Court. The petition sought a judicial
declaration that a Sales Representative Agreement entered into between C3 and S3
on May 19, 1999 was a valid contract that governed the relationship between the
two parties. On November 8, 1999, S3 answered acknowledging that the May 19,
1999 agreement was a contract between the two parties. C3 failed to respond to
informal requests by S3 to dismiss the declaratory relief action on grounds that
no justifiable controversy existed between the parties. On December 3, 1999, S3
filed a summary judgment motion seeking judgment against C3 on the grounds that
no issues of material fact remain to be determined regarding the declaratory
judgment sought by C3. C3 responded by filing an amended petition raising new
matters. Specifically, C3's new claims allege that the Sales Representative
Agreement applies to Diamond products, and that certain commissions due under
the agreement have not been paid. S3 intends to defend this action vigorously.
On January 6, 2000, PhoneTel Communications, Inc. ("PhoneTel") filed a
complaint for patent infringement against a group of defendants, including
Diamond, in the United States District Court for the Northern District of Texas.
PhoneTel generally alleges that Diamond and the other defendants are infringing
its two patents by making, using, selling, offering to sell and/or importing
digital synthesizers, personal computers, sound cards, or console game systems.
PhoneTel does not specify which Diamond products allegedly infringe its patents.
S3 filed Diamond's answer to the complaint on March 28, 2000. S3 believes that
the complaint is without merit and will vigorously defend itself against the
allegations made in the complaint.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
INVESTMENT PORTFOLIO
The Company does not use derivative financial instruments in its
investment portfolio. The Company places its investments in instruments that
meet high credit quality standards, as specified in the Company's investment
policy. The Company also limits the amount of credit exposure to any one issue,
issuer or type of investment. The Company does not expect any material loss with
respect to its investment portfolio.
The table below summarizes the Company's investment portfolio. The table
represents principal cash flows and related average fixed interest rates by
expected maturity date. The Company's policy requires that all investments
mature within twenty months.
Principal (Notional) Amounts Maturing in 2000 in U.S. Dollars:
<TABLE>
<CAPTION>
FAIR VALUE AT
SEPTEMBER 30, 2000
(IN THOUSANDS,
EXCEPT INTEREST RATES)
----------------------
<S> <C>
Cash and cash equivalents $27,303
Weighted average interest rate 5.09%
Other short-term investments $62,807
Weighted average interest rate 5.52%
Total portfolio $90,110
Weighted average interest rate 5.10%
</TABLE>
CONVERTIBLE SUBORDINATED NOTES
In September 1996, the Company completed a private placement of $103.5
million aggregate principal amount of convertible subordinated notes. The notes
mature in 2003. Interest is payable semi-annually at 5 3/4% per annum. The notes
are convertible at the option of the note holders into the Company's common
stock at an initial conversion price of $19.22 per share, subject to adjustment.
Beginning in October 1999, the notes are redeemable at the option of the Company
at an initial redemption price of 102% of the principal amount. The fair value
of the convertible subordinated notes at September 30, 2000 was approximately
$117.1 million.
IMPACT OF FOREIGN CURRENCY RATE CHANGES
The Company invoices its customers in US dollars for all products. The
Company is exposed to foreign exchange rate fluctuations as the financial
results of its foreign subsidiaries are translated into US dollars in
consolidation. The foreign subsidiaries maintain their accounts in the local
currency of the foreign location in order to centralize the foreign exchange
risk with the parent company. To date this risk has not been material.
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The effect of foreign exchange rate fluctuations on the Company's
financial statements for the three months ended September 30, 2000 and 1999 was
not material. Since foreign currency exposure increases as intercompany
receivables grow, from time to time the Company uses foreign exchange forward
contracts as a means for hedging these balances. As of September 30, 2000, the
Company held no exchange contracts.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
The semiconductor and personal computing products industries are
characterized by frequent litigation, including litigation regarding patent and
other intellectual property rights. The Company is party to various legal
proceedings that arise in the ordinary course of business. 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.
Since November 1997, a number of complaints have been filed in federal
and state courts seeking unspecified damages on behalf of an alleged class of
persons who purchased shares of the Company's common stock at various times
between April 18, 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. In addition, certain stockholders have filed derivative
actions in the state courts of California and Delaware seeking recovery on
behalf of the Company, alleging, among other things, breach of fiduciary duties
by such individual defendants. The plaintiffs in the derivative action in
Delaware have not taken any steps to pursue their case. The derivative cases in
California State court have been consolidated, and plaintiffs have filed a
consolidated amended complaint. The court has entered a stipulated order in
those derivative cases suspending court proceedings and coordinating discovery
in them with discovery in the class actions in California State courts. On
plaintiffs' motion, the federal court has dismissed the federal class actions
without prejudice. The class actions in California State court have been
consolidated, and plaintiffs have filed a consolidated amended complaint. The
Company has answered that complaint. Discovery is pending. While management
intends to defend the actions against the Company vigorously, there can be no
assurance that an adverse result or settlement with regard 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 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.
The Company has also been defending several putative class action
lawsuits naming Diamond, which were filed in June and July 1996 and June 1997 in
the California Superior Court for Santa Clara County and the U.S. District Court
for the Northern District of California. Certain former executive officers and
directors of Diamond are also named as defendants. The plaintiffs purport to
represent a class of all persons who purchased Diamond's Common Stock between
October 18, 1995 and June 20, 1996 (the "Class Period"). The complaints allege
claims under the federal securities laws and California law. The plaintiffs
allege that Diamond and the other defendants made various material
misrepresentations and omissions during the Class Period. The complaints do not
specify the amount of damages sought. On March 24, 2000, the District Court for
the Northern District of California dismissed the federal action without
prejudice. The parties have tentatively agreed to settle this matter, subject
to final documentation and court approval, for a payment of $15.0 million. The
Company funded $4.5 million of the settlement on November 1, 2000. The Company
previously accrued this amount in connection with the merger with Diamond. The
Company believes that Diamond's insurance covers the remaining $10.5 million of
the settlement and Diamond's insurers have paid that amount into the settlement.
Sega initiated a claim for arbitration in Tokyo, Japan against Diamond
in December 1998. The claim arises out of an agreement entered into between Sega
and Diamond in September 1995, in which Sega agreed to provide Diamond with Sega
game software that Diamond would bundle with its 3-D graphics board "The Edge."
Sega claims that Diamond breached the parties' agreement by failing to pay Sega
a contractual minimum royalty fee for the games as set forth in the agreement.
Sega claims as damages $3,800,000 in unpaid royalties and pre-judgment interest.
On May 28, 1999, Diamond responded to Sega's claims by filing an answer in which
it denied the material allegations of Sega's claims. The parties have filed
additional briefs in support of their claims and defenses. An evidentiary
hearing on this action has not yet been scheduled. The Company contests the
material allegations of Sega's claims. In addition, the Company has pleaded that
Sega's failure to provide it with 3-D optimized game software on a timely basis
adversely affected sales of The Edge. The Company claims that these lost sales
and profits should provide an offset to Sega's claims in the arbitration and
intends to defend the suit vigorously.
C3 Sales, Inc. ("C3") filed suit against S3 on October 6, 1999 in the
Harris County (Houston), Texas District Court. The petition sought a judicial
declaration that a Sales Representative Agreement entered into between C3 and S3
on May 19, 1999 was a valid
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<PAGE> 33
contract that governed the relationship between the two parties. On November 8,
1999, S3 answered acknowledging that the May 19, 1999 agreement was a contract
between the two parties. C3 failed to respond to informal requests by S3 to
dismiss the declaratory relief action on grounds that no justifiable controversy
existed between the parties. On December 3, 1999, S3 filed a summary judgment
motion seeking judgment against C3 on the grounds that no issues of material
fact remain to be determined regarding the declaratory judgment sought by C3. C3
responded by filing an amended petition raising new matters. Specifically, C3's
new claims allege that the Sales Representative Agreement applies to Diamond
products, and that certain commissions due under the agreement have not been
paid. S3 intends to defend this action vigorously.
On January 6, 2000, PhoneTel Communications, Inc. ("PhoneTel") filed a
complaint for patent infringement against a group of defendants, including
Diamond, in the United States District Court for the Northern District of Texas.
PhoneTel generally alleges that Diamond and the other defendants are infringing
its two patents by making, using, selling, offering to sell and/or importing
digital synthesizers, personal computers, sound cards, or console game systems.
PhoneTel does not specify which Diamond products allegedly infringe its patents.
S3 filed Diamond's answer to the complaint on March 28, 2000. S3 believes that
the complaint is without merit and will vigorously defend itself against the
allegations made in the complaint.
The ultimate outcome of these actions cannot be presently determined.
Accordingly, no provision for any liability or loss that may result from
adjudication or settlement of the lawsuits has been made in the accompanying
condensed consolidated financial statements.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
<TABLE>
<CAPTION>
EXHIBIT
NUMBER NOTES DESCRIPTION OF DOCUMENT
------ ----- -----------------------
<S> <C> <C>
27.1 Financial Data Schedule (filed only with the electronic submission of Form 10-Q in
accordance with the EDGAR requirements)
</TABLE>
(b) Reports on Form 8-K:
No reports on Form 8-K were filed during the quarter for which this
report is filed.
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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)
Date: November 14, 2000 /s/ WILLIAM F. MCFARLAND
--------------------------------------------
WILLIAM F. MCFARLAND
Controller and Interim Chief
Financial Officer
(Principal Financial and Accounting Officer)
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<PAGE> 35
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NUMBER NOTES DESCRIPTION OF DOCUMENT
------ ----- -----------------------
<S> <C> <C>
27.1 Financial Data Schedule (filed only with the electronic submission of Form 10-Q in
accordance with the EDGAR requirements)
</TABLE>
