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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 QUARTERLY PERIOD ENDED SEPTEMBER 30, 1996.
OR
[ ] TRANSITIONAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934.
FOR THE TRANSITION PERIOD FROM: TO: .
COMMISSION FILE NUMBER 0-26660
ESS TECHNOLOGY, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
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CALIFORNIA 94-2928582
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
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48401 FREMONT BOULEVARD
FREMONT, CALIFORNIA 94538
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)
(510) 492-1088
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
Indicate by check 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 [ ]
As of September 30, 1996, the registrant had 37,569,103 shares of common
stock outstanding.
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ESS TECHNOLOGY, INC.
TABLE OF CONTENTS
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PAGE
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets -- September 30, 1996 and December
31, 1995, unaudited..................................................... 3
Condensed Consolidated Statements of Operations -- three months and nine
months ended September 30, 1996 and 1995, unaudited..................... 4
Condensed Consolidated Statements of Cash Flows -- nine months ended
September 30, 1996 and 1995, unaudited.................................. 5
Notes to Condensed Consolidated Financial Statements.................... 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations........................................................... 9
PART II. OTHER INFORMATION
Item 1. Legal Proceedings....................................................... 16
Item 5. Other Information....................................................... 16
Item 6. Exhibits and Reports on Form 8-K........................................ 16
SIGNATURES ........................................................................ 17
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ESS TECHNOLOGY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(IN THOUSANDS)
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SEPTEMBER 30, DECEMBER 31,
1996 1995
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ASSETS
Current assets:
Cash and cash equivalents........................................ $ 3,451 $ 51,881
Short-term investments........................................... 29,259 26,243
Accounts receivable, net......................................... 24,393 10,236
Inventories...................................................... 31,440 19,169
Deferred income taxes............................................ 2,337 2,337
Prepaid expenses and other assets................................ 4,646 2,271
-------- --------
Total current assets.......................................... 95,526 112,137
Property and equipment, net........................................ 20,274 10,371
Other assets....................................................... 44,133 40,195
-------- --------
$159,933 $162,703
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses............................ $ 36,158 $ 33,744
Income taxes payable............................................. 1,925 3,722
Deferred income taxes............................................ 5,909 4,069
-------- --------
Total current liabilities..................................... 43,990 41,535
-------- --------
Long-term advances payable to vendors.............................. -- 15,960
-------- --------
Total liabilities............................................. 43,990 57,495
-------- --------
Commitments and contingencies (See Note 4)
Shareholders' equity:
Preferred stock, no par value, 10,000 shares authorized; none
issued and outstanding........................................... -- --
Common stock, no par value, 100,000 shares authorized; 37,569 and
36,794 shares issued and outstanding............................. 72,807 66,891
Deferred compensation related to stock options..................... (15) (60)
Retained earnings.................................................. 43,151 38,377
-------- --------
Total shareholders' equity.................................... 115,943 105,208
-------- --------
Total liabilities and shareholders' equity............... $159,933 $162,703
======== ========
</TABLE>
See notes to condensed consolidated financial statements.
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ESS TECHNOLOGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
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THREE MONTHS ENDED NINE MONTHS ENDED
------------------------------- -------------------------------
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
1996 1995 1996 1995
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Net revenues........................... $60,138 $31,389 $149,776 $68,893
Cost of revenues....................... 29,540 11,431 69,066 24,714
------- ------- -------- -------
Gross profit......................... 30,598 19,958 80,710 44,179
Operating expenses:
Research and development............. 5,577 2,666 13,760 6,005
Research and development
in-process........................ -- -- 30,355 --
Selling, general and
administrative.................... 4,352 1,920 10,540 6,909
------- ------- -------- -------
Operating income....................... 20,669 15,372 26,055 31,265
Nonoperating income, net............... 418 602 1,757 1,400
------- ------- -------- -------
Income before provision for income
taxes................................ 21,087 15,974 27,812 32,665
Provision for income taxes............. 8,224 6,530 23,038 13,378
------- ------- -------- -------
Net income............................. $12,863 $ 9,444 $ 4,774 $19,287
======= ======= ======== =======
Net income per share................... $ 0.31 $ 0.26 $ 0.11 $ 0.52
======= ======= ======== =======
Weighted average common and common
equivalent shares.................... 41,128 36,940 41,805 37,012
======= ======= ======== =======
</TABLE>
See notes to condensed consolidated financial statements
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ESS TECHNOLOGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
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NINE MONTHS ENDED
-------------------------------
SEPTEMBER 30, SEPTEMBER 30,
1996 1995
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Cash flows from operating activities:
Net income...................................................... $ 4,774 $19,287
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization................................ 2,267 640
Charges for research and development in-process.............. 30,355 --
Loss (gain) on sales of marketable equity securities, net.... -- (854)
Deemed compensation expense and compensation related to stock
options..................................................... 45 45
Other non cash activity...................................... -- (84)
Change in assets and liabilities (net of effects of VideoCore
and OSEE acquisitions):
Accounts receivable........................................ (14,157) (11,013)
Inventories................................................ (12,259) (10,736)
Deferred income taxes...................................... -- (902)
Prepaid expenses and other assets.......................... (2,521) (873)
Accounts payable and accrued expenses...................... 1,805 7,593
Income taxes payable....................................... (1,797) 875
------- -------
Net cash provided by operating activities............... 8,512 3,978
------- -------
Cash flows from investing activities:
Acquisition of property and equipment........................... (11,258) (3,309)
Sale of marketable equity securities and short-term
investments.................................................. 7,360 938
Purchase of marketable equity securities and short-term
investments.................................................. (10,376) --
Cash paid for VideoCore and OSEE acquisitions................... (9,288) --
------- -------
Net cash used in investing activities................... (23,562) (2,371)
------- -------
Cash flows from financing activities:
Repayment of long-term advances payable to vendors.............. (15,960) --
Issuance (repurchase) of common stock, net...................... (17,420) 100
------- -------
Net cash provided by (used in) financing activities..... (33,380) 100
------- -------
Net increase (decrease) in cash and cash equivalents.............. (48,430) 1,707
Cash and cash equivalents at beginning of period.................. 51,881 10,860
------- -------
Cash and cash equivalents at end of period........................ $ 3,451 $12,567
======= =======
Supplemental disclosures of cash flow information:
Common stock issued for VideoCore and OSEE acquisitions......... $23,352 $ --
======= =======
Income taxes.................................................... $24,835 $13,406
======= =======
</TABLE>
See notes to condensed consolidated financial statements.
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ESS TECHNOLOGY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. BASIS OF PRESENTATION
The unaudited Consolidated Financial Statements have been prepared by the
Company pursuant to the rules and regulations of the Securities and Exchange
Commission. Certain information and footnote disclosures normally included in
financial statements prepared in accordance with generally accepted accounting
principles have been condensed or omitted pursuant to such rules and
regulations. In the opinion of management, the financial statements reflect all
adjustments, consisting only of normal recurring adjustments, necessary for a
fair statement of the financial position, operating results and cash flows for
those periods presented. These Consolidated Financial Statements should be read
in conjunction with the Consolidated Financial Statements and notes thereto for
the years ended December 31, 1995 and 1994, included in the Company's Form 10-K.
The results of operations for the interim periods are not necessarily indicative
of the results that may be expected for any other period or for the fiscal year
which ends December 31, 1996.
CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS.
The Company considers all highly liquid investments with an initial
maturity of 90 days or less to be cash equivalents and investments with original
maturity dates of greater than 90 days to be short-term investments. The Company
accounts for its short-term investments under Financial Accounting Standard No.
115 "Accounting for Certain Investments in Debt or Equity Securities" (SFAS
115), which requires investment securities to be classified as either held to
maturity, trading or available for sale.
All of the Company's short-term investments, comprising primarily debt
instruments with contractual maturities of less than two years and marketable
equity securities have been classified as available for sale and therefore are
reported at fair value with unrealized gains and losses presented as a separate
component of shareholders' equity. Management determines the appropriate
classification of securities at the time of purchase and reevaluates the
classification at each reporting date.
NOTE 2. BALANCE SHEET COMPONENTS (IN THOUSANDS)
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SEPTEMBER 30, DECEMBER 31,
1996 1995
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Inventories:
Raw materials............................................ $ 2,484 $ 2,773
Work-in-process.......................................... 16,733 9,224
Finished goods........................................... 12,223 7,172
------- -------
$31,440 $ 19,169
======= =======
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NOTE 3. NET INCOME PER SHARE
Net income per share is computed using the weighted average number of
common and common equivalent shares ("weighted average share") outstanding
during the period. Common equivalent shares consist of the Company's common
stock issuable upon exercise of stock options during the period (using the
treasury stock method) except when anti-dilutive. Common stock issued and stock
options granted subsequent to July 31, 1994 through October 5, 1995 (the date
of the initial public offering) have been included in the calculation of
weighted average shares outstanding as if they were outstanding for reporting
periods occurring between these dates. The Company used the treasury stock
method and the initial public offering price of $15.00 per share for these
calculations.
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ESS TECHNOLOGY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 4. WAFER CAPACITY COMMITMENTS
In November 1995, the Company entered into agreements with two wafer
foundries, Taiwan Semiconductor Manufacturing Company Ltd. ("TSMC") and United
Microelectronics Corporation ("UMC"), in which the Company secured access to
additional manufacturing capacity and to certain technology.
Under the TSMC agreement, in exchange for TSMC's increased wafer capacity
commitments, the Company committed to pay approximately $32 million over the
next two years as deposits for wafers through 1999. The cash requirements
associated with this agreement are two $16 million payments due on June 30, 1996
and 1997. The Company issued two promissory notes totaling $32 million securing
these payments. The Company made the first $16 million installment by making
payments of $12.6 million and $3.4 million on June 28th and July 1,
respectively. The Company also obtained an option to expand the TSMC wafer
capacity commitments further for years 1997 through 2000. If the Company
exercises its option to commit TSMC to additional wafer capacity, the Company
would be committed to an additional $30.8 million in deposits to be paid in two
$15.4 million payments due on June 30, 1997 and 1998. If the Company is not able
to use, assign, or sell the additional wafer quantities, a portion of the
deposits may be forfeited.
Under the UMC agreement, the Company entered into a joint venture
arrangement with UMC, together with other US semiconductor companies, to build a
separate semiconductor manufacturing facility located in Taiwan at an estimated
cost of $1 billion. The Company will invest approximately $30 million in three
installments over the projected eighteen-month period required to build the
facility. The Company made the first installment payment of $6.9 million in the
first quarter of 1996. The Company will invest the remaining $23.1 in two
installments over the next 12 months. Under the terms of the agreement, the
Company will receive a 5% equity ownership in the joint venture company and
certain capacity rights. The new fabrication facility is currently projected to
commence production in 1997.
NOTE 5. ACQUISITIONS AND RELATED CHARGES
On January 3, 1996, the Company completed the acquisition of VideoCore
Technology, Inc. ("VideoCore"), a California based company, by purchasing all
outstanding shares of VideoCore in exchange for $5.4 million in cash,
approximately 525,000 shares of ESS' common stock and acquisition costs for an
aggregate purchase price of $23.6 million. VideoCore, now a wholly owned
subsidiary of the Company, is developing integrated circuits which once
completed, will incorporate advanced compression technology for digital video
products. On March 29, 1996, the Company completed its acquisition of OSEE
Corporation ("OSEE"), a California based Company, by purchasing all outstanding
shares of OSEE in exchange for $3.6 million in cash, approximately 217,000
shares of ESS' common stock and acquisition costs for an aggregate purchase
price of $9.0 million. OSEE, now a wholly owned subsidiary of the Company, is a
developer of advanced fax/modem V.34 and V.34bis algorithm technology which will
enable the Company to provide modem and computer telephony applications on
the Company's multimedia processor.
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ESS TECHNOLOGY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
These acquisitions have been recorded using the purchase method of
accounting and accordingly, the results of operations and cash flows of such
acquisitions have been included from the applicable dates of acquisition. The
acquired research and development in-process aggregating $30.4 million was
charged to expense in the first quarter of 1996. Additionally, the pro forma
effect of these acquisitions was not significant on the Company's reported
operating results for the first quarter or first nine months of 1996 or 1995.
NOTE 6. STOCK REPURCHASE PROGRAM
On July 15, 1996, the Company's board of directors authorized repurchase of
up to 2.0 million of the Company's shares of common stock over the subsequent 12
months at market prices and as market and business conditions warrant. Such
repurchases will be made at management's discretion. At September 30, 1996, the
Company had repurchased 1,802,500 shares at market prices ranging from $9.41 to
$16.75 per share.
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r
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Statements contained in this discussion that are not statements of
historical fact may be deemed to be forward-looking statements. A number of
important factors could cause actual events or the Company's actual results to
differ materially from those indicated by such forward-looking statements,
including dependence on continued growth in demand for PC multimedia
capabilities for notebook and desktop computers, as well as consumer electronic
products; the Company's ability to take advantage of new markets; increased
competition and pricing pressures, general economic conditions and conditions
specific to the semiconductor industry; the timing and market acceptance of new
product introductions; the timely development of new products; continued
availability of quality foundry capacity; and other risks set forth in this
filing and in the Company's filings from time to time with the Securities and
Exchange Commission.
This information should be read along with the unaudited condensed
consolidated financial statements and notes thereto included in Item I of this
Quarterly Report and the audited consolidated financial statements and notes
thereto and Management's Discussion and Analysis of Financial Condition and
Results of Operations for the fiscal years ended December 31, 1995 and 1994,
contained in the Company's Annual Report filed on Form 10-K.
RESULTS OF OPERATIONS
The following table discloses key elements of the statements of operation,
expressed as a percentage of revenues.
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THREE MONTHS ENDED NINE MONTHS ENDED
------------------------------- -------------------------------
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30
1996 1995 1996 1995
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Net revenues......................... 100.0% 100.0% 100.0% 100.0%
Cost of revenues..................... 49.1 36.4 46.1 35.9
----- ----- ----- -----
Gross margin........................... 50.9 63.6 53.9 64.1
Operating expenses:
Research and development.......... 9.3 8.5 9.2 8.7
Research and development
in-process...................... -- -- 20.3 --
Selling, general and
administrative.................. 7.2 6.1 7.0 10.0
----- ----- ----- -----
Operating income....................... 34.4 49.0 17.4 45.4
Nonoperating income, net............. 0.7 1.9 1.2 2.0
----- ----- ----- -----
Income before provision for income
taxes................................ 35.1 50.9 18.6 47.4
Provision for income taxes........... 13.7 20.8 15.4 19.4
----- ----- ----- -----
Net income............................. 21.4% 30.1% 3.2% 28.0%
===== ===== ===== =====
</TABLE>
Net Revenues. The Company's net revenues, which have primarily been
derived from PC audio semiconductor product sales, increased from $31.4 million
in the third quarter of 1995 to $60.1 million reported in the third quarter of
1996. Net revenues increased primarily due to increased unit shipments of the
Company's PC audio and video semiconductor products. The Company's overall
average selling price for its products was higher in the third quarter of 1996
as compared to the same quarter of 1995, primarily due to a change in sales mix
to higher priced integrated PC audio and video semiconductor products and lower
unit shipments of consumer speech/sound semiconductors. This mix shift was
partially offset by average selling price declines of certain individual
products during the past year. Declining product prices over the life of such
products are common in the semiconductor industry. As competition increases and
product prices decline, the Company expects prices on existing products will
decline further. International revenues accounted for approximately 89% and 70%
of the Company's net revenues in the third quarter of 1996 and 1995,
respectively, reflecting continued
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growth in the Company's international sales including shipments to foreign
locations of multinational U.S. based companies.
The Company's net revenues increased from $68.9 million in the first nine
months of 1995 to $149.8 million reported in the first nine months 1996. Net
revenues increased primarily due to increased unit shipments of the Company's PC
audio semiconductor products. In addition, the Company commenced shipments of
video semiconductors in the second quarter of 1996. International revenues
accounted for approximately 90% and 69% of the Company's net revenues in the
first nine months of 1996 and 1995, respectively, reflecting continued growth in
the Company's international sales.
Gross Profit. The Company's gross profit increased from $20.0 million and
$44.2 million in the third quarter and first nine months of 1995, respectively,
to $30.6 million and $80.7 million in the third quarter and first nine months of
1996, respectively. The increase in gross profit in both the third quarter and
first nine months of 1996 as compared to the same periods in 1995 was primarily
the result of the increase in unit shipments of the Company's PC audio and video
semiconductor products. Gross profit margin decreased in both the third quarter
and first nine months of 1996 reflecting lower selling prices arising from
highly competitive market conditions.
The Company's overall gross profit and margin are subject to change due to
various factors, including among others, competitive product pricing, unit
volumes shipped, new product introductions, yields, wafer costs, assembly costs
and product mix. The Company has encountered increased competition from other
suppliers who are offering competitive single chip products. In addition, the
Company expects that overall average selling prices for its existing products
will continue to decline over time and that selling prices for each product will
decline significantly over the life of the product. The Company believes that in
order to maintain or increase gross profit, it must achieve higher unit volume
shipments, cost reductions, new features and product introductions. No
assurances can be given that the Company will be able to ship higher volumes,
reduce costs, add new features or introduce new products that gain market
acceptance.
Research and Development. Research and development expenses were $5.6
million and $13.8 million in the third quarter and first nine months of 1996,
excluding a one-time pre-tax charge of $30.4 million related to acquired
research and development in-process from the acquisition of VideoCore and OSEE
in the first quarter of 1996, respectively, an increase of $2.9 million and $7.8
million from the third quarter and first nine months of 1995, respectively. The
increase in absolute dollars was primarily due to one-time charges for
technology licensing fees as well as the increase in the Company's engineering
staff, engineering test runs, masks and internal and external consulting
expenses associated with research and development efforts to support the
introduction of new multimedia products.
Selling, General and Administrative. Selling, general and administrative
expenses were $4.4 million and $10.5 million in the third quarter and first nine
months of 1996, respectively, an increase of $2.4 million and $3.6 million from
the third quarter and first nine months of 1995, respectively. In the first
quarter of 1995, the Company recorded legal expenses of $1.8 million for the
ongoing litigation with Yamaha Corporation. Excluding this legal expense,
selling, general and administrative expense increased by $5.4 million from the
first nine months of 1995. The increase in absolute dollars was primarily due to
the increase in commissions and bonuses on higher sales volumes, increased
personnel and related expenses resulting from the Company's status as a
public company.
Interest Income. Interest income consists of income on cash available for
investment. Interest income, was $372,000 and $1.7 million in the third quarter
and first nine months of 1996, respectively, compared to $195,000 and $505,000
in the third quarter and first nine months of 1995, respectively. The increase
in interest income for the third quarter of 1996 was primarily due to the
increased cash available from the proceeds of the Company's initial public
offering in October of 1995 partially offset by cash used by the Company in the
repurchase of its common stock, acquisitions of VideoCore and OSEE and payments
under the TSMC wafer capacity and UMC joint venture agreements.
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Provision for Income Taxes. The Company's effective tax rate was 39% and
40% for the third quarter and first nine months of 1996, respectively, compared
to 41% in the third quarter and first nine months of 1995. The effective tax
rate for the first nine months of 1996 was approximately equal to the combined
federal and state statutory rates.
During the third quarter of 1996, the Internal Revenue Service completed
their examination of the Company's federal income tax returns for 1991 to 1993.
The Company had previously provided sufficient reserves such that the results of
these examinations did not have a material adverse impact on the Company's
financial position or results of operations.
LIQUIDITY AND CAPITAL RESOURCES
Since its inception, the Company has financed its cash requirements from
cash generated from operations, the sale of equity securities, bank lines of
credit and long-term and short-term debt. At September 30, 1996, ESS had cash
and cash equivalents and short-term investments of $32.7 million and working
capital of $51.5 million. As of September 30, 1996, the Company had two $10.0
million bank lines of credit expiring on March 31, 1997 and May 1, 1997. These
lines of credit requires the Company to achieve certain financial ratios and
operating results. There were no borrowing under these lines of credit as of
September 30, 1996.
In the first nine months of 1996, the Company generated approximately $8.5
million from its operating activities. Approximately $28.9 million was used to
finance working capital, primarily due to increases in accounts receivable and
inventories reflecting a growth in sales and a higher percentage of revenue to
customers having credit terms offset in part by an increase in accounts payable
and accrued expenses net of the effect of VideoCore and OSEE acquisitions. $19.5
million was used to repurchase 1.8 million shares of common stock; $16.0 million
and $6.9 million were used to pay the first installment under the TSMC wafer
capacity and UMC joint venture agreements, respectively, $10.4 million was used
to purchase short-term investments; $9.3 million was used to acquire VideoCore
and OSEE and $11.3 million was used to purchase property, plant and equipment
primarily to fund the construction of a new headquarters facility.
The Company believes that its existing cash and cash equivalents as of
September 30, 1996, together with the cash generated from operations and
available borrowings under its line of credit, will be sufficient to fund
acquisitions of property and equipment and provide adequate working capital
through at least the next twelve months. Capital expenditures for the next
twelve months are anticipated to be approximately $14 million of which
approximately $6 million will be used to fund construction of additional
facilities and approximately $8 million will be used to acquire capital
equipment. In addition, the Company is obligated to pay approximately $16
million over the next 9 months to TSMC in exchange for certain wafer capacity
commitments and will invest approximately $23 million in 2 installments over the
next 12 months in exchange for an equity ownership in a joint venture with UMC
to build a new foundry and for certain wafer capacity commitments. The Company
may also utilize cash to acquire or invest in complementary businesses or
products or to obtain the right to use complementary technologies. From time to
time, in the ordinary course of business, the Company may evaluate potential
acquisitions of or investment in such businesses, products or technologies owned
by third parties. The Company also has bank lines of credit which may be
utilized to provide additional working capital.
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FACTORS THAT MAY AFFECT FUTURE RESULTS
Potential Fluctuations in Operating Results. The Company's operating
results are subject to quarterly and other fluctuations due to a variety of
factors, including the gain or loss of significant customers, increased
competitive pressures, changes in pricing policies by the Company, its
competitors or its suppliers, including decreases in unit average selling prices
("ASPs") of the Company's products, the timing of new product announcements and
introductions by the Company or its competitors and market acceptance of new or
enhanced versions of the Company's and its customers' products. Other factors
include the availability of foundry capacity, fluctuations in manufacturing
yields, availability and cost of raw materials, changes in the mix of products
sold, the cyclical nature of both the semiconductor industry and the market for
PCs, seasonal customer demand, the timing of significant orders and significant
increases in expenses associated with the expansion of operations. The Company's
operating results could also be adversely affected by economic conditions
generally in various geographic areas where the Company or its customers do
business, or order cancellations or rescheduling. Because the Company must order
products in advance of product shipments and because the markets for the
Company's products are volatile and its products are subject to rapid
technological and price changes, there is a risk that the Company will produce
excess or insufficient inventories of particular products. These factors are
difficult to forecast, and these or other factors could materially affect the
Company's quarterly or annual operating results. There can be no assurance as to
the level of sales or earnings that may be attained by the Company in any given
period in the future.
Competition. The markets in which the Company competes are intensely
competitive and are characterized by rapid technological change, price declines
and rapid product obsolescence. The Company currently competes with add-in card
suppliers and semiconductor manufacturers. The Company expects competition to
increase in the future from existing competitors and from other companies that
may enter the Company's existing or future markets with products that may be
less costly or provide higher levels of integration, higher performance or
additional features. The Company is unable to predict the timing and nature of
any such competitive product offerings. The announcement and commercial shipment
of competitive products could adversely affect sales of the Company's products
and may result in increased price competition that would adversely affect the
ASP's and margins of the Company's products. In general, product prices in the
semiconductor industry have decreased over the life of a particular product. The
markets for most of the applications for the Company's products, particularly
the PC market, are characterized by intense price competition. The willingness
of prospective customers to design the Company's products into their products
depends to a significant extent upon the ability of the Company to sell its
products at a price that is cost-effective for such customers. As the markets
for the Company's products mature and competition increases, the Company
anticipates that prices for its products will continue to decline. If the
Company is unable to reduce its costs sufficiently to offset declines in product
prices or is unable to introduce more advanced products with higher product
prices, the Company's business, financial condition and results of operations
would be materially adversely affected.
The Company's existing and potential competitors consist principally of
large domestic and international companies that have substantially greater
financial, manufacturing, technical, marketing, distribution and other
resources, greater intellectual property rights, broader product lines and
longer-standing relationships with customers than the Company. The Company's
competitors also include a number of smaller and emerging companies. The
Company's principal audio competitors include Cirrus Logic, Creative Technology,
OPTi and Yamaha. The Company's principal video competitors include C-Cube,
Hyundai, LSI Logic and SGS Thompson. Certain of the Company's current and
potential competitors maintain their own semiconductor foundries and may
therefore benefit from certain capacity, cost and technical advantages. The
Company believes that its ability to compete successfully depends on a number of
factors, both within and outside of its control, including the price, quality
and performance of the Company's and its competitors' products, the timing and
success of new product introductions by the Company, its customers and its
12
<PAGE> 13
competitors, the emergence of new multimedia standards, the development of
technical innovations, the ability to obtain adequate foundry capacity and
sources of raw materials, the efficiency of production, the rate at which the
Company's customers design the Company's products into their products, the
number and nature of the Company's competitors in a given market, the assertion
of intellectual property rights and general market and economic conditions.
There can be no assurance that the Company will be able to compete successfully
in the future.
Each successive generation of microprocessors has provided increased
performance, which could in the future result in a microprocessor capable of
performing audio functions. In this regard, Intel Corporation has developed
Native Signal Processing ("NSP") capability and an extended multimedia system
architecture ("MMX") for use in conjunction with its Pentium microprocessor, and
is promoting the processing power of the Pentium for data and signal intensive
functions such as graphics acceleration and other multimedia functions. There
can be no assurance that the increased capabilities of microprocessors will not
adversely affect demand for the Company's products.
Dependence on Single Product Line and PC Industry. In the first nine
months of 1996, sales of PC audio semiconductors accounted for substantially all
of the Company's net revenues, and the Company expects that sales of audio
semiconductors will continue to account for a significant majority of its net
revenues for the foreseeable future. Any reduction in demand for the Company's
audio semiconductors, whether because of a reduction in demand for PCs in
general or PC audio, increased competition or otherwise, would have a material
adverse effect on the Company's business, financial condition and results of
operations. The Company is currently engaged in the development and introduction
of new PC audio products as well as new multimedia products for the PC and
consumer markets that provide capabilities such as video and fax/modem/voice
applications. There can be no assurance that the Company will be able to
identify market trends or new product opportunities, develop and market new
products, achieve design wins or respond effectively to new technological
changes or product announcements by others. A failure in any of these areas
would have a material adverse effect on the Company's business, financial
condition and results of operations.
Most of the Company's products are sold for incorporation into multimedia
desktop and notebook computers. ESS semiconductor products are incorporated into
motherboards by multimedia PC original equipment manufacturers ("OEMs") or in
add-in cards. Therefore, the Company is heavily dependent on the continued
growth of the markets for multimedia desktop and notebook computers and
multimedia applications. A decline in demand in the PC industry could result in
a corresponding decline in demand for the Company's products, which would have a
material adverse effect on the Company's business, financial condition and
results of operations.
Importance of New Products and Technological Change. The markets for the
Company's products are characterized by evolving industry standards, rapid
technological change and product obsolescence. The Company's success is highly
dependent upon the successful development and timely introduction of new
products at competitive price and performance levels. The success of new
products depends on a number of factors, including timely completion of product
development, market acceptance of the Company's and its customers' new products,
securing sufficient foundry capacity for volume manufacturing of wafers,
achievement of acceptable wafer fabrication yields by the Company's independent
foundries and the Company's ability to offer new products at competitive prices.
In order to succeed in having the Company's products incorporated into new
products being designed by desktop and notebook computer manufacturers, the
Company must anticipate market trends and performance and functionality
requirements of such manufacturers and must successfully develop and manufacture
products that meet these requirements. In addition, the Company must meet the
timing and price requirements of such manufacturers and must make such products
available in sufficient quantities. Accordingly, in selling to OEMs, the Company
can often incur significant expenditures prior to volume sales of new products,
if any. In order to help accomplish these goals, the Company has in the past and
will continue to consider in the future the acquisition of other companies or
the products and technologies of other companies. Such acquisitions carry
additional risks such as a lack of integration with existing products and
corporate culture, the potential for large write-offs and the diversion of
management attention.
13
<PAGE> 14
Dependence on TSMC and Other Third Parties. The Company relies on
independent foundries to manufacture all of its products. A substantial majority
of the Company's products are currently manufactured by TSMC, which has
manufactured certain of the Company's products since 1989. The Company also has
foundry arrangements with Sharp Corporation, IC Works, and UMC, which have been
manufacturing certain of the Company's products since 1986, 1991 and 1995,
respectively. TSMC, in particular, provides the Company with access to advanced
process technology necessary for the manufacture of the Company's products.
These foundries fabricate products for other companies and, with the exception
of TSMC, manufacture products of their own design. In November 1995, the Company
entered into long-term agreements with TSMC and UMC in which the Company has
secured access to additional capacity and to leading edge technology. In
addition, the Company is obligated to pay approximately $16 million over the
next nine months to TSMC in exchange for certain wafer capacity commitments and
will invest approximately $23 million in 2 installments over the next year in
exchange for an equity ownership in a joint venture with UMC to build a new
foundry and for certain wafer capacity commitments. If the Company is not able
to use, assign, or sell the additional wafer quantities, a portion of the
deposits may be forfeited.
While the Company has entered into long-term agreements with two of its
foundries, the Company's reliance on these and other independent foundries
involves a number of risks, including the absence of adequate capacity, the
unavailability of, or interruption in access to, certain process technologies
and reduced control over delivery schedules, manufacturing yields and costs, and
the international risks more fully described below. The Company expects to rely
upon TSMC and UMC to manufacture a substantial majority of the Company's
products for the foreseeable future. In the event that TSMC and UMC are unable
to continue to manufacture the Company's key products in required volumes, the
Company will have to identify and secure additional foundry capacity. In such an
event, the Company may be unable to identify or secure additional foundry
capacity from another manufacturer, particularly at the levels that the Company
currently expects TSMC and UMC to provide. Even if such capacity is available
from another manufacturer, the qualification process could take six months or
longer. The loss of any of its foundries as a supplier, the inability of the
Company to acquire additional capacity at its current suppliers or qualify other
wafer manufacturers for additional foundry capacity should additional capacity
be necessary, or any other circumstances causing a significant interruption in
the supply of semiconductors to the Company would have a material adverse effect
on the Company's business, financial condition and results of operations.
To address potential foundry capacity constraints in the future, ESS will
continue to consider and may be required to enter into additional arrangements,
including equity investments in or loans to independent wafer manufacturers in
exchange for guaranteed production capacity, joint ventures to own and operate
foundries, or "take or pay" contracts that commit the Company to purchase
specified quantities of wafers over extended periods. Any such arrangements
could require the Company to commit substantial capital and grant licenses to
its technology. The need to commit substantial capital may require the Company
to obtain additional debt or equity financing, which could result in dilution to
the Company's shareholders. There can be no assurance that such additional
financing, if required, will be available when needed or, if available, will be
obtained on terms acceptable to the Company.
International Operations. In the first nine months of 1996, international
sales, accounted for 90% of the Company's net revenues. Substantially all of the
Company's international sales were to customers in Taiwan, Japan, Singapore and
Hong Kong and includes shipments to foreign locations of multinational U.S.
based companies. The Company expects that international sales will continue to
represent a significant portion of its net revenues for the foreseeable future.
In addition, substantially all of the Company's products are manufactured,
assembled and tested by independent third parties in Asia. Due to its reliance
on international sales and foreign third-party manufacturing, assembly and
testing operations, the Company is subject to the risks of conducting business
outside of the United States. These risks include unexpected changes in, or
impositions of legislative or regulatory requirements, delays resulting from
difficulty in obtaining export licenses for certain technology, tariffs, quotas
and other trade barriers and restrictions, longer payment cycles, greater
difficulty in accounts receivable collection, potentially adverse taxes, the
burdens of complying with a variety of foreign laws and other factors beyond the
Company's control. The Company is also subject to
14
<PAGE> 15
general geopolitical risks in connection with its international trade
relationships. Although the Company has not to date experienced any material
adverse effect on its business, financial condition or results of operations as
a result of such regulatory, geopolitical and other factors, there can be no
assurance that such factors will not have a material adverse effect on the
Company's business, financial condition and results of operations in the future
or require the Company to modify its current business practices.
In addition, the laws of certain foreign countries in which the Company's
products are or may be manufactured or sold, including various countries in
Asia, may not protect the Company's products or intellectual property rights to
the same extent as do the laws of the United States and thus make the
possibility of piracy of the Company's technology and products more likely.
Currently, all of the Company's product sales and all of its arrangements with
foundries and assembly and test vendors, other than its foundry arrangement with
Sharp Corporation, provide for pricing and payment in U.S. dollars. To date,
although the effect of currency fluctuations have been insignificant, there can
be no assurance that fluctuations in currency exchange rates will not have a
material adverse effect on the Company's business, financial condition and
results of operations. In addition, to date the Company has not engaged in any
currency hedging activities, although the Company may do so in the future.
Further, there can be no assurance that one or more of the foregoing factors
will not have a material adverse effect on the Company's business, financial
condition and results of operations or require the Company to modify its current
business practices.
Semiconductor Industry. The semiconductor industry has historically been
characterized by rapid technological change, cyclical market patterns,
significant price erosion, periods of over-capacity and production shortages,
variations in manufacturing costs and yields and significant expenditures for
capital equipment and product development. In addition, the industry has
experienced significant economic downturns at various times, characterized by
diminished product demand and accelerated erosion of product prices. The Company
may experience substantial period-to-period fluctuations in operating results
due to general semiconductor industry conditions.
Dependence on Key Personnel. The Company's success depends to a
significant degree upon the continued contributions of Fred S.L. Chan, the
Company's Chief Executive Officer and Chairman of the Board of Directors. Mr.
Chan, together with his spouse, Annie M.H. Chan, a director of the Company and
certain trusts for the benefit of the Chan's children and certain charities
beneficially own, in the aggregate, approximately 43% of the Company's Common
Stock. The future success of the Company depends on its ability to continue to
attract, retain and motivate qualified senior management, sales and technical
personnel, particularly highly skilled semiconductor design personnel and
software engineers, for whom competition is intense. Recently, the Company has
hired a number of key executives and management personnel (See Item 5). The loss
of Mr. Chan, other key executive officers, key design personnel or software
engineers or the inability to hire and retain sufficient qualified personnel
could have a material adverse effect on the Company's business, financial
condition and results of operations. There can be no assurance that the Company
will be able to retain these employees. The Company currently does not maintain
any key man life insurance on the life of any of its key employees.
15
<PAGE> 16
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On May 17, 1996, the Company and Yamaha Corporation settled all patent
infringement litigation between the two companies. See also the Company's Form
10-Q's for the quarters ended March 31, and June 30, 1996.
ITEM 5. OTHER INFORMATION
On September 16, October 14 and November 4, 1996, the Company appointed Mr.
John H. Barnet as Vice President, Finance and Chief Financial Officer, Mr.
Herbert J. Martin as President and Chief Operating Officer and Mr. Bo E.
Ericsson as Vice President, Marketing, respectively. Due to the recent
management changes and other recent changes to the internal executive officers
reporting structures within the Company, the executive officers of the Company
now consist of the following individuals:
Fred S.L. Chan Chief Executive Officer and Chairman of the Board
Herbert J. Martin President and Chief Operating Officer
John H. Barnet Vice President, Finance and Chief Financial Officer
Chi-Shin Wang Chief Technical Officer
Bo E. Ericsson Vice President, Marketing
Nicholas Aretakis Vice President, Sales
Robert L. Blair Vice President, Operation
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
10.27 -- Form of Employment Agreement and Promissory Note among the
Registrant and John H. Barnet dated August 22 and September
16, 1996, respectively.
27.01 -- Financial Data schedule
(b) Reports on Form 8-K. No reports were filed on Form 8-K for the quarter
ended September 30, 1996.
16
<PAGE> 17
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this amendment to report on Form 10-Q to be signed on
its behalf by the undersigned, thereunto duly authorized.
ESS TECHNOLOGY, INC.
(Registrant)
<TABLE>
<S> <C>
Date: November 14, 1996 By: /s/ FRED S.L. CHAN
------------------------------------------
Fred S.L. Chan
Chief Executive Officer
and Chairman of the Board
Date: November 14, 1996 By: /s/ JOHN H. BARNET
------------------------------------------
John H. Barnet
Vice President, Chief
Financial Officer and Secretary
</TABLE>
17
<PAGE> 18
EXHIBIT INDEX
Exhibit Description
------- -------------
10.27 Form of Employment Agreement and Promissory Note among
the Registrant and John H. Barnet dated August 22 and
September 16, 1996, respectively.
27.01 Financial Data Schedule
<PAGE> 1
Exhibit 10.27
[ESS TECHNOLOGY, INC. LOGO]
August 22, 1996
MR. JOHN H. BARNET
2 Robert S. Drive
Menlo Park, CA 94025
Dear John,
I am delighted to welcome you to the ESS team as Vice President,
Finance and Chief Financial Officer.
I understand you will assume your new duties no later than September
23, 1996. Congratulations and welcome aboard!
As Vice President, Finance and Chief Financial Officer, you will report
directly to me, President and Chief Executive Officer. Your duties will
include all financial and administrative functions of the Company as outlined
in the position brief given to you by Frank Bacci.
Your initial salary will be $185,000 per annum. You will also have the
opportunity to earn 25% of your current annual salary under ESS's executive
achievement bonus pool, provided that the plan's bonus objectives are
achieved. The annual objectives shall be on the same basis as other
executives. This bonus will be paid at the end of February following each
calendar year of employment. The bonus for 1996 will be pro-rated and
guaranteed. You will also receive the Company's standard employee benefits
package, and will be subject to the Company's vacation policy.
You will receive a sign-up bonus of $400,000 to be paid to you in your
first week of employment. Such bonus must be repaid in proration to the Company
if you voluntarily, other than by death or disability, terminate your
employment less than one full year from your start date. Both you and the
Company will provide each other a three month advance notice for termination of
employment.
You will also be granted an option under the Company's 1995 Equity
Incentive Plan for 200,000 shares of the Company's stock (the "Option") to vest
as follows: 40,000 shares will vest on your start date, and the remaining
160,000 shares will vest (40,000 shares per year each) on the next four
anniversaries of your start date. The terms of the Option will be consistent
with the ESS 1995 Equity Incentive Plan except as specifically provided to the
contrary herein. To the extent possible under the Internal Revenue Code of
1986, as amended (the "Code"), the Option will constitute an "incentive stock
option." The Option will be priced at 100% of fair market value as of your
start date. Shares underlying the Option may not be sold for one full year
following your start date. You will have the right to receive at least $5.00
per share for the first 80,000 of your Option shares which are vested. This
right may be exercised at any time between the first and third anniversaries of
your start date, provided you do so while employed by the Company and within 90
days after termination of such employment. The mechanics for you to exercise
this right will depend upon the fair market value of ESS shares as quoted on
Nasdaq, as follows:
Initials ( /s/ )
<PAGE> 2
[ESS Technology, Inc. LETTERHEAD]
(i) If such value exceeds your exercise price by an amount less than
$5.00 per share, then you may exercise the Option and the Company will
pay you the difference between $5.00 and such amount; or
(ii) If such value is less than your exercise price, then the Company
will purchase the Option for $5.00 per share.
In the event that you are terminated without cause in the first year of your
employment, the 40,000 shares underlying the Option that vest on the first
anniversary date shall become vested immediately. In addition, should there be
a change in control of the Company such that the stockholders of the Company no
longer hold a majority of the capital stock of the new entity, the shares
underlying the Option will accelerate and become vested immediately unless you
are hired by such a new entity with similar compensation package.
You will receive a loan from the Company for $400,000 commencing on
your start date at the current statutory minimum interest rate necessary to
avoid imputed income under the Code, which shall be evidenced by a recourse
promissory note. The loan will be due and payable one year from your start date
or 90 days after your earlier termination of employment. All proceeds from any
sale of the Option or of shares underlying the Option, net of taxes, shall be
applied to reduction of such loan. The Option and any shares exercised
thereunder will be held by the Company as collateral for the loan.
Tax consequences, if any, of this transaction will be your
responsibility.
As an employee of the Company, you will have access to Company
confidential information and you may, during the course of your employment,
develop certain information or inventions which will be the property of the
Company. To protect the interests of the Company, you will need to sign the
Company's standard "Employee Inventions and Confidentiality Agreement" as a
condition of your employment. We wish to impress upon you that we do not wish
you to bring with you any confidential or proprietary material of any former
employer or violate any other obligation to your former employers.
Should you decide to accept our offer, you will be an at-will employee
of the Company, which means the employment relationship can be terminated by
either of us for any reason at any time. Further, your participation in any
stock award or benefit program is not to be regarded as assuring you of
continuing employment for any particular period of time.
Initials ( ) ( )
<PAGE> 3
[LETTERHEAD]
ESS Technology, Inc.
Please signify your acceptance of this offer and these conditions by
signing and returning a copy of this letter. I look forward to having you join
our outstanding team, and I know this will be a mutually beneficial relationship
for many years to come. Again, my personal thanks and congratulations!
ESS TECHNOLOGY, INC.
By: /s/ FRED S.L. CHAN /s/ JOHN H. BARNET
----------------------------- -----------------------------
Fred S.L. Chan John H. Barnet
Chairman of the Board, President
and Chief Executive Officer Date: August 25, 1996
-----------------------
<PAGE> 4
[LETTERHEAD]
ESS Technology, Inc.
PROMISSORY NOTE
$400,000 Fremont, California
- -------- September 16, 1996
At the time hereinafter stated and as stated in the offer letter dated August
22, 1996, for value received, the undersigned, an employee of ESS Technology,
Inc. ("the Company"), promises to pay the Company the principal sum of $400,000
with interest from the date hereof at a rate of six point zero two percent
(6.02%) per annum (September 1996 statutory minimum interest rate), compounded
annually, on the unpaid balance of said principal sum. Said principal and
interest shall be due and payable one year from the date or 90 days after the
undersigned earlier termination of employment.
Principal and interest are payable in lawful money of United States of America.
Should suit be commenced to collect this Note or any portion thereof, such sum
as the Court may deem reasonable shall be added hereto as attorneys' fees. The
maker and endorsers have severally waived presentment for payment, protest,
notice of protest, and notice of non-payment of this Note.
This Note, which is full recourse, is secured by a pledge of certain Options and
any shares exercised thereunder which will be held by the Company as collateral
for the note. All proceeds from any sale of the Options or of shares underlying
the Options, net of taxes, shall be applied to reduction of such note.
/s/ JOHN BARNET /s/ FRED S.L. CHAN
- --------------------------- ---------------------------
John Barnet Fred S.L. Chan
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<SALES> 60,138
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