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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q/A-1
(Mark One)
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
For the quarterly period ended March 31, 1996.
OR
[ ] Transitional Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
For the transition period from: to: .
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Commission file number 0-26660
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ESS TECHNOLOGY, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
CALIFORNIA 94-2928582
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
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46107 LANDING PARKWAY
FREMONT, CALIFORNIA 94538
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE )
(510) 226-1088
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
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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 April 30, 1996, the registrant had 38,293,078 shares of common stock
outstanding.
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ESS TECHNOLOGY, INC.
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Part I. FINANCIAL INFORMATION Page
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<S> <C>
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets - March 31, 1996 3
and December 31, 1995, unaudited
Condensed Consolidated Statements of Operations - three months 4
ended March 31, 1996 and 1995, unaudited
Condensed Consolidated Statements of Cash Flows - three 5
months ended March 31, 1996 and 1995, unaudited
Notes to Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition and 8
Results of Operations
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 15
Item 6. Exhibits and Reports on Form 8-K 17
SIGNATURES 18
</TABLE>
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ESS TECHNOLOGY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(in thousands)
<TABLE>
<CAPTION>
Mar. 31, Dec. 31,
1996 1995
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<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 36,773 $ 51,881
Short-term investments 36,619 26,243
Accounts receivable, net 13,501 10,236
Inventories 20,523 19,169
Deferred income taxes 2,337 2,337
Prepaid expenses and other assets 3,192 2,271
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Total current assets 112,945 112,137
Property and equipment, net 12,000 10,371
Other assets 44,694 40,195
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$169,639 $162,703
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LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses $ 31,095 $ 33,744
Income taxes payable 7,666 3,722
Deferred income taxes 5,909 4,069
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Total current liabilities 44,670 41,535
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Long-term advances payable to vendors 15,960 15,960
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Total Liabilities 60,630 57,495
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Commitments and contingencies (See Notes 4 and 5)
Shareholders' equity:
Preferred stock, no par value, 10,000 shares authorized;
none issued and outstanding -- --
Common stock, no par value, 100,000 shares authorized;
36,794 and 35,473 shares issued and outstanding
at March 31, 1996 and December 31, 1995,
respectively 90,598 66,891
Deferred compensation related to stock options (45) (60)
Retained earnings 18,456 38,377
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Total shareholders' equity 109,009 105,208
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Total liabilities and shareholders' equity $169,639 $162,703
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</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)
<TABLE>
<CAPTION>
Three Months Ended
--------------------------------
Mar. 31, 1996 Mar. 31, 1995
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<S> <C> <C>
Net revenues $ 41,188 $16,141
Cost of revenues 17,637 5,168
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Gross profit 23,551 10,973
Operating expenses:
Research and development 3,631 1,229
Research and development in-process (Note 6) 30,355 --
Selling, general and administrative. 2,935 3,040
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Operating income(loss) (13,370) 6,704
Interest income, net 699 140
Gain on marketable equity securities -- 219
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Income(loss) before provision for income taxes. (12,671) 7,063
Provision for income taxes 7,250 2,896
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Net income(loss) $(19,921) $ 4,167
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Net income(loss) per share $ (0.55) $ 0.11
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Weighted average common and common
equivalent shares 36,234 36,775
======== =======
</TABLE>
See notes to condensed consolidated financial statements.
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ESS TECHNOLOGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(in thousands)
<TABLE>
<CAPTION>
Three Months Ended
-----------------------------
Mar. 31, Mar. 31,
1996 1995
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<S> <C> <C>
Cash flows from operating activities:
Net income $(19,921) $ 4,167
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 432 71
Research and development in-process costs 30,355 --
Gain on sales of short-term investments -- (219)
Deemed compensation expense and compensation related to stock options 15 15
Change in assets and liabilities (net of affect of Video Core and
OSEE acquisitions):
Accounts receivable (3,265) (1,635)
Inventories (1,342) (432)
Prepaid expenses and other assets (820) (180)
Accounts payable and accrued expenses (3,256) 2,125
Income taxes payable 3,944 1,118
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Net cash provided by operating activities 6,142 5,030
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Cash flows from investing activities:
Acquisition of property and equipment (1,941) (299)
Sale of short-term investments -- 209
Purchase of short-term investments (10,376) --
Cash paid for Video Core and OSEE acquisitions (9,288) --
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Net cash provided by (used in) investing activities (21,605) (90)
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Cash flows from financing activities:
Issuance (purchase) of common stock 355 --
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Net cash provided by (used in) financing activities 355 --
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Net increase (decrease) in cash and cash equivalents. (15,108) 4,940
Cash and cash equivalents at beginning of period. 51,881 10,860
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Cash and cash equivalents at end of period $ 36,773 $15,800
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Supplemental disclosures of cash flow information:
Cash paid during the period for income taxes $ 3,300 $ 2,363
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Common Stock issued for Video Core and OSEE acquisitions $ 23,352 $ --
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</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.
NOTE 2. BALANCE SHEET COMPONENTS (IN THOUSANDS)
<TABLE>
<CAPTION>
Mar. 31, 1996 Dec. 31, 1995
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<S> <C> <C>
Inventories:
Raw materials $ 1,720 $ 2,773
Work-in-process 7,782 9,224
Finished goods 11,021 7,172
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$20,523 $19,169
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</TABLE>
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 the date of the initial
public offering (using the treasury stock method and the initial public offering
price of $15.00 per share) have been included in the calculation of weighted
average shares outstanding as if they were outstanding for all applicable
periods.
NOTE 4. YAMAHA LITIGATION
In March 1995, the Company was served with a patent infringement claim
in which Yamaha Corporation ("Yamaha") claimed that the Company's ESFM products
infringe upon patents held by Yamaha. The complaint seeks an injunction against
future infringement, damages for past infringement, fees and costs. If the
Company were found to be infringing a valid Yamaha patent, then the Company
could be required to cease the sale of ESFM products, which represent a
significant portion of the Company's revenues.
Management has investigated Yamaha's claims and discussed them with its
patent counsel, who was consulted early during the design and development of the
allegedly infringing ESFM products. On May 1, 1995, the U.S. District Court in
Los Angeles denied the plaintiff's request for a preliminary injunction. In its
order denying the request for preliminary injunction, the District Court stated
that its decision was based on a determination that Yamaha was unlikely to
succeed on the merits. The Court's
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decision was also based on a balance of the relative hardships that would be
suffered by the Company or Yamaha as a result of the granting or denial of the
preliminary injunction. Yamaha appealed the order on May 17, 1995. On March 29,
1996, the U.S. Court of Appeals for the Federal Circuit confirmed the denial of
Yamaha's request for a preliminary injunction. Based upon its investigations and
its discussions with patent counsel, the District Court's order denying the
preliminary injunction and the Federal Court's confirmation of the order denying
the preliminary injunction, the Company believes it is not infringing any valid
patent of Yamaha. See "Part II. Other Items - Item 1. Legal Proceedings."
The Company is vigorously contesting all of Yamaha's claims. In
connection with the Yamaha litigation, the Company has incurred and will
continue to incur substantial legal and other expenses. While the outcome of
such lawsuits cannot be accurately predicted, based on the facts currently
known, management does not believe that the ultimate resolution of this matter
will have a material adverse impact on the Company's financial position or
results of operations.
NOTE 5. WAFER CAPACITY COMMITMENTS
In November of 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 in the sum of
$32 million securing these payments. 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 1996. 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 6. 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
is to enable the Company to provide modem and computer telephony applications
on the Company's multimedia processor.
The purchase price of these companies has been allocated to assets acquired and
facilities assumed based upon the book value of Videocore's and OSEE's current
assets, equipment and facilities, which management believes approximates their
fair values, and independent appraisal for all other identifiable assets as
follows:
(in thousands):
<TABLE>
<CAPTION>
<S> <C>
Research and development in-process $30,355
Covenants not to compete 4,600
Current Assets 12
Property and Equipment 120
Current Liabilities Assumed (607)
Other Liabilities Assumed (1,840)
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$32,640
=======
</TABLE>
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 of 1996 or 1995 was not significant.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
This information should be read along with the 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.
<TABLE>
<CAPTION>
Three Months Ended
------------------------------------
Mar. 31, 1996 Mar. 31, 1995
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<S> <C> <C>
PC audio semiconductor products 99.0% 92.6%
Consumer speech/sound semiconductor products 0.5 5.9
Licensing and other 0.5 1.5
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Net revenues 100.0 100.0
Cost of revenues 42.8 32.0
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Gross margin 57.2 68.0
Operating expenses:
Research and development 8.9 7.6
Research and development in-process 73.7 --
Selling, general and administrative. 7.1 18.8
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Operating income (loss) (32.5) 41.5
Nonoperating income (expense), net 1.7 2.2
----- -----
Income (loss) before provision for income taxes (30.8) 43.7
Provision for income taxes (17.6) (17.9)
----- -----
Net income (loss) (48.4)% 25.8%
===== =====
</TABLE>
Net Revenues. The Company's net revenues, which have primarily been
derived from PC audio semiconductor product sales, increased from $16.1 million
in the first quarter of 1995 to $41.2 million reported in the first quarter of
1996. Net revenues increased primarily due to increased unit shipments of the
Company's existing and new PC audio semiconductor products, partially offset by
a decrease in unit shipments of consumer speech/sound semiconductors. The
Company's overall average selling price for its products was higher in the first
quarter of 1996 as compared to the same quarter of 1995, primarily due to
increased sales of more highly integrated PC audio semiconductor products, lack
of competitive single chip solutions from competitors and lower sales of
consumer speech/sound semiconductors. However, as is common in the semiconductor
industry, average selling prices of individual products declined during the past
year, and as competition increases the Company expects prices will decline
further. International revenues accounted for approximately 89% and 66% of the
Company's net revenues in the first quarter of 1996 and 1995, respectively,
reflecting continued growth in the Company's international sales.
Gross Profit. The Company's gross profit increased from $11.0 million
in the first quarter of 1995 to $23.6 million in the first quarter of 1996. The
increase in gross profit in the first quarter of 1996 as compared to the same
period in 1995 was primarily the result of the increase in unit shipments of the
Company's PC audio semiconductors, partially offset by a decrease in unit
shipments of consumer speech/sound semiconductors.
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The Company's overall gross margin is subject to change due to various
factors, including among others, competitive product pricing, yields, wafer
costs, assembly costs and product mix. The Company anticipates encountering
additional competition from other suppliers who are expected to offer
competitive single chip products, which may have a material adverse effect on
the Company's gross margin. 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. As a result, the Company does not believe that its
current gross margin is sustainable and believes that its gross margin will
decline in the future.
Research and Development. Research and development expenses, excluding
a one-time pre-tax charge of $30.4 million related to acquired research and
development in-process from the acquisitions of VideoCore and OSEE, was $3.6
million in the first quarter of 1996, an increase of $2.4 million from the first
quarter of 1995. The increase in absolute dollars was primarily due to the
increase in the Company's engineering staff and internal and outside consulting
expenses associated with research and development efforts to support the
introduction of new PC audio semiconductor products and multimedia products.
Selling, General and Administrative. Selling, general and
administrative expenses were $2.9 million in the first quarter of 1996, a
decrease of $0.1 million from the first quarter of 1995. 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 expenses increased by $1.7 million from the first
quarter of 1995. The increase in absolute dollars was primarily due to the
increase in commissions on higher sales volumes, and increased personnel and
related expenses resulting from the Company's recent status as a public
company, and to a lesser extent, promotional expenses and costs associated
with the expansion of the Company's sales activities.
Interest Income. Interest income consists of income on cash available
for investment. Interest income, was $699,000 in the first quarter of 1996,
compared to $140,000 in the first quarter of 1995. The increase in interest
income, net for the first 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 its
acquisitions of VideoCore and OSEE.
Gain on Sale of Marketable Securities. The Company had no gains in the
first quarter of 1996, compared to $219,000 in the first quarter of 1995 on the
Company's sales of certain marketable equity securities.
Provision for Income Taxes. The Company's effective tax rate remained
constant at 41% in the first quarter of 1996 and 1995.
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 March 31, 1996, ESS had cash and
cash equivalents and short-term investments of $73.4 million and working capital
of $68.3 million. As of March 31, 1996, the Company had a $10.0 million bank
line of credit expiring on March 31, 1997. The line of credit requires the
Company to achieve certain financial ratios and operating results. There were no
borrowing under the line of credit as of March 31, 1996
In the first three months of 1996, the Company's operating activities
provided net cash of approximately $6.0 million primarily from net income of
approximately $10.4 million during the first three months of 1996 after
excluding a one-time pre-tax charge of $30.4 million related to the acquired
research and development in-process from the acquisitions of VideoCore and
OSEE. Excluding the $4.6 million of intangible asset created by the
acquisition of VideoCore and OSEE, during the first three months of 1996,
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approximately $4.7 million was used to finance working capital, primarily due to
increases in accounts receivable and inventories, reflecting growth in sales of
the Company's PC audio products, coupled with an decrease in accounts payable
and accrued liabilities. In the first three months of 1996, the purchase of
short-term investments and property and equipment used approximately
$12.3 million. Additionally, the Company used $9.3 million on the acquisitions
of Video Core and OSEE.
The Company believes that its existing cash and cash equivalents as of
March 31, 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 $16 million of which approximately $9 million
will be used to fund construction of a new headquarters facilities and
approximately $7 million will be used to acquire capital equipment. In
addition, the Company is obligated to pay approximately $32 million over the
next 2 years to TSMC in exchange for certain wafer capacity commitments and
will invest approximately $23 million in 2 installments over the next 15
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. However, the Company has no present
understandings, commitments or agreements with respect to any material
acquisition of or investments in other businesses, products or technologies.
The Company also has a bank line of credit which may be utilized to provide
additional working capital.
FACTORS THAT MAY AFFECT FUTURE RESULTS
Except for the historical information contained in this Quarterly
Report on Form 10-Q, the matters discussed in this report are forward looking
statements. These forward looking statements concern matters that involve risks
and uncertainties, including but not limited to those set forth below, that
could cause actual results to differ materially from those projected in the
forward looking statements. In any event, the matters set forth below should be
carefully considered when evaluating the Company's business and prospects.
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 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. In addition,
the Company's quarterly operating results could be materially adversely affected
by legal expenses incurred in connection with, or any adverse judgment in, the
patent litigation with Yamaha Corporation. 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. 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.
Patent Litigation with Yamaha Corporation. In March 1995, Yamaha files
a lawsuit against the Company alleging that the Company's FM synthesis products
infringe two of Yamaha's patents. See "Part II. Other Items - Item 1. Legal
Proceedings."
Competition; Pricing Pressures. 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 sound card suppliers and semiconductor
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manufacturers. The Company expects competition to increase in the future from
existing competitors, including Yamaha, 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, such as announcements by Yamaha, could adversely affect
sales of the Company's products and may result in increased price competition
that would adversely affect the average selling prices ("ASPs") 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. 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 competitors, the emergence
of new multimedia PC 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 three
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.
Most of the Company's products are sold for incorporation into
multimedia desktop and notebook computers. ESS audio semiconductors are
incorporated into motherboards by multimedia PC original equipment manufacturers
("OEMs") or in add-in sound cards. Therefore, the Company is heavily
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dependent on the continued growth of the markets for multimedia desktop and
notebook computers and multimedia applications utilizing high quality audio.
Currently, the market for PCs, including multimedia PCs is undergoing a slower
rate of growth than in previous years and the overall PC industry has
historically been cyclical. There can be no assurance that the high levels of
growth previously experienced by the PC industry will return in future periods.
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. The Company is currently engaged in the development of new
PC audio products as well as new multimedia products that provide telephony
capabilities such as fax/modem/voice, and graphics and video 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.
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 $32 million over the
next 2 years to TSMC in exchange for certain wafer capacity commitments and
will invest approximately $23 million in 2 installments over the next 15
months in exchange for an equity ownership in a joint venture with UMC to
build a new foundry and for certain wafer capacity commitments.
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
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<PAGE> 13
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 three months of 1996,
international sales, accounted for a substantial majority of the Company's net
revenues. Substantially all of the Company's international sales were to
customers in Taiwan, Japan, Singapore and Hong Kong. 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 general geopolitical risks in connection with its international trade
relationships. In particular, Taiwan, which represents a majority of the
Company's sales and is the location of its major foundries and two test
facilities, is currently experiencing military threats from mainland China. If
the highly publicized tensions escalate, it is possible that purchases by
Taiwanese customers will decline significantly and semiconductor manufacturing
in Taiwan will be seriously impeded, cutting off the Company's main supply of
guaranteed wafer production. This could also lead to capacity constraints at
non-Taiwanese foundries. 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
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<PAGE> 14
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. Although
the semiconductor industry in recent periods has experienced increased demand,
it is uncertain how long these conditions will continue. The Company may
experience substantial period-to-period fluctuations in operating results due to
general semiconductor industry conditions.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In March 1995, Yamaha filed a lawsuit against the Company alleging that
the Company's FM synthesis products infringe two of Yamaha's patents, U.S.
Patent No. 4,249,447 and U.S. Patent No. 4,813,326 (the "Yamaha Patents").
Yamaha initiated suit with a motion for a temporary restraining order and a
request for a preliminary injunction. In addition, in its complaint, Yamaha
seeks a permanent injunction against future infringement, damages for past
infringement, attorneys' fees and costs. Yamaha's lawsuit alleges infringement
by all of the Company's FM synthesis chips, currently consisting of the ES1488,
ES1688, ES1788, ES1868 and ES1888. For 1995, the Company had revenues of
approximately $52.9 million attributable to sales of these products,
constituting approximately 50% of net revenues. Further, a substantial majority
of the Company's revenues for the foreseeable future is expected to be dependent
upon sales of these and future products incorporating FM synthesis. The lawsuit,
entitled Yamaha Corporation vs. ESS Technology, Inc., is pending in the U.S.
District Court for the Central District of California in Los Angeles,
California.
Yamaha's requests for a temporary restraining order and preliminary
injunction were denied on March 17, 1995 and May 1, 1995, respectively. In its
order denying the request for preliminary injunction, the District Court stated
that its decision was based on an assessment of the likelihood of Yamaha's
success on the merits, as well as a balance of the relative hardships that would
be suffered by ESS or Yamaha as a result of the granting or denial of the
preliminary injunction. Yamaha appealed the District Court's denial of the
request for preliminary injunction to the U.S. Court of Appeals for the Federal
Circuit. On March 29, 1996, that Court affirmed the denial of the request for
preliminary Injunction.
On August 18, 1995 the District Court granted in part and denied in
part a motion for summary judgment which had been filed by the Company. The
District Court held that the Company's FM synthesis products did not literally
infringe Yamaha's U.S. Patent No. 4,249,447, but held that there was a triable
issue of fact as to the infringement of such patent on another basis. The Court
also found triable issues of fact and, therefore, denied the Company's motion
for summary judgment with regard to U.S. Patent No. 4,813,326. Trial in the
Yamaha litigation is expected to begin in early 1997.
The Company does not believe that its products infringe the Yamaha
Patents and, as a result, the Company believes it will ultimately prevail in its
litigation with Yamaha. ESS was aware of the Yamaha Patents during the period it
was designing its FM synthesis products in 1993 and 1994 and received opinions
from its patent counsel, the Law Offices of Thomas E. Schatzel, regarding
non-infringement in connection with the design of such products before the
products were sold. ESS is vigorously contesting all of Yamaha's claims.
However, the Company cannot predict the final resolution of the lawsuit. In
the event a permanent injunction were to be granted after trial, the Company
would be unable to sell the ES1488, ES1688, ES1788, ES1868 and ES1888 and any
other products incorporating the Company's current technique for providing FM
synthesis capability. The grant of a permanent injunction would result in a
material adverse effect on the Company's business, financial condition and
results of operations, including a substantial reduction in the Company's
revenues and income, losses for an extended period of time and a substantial
depletion in the Company's financial resources. In addition, the Company could
be required to pay significant monetary damages to Yamaha, which are subject to
trebling in the event of a finding of willful infringement. Further, the Company
has agreed to indemnify customers from liability with respect to claimed
infringements of the Yamaha Patents and, in the event of a determination of
infringement and the grant of an injunction, the Company has agreed to either
secure a license for its customers to continue using the enjoined chips, replace
the chips with noninfringing chips or remove the chips and refund the purchase
price of such chips. Such indemnification increases the Company's exposure to,
and amount of, potential costs and liability in such event, and could have a
material adverse effect on the Company's business, financial condition and
results of operations. In the event of an injunction, the Company could
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<PAGE> 16
attempt to obtain a license from Yamaha to enable the Company to continue to
sell products incorporating the Company's current technique for implementing FM
synthesis. The Company could also attempt to develop a different technique for
implementing FM synthesis and modify the design of its products in an effort to
avoid infringement of the Yamaha Patents. Even if successful, any such efforts
would require a substantial period of time to complete and there can be no
assurance that such efforts would result in competitive products. During such
period, the Company could continue to sell the ES488, ES688 and other products
that do not incorporate FM synthesis capability. However, there can be no
assurance as to the amount of revenues that the Company would receive from the
sale of such products.
In connection with the Yamaha litigation, the Company has incurred and
expects to continue to incur substantial legal and other expenses. In addition,
the Yamaha litigation has diverted and is expected to continue to divert the
efforts and attention of the Company's management and technical personnel.
Patent litigation is highly complex and can extend for a protracted period of
time, which can substantially increase the cost of such litigation. Accordingly,
the expenses and diversion of resources associated with the Yamaha litigation
could have a material adverse effect on the Company's business, financial
condition and results of operations. If the Yamaha lawsuit were to be resolved
by a settlement, ESS might be required to make substantial payments to Yamaha or
to grant a license to Yamaha to utilize certain of the Company's technology,
which could have a material adverse effect on the Company's business, financial
condition and results of operations.
Yamaha is the holder of a number of patents relating to the use of
music synthesis technology. In addition, new patent applications may be
currently pending or be filed in the future by Yamaha. Pending U.S. patent
applications are confidential until patents are issued, and thus it is
impossible to ascertain all possible patent infringement issues. The Company
believes that Yamaha may have a strategy of protecting their market share by
filing intellectual property claims against certain competitors and may assert
additional claims against the Company in the future regardless of the outcome of
the present litigation. Potential additional litigation would likely involve
different patents or other claims. In addition, new patent applications may be
currently pending or be filed in the future by Yamaha. The legal and other
expenses and diversion of resources associated with any such litigation could
materially and adversely affect the Company's business, financial condition and
results of operations.
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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
27.01 -- Financial Data schedule
(b) Reports on Form 8-K. The Company filed a report Form 8-K dated
January 17, 1996 pursuant to Item 2 of Form 8-K and the required
financial statement were filed with the Form 8-K/A dated March 16,
1996.
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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)
Date: July 19, 1996 By: /s/ RALPH J. HARMS
--------------------
Ralph J. Harms
Vice President, Chief
Financial Officer and Secretary
Page 18
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