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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 June 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)
CALIFORNIA 94-2928582
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
46107 LANDING PARKWAY
FREMONT, CALIFORNIA 94538
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE )
(510) 226-1088
(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 July 31, 1996, the registrant had 38,080,028 shares of common stock
outstanding.
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ESS TECHNOLOGY, INC.
TABLE OF CONTENTS
<TABLE>
Part I. FINANCIAL INFORMATION Page
----
<S> <C>
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets - June 30, 1996 3
and December 31, 1995, unaudited
Condensed Consolidated Statements of Operations - three months 4
and six months ended June 30, 1996 and 1995, unaudited
Condensed Consolidated Statements of Cash Flows - six 5
months ended June 30, 1996 and 1995, unaudited
Notes to Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition and 9
Results of Operations
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 15
Item 4. Submission of Matters to a Vote of Security Holders 15
Item 6. Exhibits and Reports on Form 8-K 16
SIGNATURES 17
</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>
June 30, Dec. 31,
1996 1995
---- ----
ASSETS
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 18,833 $ 51,881
Short-term investments 33,134 26,243
Accounts receivable, net 19,992 10,236
Inventories 23,548 19,169
Deferred income taxes 2,337 2,337
Prepaid expenses and other assets 3,512 2,271
--------- ---------
Total current assets 101,356 112,137
Property and equipment, net 16,235 10,371
Other assets 44,406 40,195
--------- ---------
$ 161,997 $ 162,703
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses $ 32,822 $ 33,744
Income taxes payable 2,229 3,722
Deferred income taxes 5,909 4,069
--------- ---------
Total current liabilities 40,960 41,535
--------- ---------
Long-term advances payable to vendors -- 15,960
--------- ---------
Total liabilities 40,960 57,495
--------- ---------
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;
39,165 and 36,794 shares issued and outstanding 92,298 66,891
Cumulative marketable securities valuation adjustment (1,520) --
Deferred compensation related to stock options (30) (60)
Retained earnings 30,289 38,377
--------- ---------
Total shareholders' equity 121,037 105,208
--------- ---------
Total liabilities and shareholders' equity $ 161,997 $ 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)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
---------------------- -----------------------
June 30, June 30, June 30, June 30,
1996 1995 1996 1995
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Net revenues $ 48,450 $ 21,363 $ 89,638 $ 37,504
Cost of revenues 21,889 8,115 39,526 13,283
-------- -------- -------- --------
Gross profit 26,561 13,248 50,112 24,221
Operating expenses:
Research and development 4,551 2,110 8,182 3,339
Research and development in-process -- -- 30,355 --
Selling, general and administrative 3,253 1.949 6,188 4,989
-------- -------- -------- --------
Operating income 18,757 9,189 5,387 15,893
Nonoperating income, net 640 439 1,339 798
-------- -------- -------- --------
Income before provision for income taxes 19,397 9,628 6,726 16,691
Provision for income taxes 7,565 3,952 14,815 6,848
-------- -------- -------- --------
Net income $ 11,832 $ 5,676 $ (8,089) $ 9,843
======== ======== ======== ========
Net income per share $0.28 $0.15 $(0.22) $0.27
======== ======== ======== ========
Weighted average common and common
equivalent shares 42,414 37,323 37,463 37,049
======== ======== ======== ========
</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>
Six Months Ended
----------------
June 30, June 30,
1996 1995
-------- --------
<S> <C> <C>
Cash flows from operating activities:
Net income $ (8,089) $ 9,843
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 1,201 311
Charges for research and development in-process 30,355 --
Loss (gain) on sales of marketable equity securities, net -- (487)
Deemed compensation expense and compensation related to stock options 30 30
Other non cash activity -- (85)
Change in assets and liabilities (net of effects of VideoCore and
OSEE acquisitions):
Accounts receivable (9,756) (4,491)
Inventories (4,367) (3,533)
Deferred income taxes -- (902)
Prepaid expenses and other assets (1,140) (200)
Accounts payable and accrued expenses (4,889) 5,766
Income taxes payable (1,493) (1,873)
-------- --------
Net cash provided by operating activities 1,852 4,379
-------- --------
Cash flows from investing activities:
Acquisition of property and equipment (6,672) (1,188)
Sale of marketable equity securities and short-term investments 1,965 571
Purchase of marketable equity securities and short-term investments (10,376) --
Cash paid for VideoCore and OSEE acquisitions (9,288) --
-------- --------
Net cash provided by (used in) investing activities (24,371) (617)
-------- --------
Cash flows from financing activities:
Repayment of long-term debt (12,600) --
Issuance of common stock 2,071 73
-------- --------
Net cash provided by (used in) financing activities (10,529) 73
-------- --------
Net increase (decrease) in cash and cash equivalents (33,048) 3,835
Cash and cash equivalents at beginning of period 51,881 10,860
-------- --------
Cash and cash equivalents at end of period $ 18,833 $ 14,695
======== ========
Supplemental disclosures of cash flow information:
Common stock issued for VideoCore and OSEE acquisitions $ 23,352 $--
======== ========
Income taxes $ 13,001 $ 9,624
======== ========
</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)
<TABLE>
<CAPTION>
June 30, 1996 Dec. 31, 1995
------------- ---- --------
<S> <C> <C>
Inventories:
Raw materials $ 1,461 $ 2,773
Work-in-process 14,376 9,224
Finished goods 7,711 7,172
------- -------
$23,548 $19,169
======= =======
</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
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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 sought an injunction against
future infringement, damages for past infringement, fees and costs.
On May 17, 1996, the Company and Yamaha settled all patent infringement
litigation between the two companies. The settlement agreement did not have a
material adverse affect on the financial position of the Company as of June 30,
1996 or on the results of operations for any period through June 30, 1996. Also,
the settlement agreement does not have a material adverse affect on the
Company's ability to sell its products or conduct its operations. See "Part II.
Other Items - Item 1. Legal Proceedings."
NOTE 5. 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. 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.
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 and first six months of 1996 or 1995.
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NOTE 7. SUBSEQUENT EVENTS - STOCK REPURCHASE PROGRAM
On July 15, 1996, the Company's board of directors authorized repurchase of
the Company's shares up to 2.0 million over the next 12 months at market prices
and as market and business conditions warrant. Such repurchases will be made at
management's discretion. At July 31, 1996, the Company had repurchased
1,123,500 shares at market prices ranging from $ 9.41 to $11.63 per share.
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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 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.
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
-------------------------- --------------------------
June 30, June 30, June 30, June 30,
1996 1995 1996 1995
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Net revenues 100.0% 100.0% 100.0 % 100.0%
Cost of revenues 45.2 38.0 44.1 35.4
----- ----- ----- -----
Gross margin 54.8 62.0 55.9 64.6
Operating expenses:
Research and development 9.4 9.9 9.1 8.9
Research and development in-process -- -- 33.9 --
Selling, general and administrative 6.7 9.1 6.9 13.3
----- ----- ----- -----
Operating income (loss) 38.7 43.0 6.0 42.4
Nonoperating income (expense), net 1.3 2.1 1.5 2.1
----- ----- ----- -----
Income before provision for income taxes 40.0 45.1 7.5 44.5
Provision for income taxes 15.6 18.5 16.5 18.3
----- ----- ----- -----
Net income (loss) 24.4% 26.6% (9.0)% 26.2%
===== ===== ====== =====
</TABLE>
Net Revenues. The Company's net revenues, which have primarily been derived
from PC audio semiconductor product sales, increased from $21.4 million in the
second quarter of 1995 to $48.5 million reported in the second quarter of 1996.
Net revenues increased primarily due to increased unit shipments of the
Company's PC audio semiconductor products. In addition, during the second
quarter, the Company commenced volume shipments of its MPEG1 video products. The
Company's overall average selling price for its products was higher in the
second quarter of 1996 as compared to the same quarter of 1995, primarily due to
increased sales of more highly integrated PC audio semiconductor products 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
91% and 68% of the Company's net revenues in the second quarter of 1996 and
1995, respectively, reflecting continued growth in the Company's international
sales. International revenues include shipments to foreign locations of
multinational U.S. based companies.
The Company's net revenues increased from $37.5 million in the first six
months of 1995 to $89.6 million reported in the first six months 1996. Net
revenues increased primarily due to increased unit shipments of the Company's
existing PC audio semiconductor products and new PC audio and video
semiconductor products, partially offset by a decrease in unit shipments of
consumer speech/sound semiconductors. International revenues accounted for
approximately 91% and 68% of the Company's net revenues in the first six months
of 1996 and 1995, respectively, reflecting continued growth in the Company's
international sales.
Gross Profit. The Company's gross profit increased from $13.2 million and
$24.2 million in the second quarter and first six months of 1995, respectively,
to $26.6 million and $50.1 million in the second quarter and first six months of
1996. The increase in gross profit in both the second quarter and first six
months of 1996 as compared
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to the same periods in 1995 was primarily the result of the increase in unit
shipments of the Company's PC audio semiconductor products.
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 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.
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 was $4.6
million and $8.2 million in the second quarter and first six 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 $2.4 million and $4.8
million from the second quarter of 1995, respectively. The increase in absolute
dollars was primarily due to 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 $3.3 million and $6.2 million in the second quarter and first six
months of 1996, respectively, an increase of $1.3 million and $1.2 million from
the second quarter and first six 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 $3.0 million from the
first six months 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.
Interest Income. Interest income consists of income on cash available for
investment. Interest income, was $632,000 and $1.3 million in the second quarter
and first six months of 1996, respectively, compared to $171,000 and $311,000 in
the second quarter and first six months of 1995, respectively. The increase in
interest income, net for the second 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 and payments under the TSMC wafer capacity
and UMC joint venture agreements.
Provision for Income Taxes. The Company's effective tax rate was 39% and
40% for the second quarter and first six months of 1996, respectively, compared
to 41% in the second quarter and first six months 1995. The effective tax rate
for the first six months of 1996 was approximately equal to the combined federal
and state statutory rates.
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 June 30, 1996, ESS had cash and
cash equivalents and short-term investments of $52.0 million and working capital
of $60.4 million. As of June 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 June 30,
1996.
In the first six months of 1996, the Company's operating activities
provided approximately $1.9 million. Excluding the $4.6 million of intangible
asset created by the acquisition of VideoCore and OSEE, during the first six
months of 1996 approximately $21.6 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
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having credit terms compared to customers on letter of credit, coupled with a
decrease in accounts payable and accrued expenses. Additionally, during the
first six months of 1996, the Company has used approximately $12.6 million and
$6.9 million to pay the first installment under the TSMC wafer capacity and UMC
joint venture agreement, respectively, $10.4 million to purchase short-term
investments, $9.3 million to acquire VideoCore and OSEE and $6.7 million which
was primarily to fund the construction of a new headquarters facility and
purchase property, plant and equipment.
On July 15, 1996, the Company's board of directors authorized repurchase of
the Company's shares up to 2.0 million over the next 12 months at market prices
and as market and business conditions warrant. Such repurchases will be made at
management's discretion. At July 31, 1996, the Company had repurchased
1,123,500 shares at market prices ranging from $ 9.41 to $11.63 per share.
The Company believes that its existing cash and cash equivalents as of June
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 $5 million
will be used to fund construction of a new headquarters facilities and
approximately $9 million will be used to acquire capital equipment. In
addition, the Company is obligated to pay approximately $19 million over the
next 18 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.
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 bank lines 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. 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.
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 manufacturers. The Company
expects
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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 six 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 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.
12
<PAGE> 13
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 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 $19 million over the
next year 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.
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
13
<PAGE> 14
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 six months of 1996, international
sales, accounted for 91% 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 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. 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.
14
<PAGE> 15
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 sought a
permanent injunction against future infringement, damages for past infringement,
attorneys' fees and costs. Yamaha's lawsuit alleged infringement by all of the
Company's FM synthesis chips, currently consisting of the ES1488, ES1688,
ES1788, ES1868 and ES1888. The lawsuit, entitled Yamaha Corporation vs. ESS
Technology, Inc., was filed 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.
On May 17, 1996, the Company and Yamaha settled all patent infringement
litigation between the two companies. The settlement agreement did not have a
material adverse affect on the financial position of the Company as of June 30,
1996 or on the results of operations for any period through June 30, 1996. Also,
the agreement does not have a material adverse affect on the Company's ability
to sell its products or conduct its operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Annual Meeting of Stockholders of ESS Technology, Inc. was held on June
20, 1996 in San Jose California. Of the total 37,610,573 shares outstanding as
of the record date, 32,940,036 were present or represented by proxies at the
meeting. The table below presents the results of the election of the Company's
board of directors:
<TABLE>
<CAPTION>
Votes Votes
For Withheld
--- --------
<S> <C> <C>
Fred S.L. Chan 32,789,595 150,441
Annie M.H. Chan 32,788,755 151,281
Michael A. Aymar 32,790,455 149,581
Peter T. Mok 32,788,555 151,481
Herbert J. Martin 32,787,755 152,281
Ilbok Lee 32,789,455 150,581
</TABLE>
The stockholders ratified the appointment of Price Waterhouse LLP as the
Company's independent accountants for the year ending December 31, 1996. The
proposal received 32,917,091 affirmative votes, 12,456 negative votes, 10,489
abstentions, and zero broker non-votes.
15
<PAGE> 16
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
27.01 -- Financial Data schedule
(b) Reports on Form 8-K. No reports were filed on Form 8-K for the quarter
ended June 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)
Date: August 14, 1996 By: /s/ FRED S.L. CHAN
-------------------
Fred S.L. Chan
President, Chief Executive Officer
and Chairman of the Board
Date: August 14, 1996 By: /s/ RALPH J. HARMS
-------------------
Ralph J. Harms
Vice President, Chief
Financial Officer and Secretary
17
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<CURRENCY> U.S. DOLLARS
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> APR-01-1996
<PERIOD-END> JUN-30-1996
<EXCHANGE-RATE> 1
<CASH> 18,833
<SECURITIES> 33,134
<RECEIVABLES> 20,094
<ALLOWANCES> 102
<INVENTORY> 23,548
<CURRENT-ASSETS> 101,356
<PP&E> 19,798
<DEPRECIATION> 3,563
<TOTAL-ASSETS> 161,997
<CURRENT-LIABILITIES> 40,960
<BONDS> 0
0
0
<COMMON> 92,298
<OTHER-SE> (1,550)
<TOTAL-LIABILITY-AND-EQUITY> 161,997
<SALES> 48,450
<TOTAL-REVENUES> 48,450
<CGS> 21,889
<TOTAL-COSTS> 21,889
<OTHER-EXPENSES> 7,804
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (640)
<INCOME-PRETAX> 19,397
<INCOME-TAX> 7,565
<INCOME-CONTINUING> 11,832
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 11,832
<EPS-PRIMARY> 0.28
<EPS-DILUTED> 0.28
</TABLE>
