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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934.
For the quarterly period ended September 30, 1997.
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.)
48401 FREMONT BOULEVARD
FREMONT, CALIFORNIA 94538
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)
(510) 492-1088
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
Indicate by check whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ]
As of September 30, 1997, the registrant had 40,442,389 shares of common
stock outstanding.
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ESS TECHNOLOGY, INC.
TABLE OF CONTENTS
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PAGE
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets - September 30, 3
1997 and December 31, 1996, unaudited
Condensed Consolidated Statements of Operations - three
and nine months ended September 30, 1997 and 1996,
unaudited 4
Condensed Consolidated Statements of Cash Flows -
nine months ended September 30, 1997 and 1996, unaudited 5
Notes to Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 8
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K 16
SIGNATURES 17
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ESS TECHNOLOGY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(in thousands)
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SEPT. 30, DEC. 31,
1997 1996
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ASSETS
Current assets:
Cash and cash equivalents $ 42,373 $ 49,055
Short-term investments 2,280 20,149
Accounts receivable, net 37,011 22,054
Inventories 36,513 33,150
Deferred income taxes 3,270 3,270
Prepaid expenses and other assets 5,055 6,338
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Total current assets 126,502 134,016
Property and equipment, net 29,657 22,366
Other assets 62,164 55,603
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$218,323 $211,985
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LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses $ 26,958 $ 29,504
Advances payable to vendors - 28,929
Income taxes payable 1,970 4,964
Deferred income taxes 9,947 5,412
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Total current liabilities 38,875 68,809
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Commitments and contingencies (See Note 3)
Shareholders' equity:
Preferred stock, no par value, 10,000 shares authorized;
none issued and outstanding -- --
Common stock, no par value, 100,000 shares authorized;
40,442 and 38,127 shares issued and outstanding 133,755 98,655
Retained earnings 45,693 44,521
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Total shareholders' equity 179,448 143,176
-------- --------
Total liabilities and shareholders' equity $218,323 $211,985
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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>
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THREE MONTHS ENDED NINE MONTHS ENDED
---------------------- ----------------------
SEPT. 30, SEPT. 30, SEPT. 30, SEPT. 30,
1997 1996 1997 1996
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Net revenues $ 52,172 $ 60,138 $178,782 $149,776
Cost of revenues 35,200 29,540 104,191 69,066
-------- -------- -------- --------
Gross profit 16,972 30,598 74,591 80,710
Operating expenses:
Research and development 8,343 5,577 20,971 13,760
Research and development in-process - -- 22,200 30,355
Selling, general and administrative 6,303 4,352 17,476 10,540
-------- -------- -------- --------
Operating income 2,326 20,669 13,944 26,055
Nonoperating income, net 417 418 1,864 1,757
-------- -------- -------- --------
Income before provision for income taxes 2,743 21,087 15,808 27,812
Provision for income taxes 1,025 8,224 14,636 23,038
-------- -------- -------- --------
Net income $ 1,718 $ 12,863 $ 1,172 $ 4,774
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Net income per share $ 0.04 $ 0.31 $ 0.03 $ 0.11
======== ======== ======== ========
Weighted average common and
common equivalent shares 43,390 41,128 42,773 41,805
======== ======== ======== ========
</TABLE>
See notes to condensed consolidated financial statements
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ESS TECHNOLOGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(in thousands)
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NINE MONTHS ENDED
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SEPT. 30, SEPT. 30,
1997 1996
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Cash flows from operating activities:
Net income $ 1,172 $ 4,774
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation and amortization 5,026 2,267
Charges for research and development in-process 22,200 30,355
Compensation related to stock options -- 45
Change in assets and liabilities (net of
effects of acquisitions):
Accounts receivable (14,943) (14,157)
Inventories (3,266) (12,259)
Prepaid expenses and other assets 5,984 (2,521)
Accounts payable and accrued expenses (32,258) 1,805
Income taxes payable (2,994) (1,797)
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Net cash provided by (used in) operating activities (19,079) 8,512
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Cash flows from investing activities:
Acquisition of property and equipment (10,398) (11,258)
Sale of marketable equity securities and short-term investments 18,889 7,360
Purchase of marketable equity securities and short-term investments (1,020) (10,376)
Cash received from (paid for) acquisitions 2,529 (9,288)
-------- --------
Net cash provided by (used in) investing activities 10,000 (23,562)
-------- --------
Cash flows from financing activities:
Repayment of long-term advances payable to vendors -- (15,960)
Issuance of common stock 2,397 (17,420)
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Net cash provided by (used in) financing activities 2,397 (33,380)
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Net decrease in cash and cash equivalents (6,682) (48,430)
Cash and cash equivalents at beginning of period 49,055 51,881
-------- --------
Cash and cash equivalents at end of period $ 42,373 $ 3,451
======== ========
Supplemental disclosures of cash flow information:
Common stock issued for acquisitions $ 32,703 $ 23,352
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Income taxes $ 18,300 $ 24,835
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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, 1996 and 1995, 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, 1997.
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. Interest income is accrued as earned. At
September 30, 1997 the fair value of the Company's investments approximated
cost.
Revenue Recognition
Revenue from product sales is recognized at the time of shipment except
for certain shipments to distributors with right of return and allowance in
which case revenue is deferred until the distributor resells the product. For
sales recognized at the time of shipment, reserves for estimated returns and
price adjustments are provided at the time of shipment.
NOTE 2. BALANCE SHEET COMPONENTS (IN THOUSANDS)
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SEPT. 30, 1997 DEC. 31, 1996
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Inventories:
Raw materials $2,851 $ 2,192
Work-in-process 22,867 14,302
Finished goods 13,236 18,797
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38,954 35,291
Less: inventory reserves (2,441) (2,141)
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$36,513 $33,150
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NOTE 3. 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.
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Under the TSMC agreement, in exchange for TSMC's increased wafer
capacity commitments, the Company agreed to pay approximately $32 million over
the next two years as deposits for wafers through 1999. The cash requirements
associated with this agreement were 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 paid the first $16 million installment by
making payments of $12.6 million and $3.4 million on June 28 and July 1, 1996,
respectively. In the third quarter of 1997, the Company paid the second
installment of $16 million. 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 agreed to invest approximately $24.4 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 and the second installment payment of $13.0 million in
the first quarter of 1997. Under the terms of the agreement, the Company will
receive approximately a 5% equity ownership in the joint venture company and
certain capacity rights. In the third quarter of 1997, the joint venture
semiconductor manufacturing facility under construction suffered heavy damages
from a fire during its construction. The management of the joint venture has
stated that it expects that insurance will cover its fire losses. The Company
does not anticipate any potential wafer capacity constraints at this time.
NOTE 4. RECENT ACCOUNTING PRONOUNCEMENT
In February 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 128 ("SFAS 128"), "Earnings per
Share." This statement redefines earnings per share under generally accepted
accounting principles. Under the new standard, primary earnings per share is
replaced by basic earnings per share and fully diluted earnings per share is
replaced by diluted earnings per share. The Company is required to adopt the new
standard in the fourth calendar quarter of 1997. The following table sets forth
primary earnings per share as reported and unaudited pro forma basic and diluted
earnings per share assuming SFAS 128 had been applied during the periods
presented:
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THREE MONTHS ENDED NINE MONTHS ENDED
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SEPT. 30, SEPT. 30, SEPT. 30, SEPT. 30,
1997 1996 1997 1996
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Primary earnings per share as reported $0.04 $0.31 $0.03 $0.11
Pro forma earnings per share 0.04 0.34 0.03 0.13
Pro forma diluted earnings per share 0.04 0.31 0.03 0.11
</TABLE>
NOTE 5. STOCK REPURCHASE PROGRAM
On April 29, 1997, the Company's board of directors authorized the
repurchase of up to two million of the Company's common shares at market prices
and as market and business conditions warrants. Such repurchases will be made at
management's discretion. At September 30, 1997, the Company had not repurchased
shares.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Statements contained in this discussion that are not statements of
historical fact may be deemed to be forward-looking statements. A number of
important factors could cause actual events or the Company's actual results to
differ materially from those indicated by such forward-looking statements,
including dependence on continued growth in demand for PC multimedia
capabilities for notebook and desktop computers, as well as consumer electronic
products; the Company's ability to take advantage of new markets; increased
competition and pricing pressures, general economic conditions and conditions
specific to the semiconductor industry; the timing and market acceptance of new
product introductions; the timely development of new products; continued
availability of quality foundry capacity; dependence on sales to customers in
Asia which are denominated in United States dollars; and other risks set forth
in this filing and in the Company's filings from time to time with the
Securities and Exchange Commission.
This information should be read along with the unaudited condensed
consolidated financial statements and notes thereto included in Item I of this
Quarterly Report and the audited Consolidated Financial Statements and notes
thereto and Management's Discussion and Analysis of Financial Condition and
Results of Operations for the fiscal years ended December 31, 1996 and 1995,
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
operations, expressed as a percentage of revenues.
<TABLE>
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THREE MONTHS ENDED NINE MONTHS ENDED
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SEPT. 30, SEPT. 30, SEPT. 30, SEPT. 30,
1997 1996 1997 1996
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<S> <C> <C> <C> <C>
Net revenues 100.0% 100.0% 100.0% 100.0%
Cost of revenues 67.5 49.1 58.3 46.1
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Gross margin 32.5 50.9 41.7 53.9
Operating expenses:
Research and development 16.0 9.3 11.7 9.2
Research and development in-process -- -- 12.4 20.3
Selling, general and administrative 12.1 7.2 9.8 7.0
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Operating income 4.4 34.4 7.8 17.4
Nonoperating income, net 0.8 0.7 1.0 1.2
----- ----- ----- -----
Income before provision for income taxes 5.2 35.1 8.8 18.6
Provision for income taxes 1.9 13.7 8.2 15.4
----- ----- ----- -----
Net income 3.3% 21.4% 0.6% 3.2%
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Net Revenues. The Company's net revenues decreased from $60.1 million in
the third quarter of 1996 to $52.2 million in the third quarter of 1997. Net
revenues for the third quarter of 1997 decreased 13% from 1996 as a result of a
highly competitive pricing environment. International revenues accounted for
substantially all of the Company's revenues in the third quarters of 1997 and
1996. International revenues include shipments to foreign locations of
multinational U.S. based companies.
The Company's net revenues increased from $149.8 million in the first
nine months of 1996 to $178.8 million reported in the first nine months of 1997,
a 19% increase. Net revenues increased primarily due to increased unit shipments
of the Company's existing PC audio products and sales of new PC audio and video
semiconductor products. International revenues accounted for substantially all
of the Company's net revenues for the first nine months of 1996 and 1997.
Gross Profit. The Company's gross profit decreased from $30.6 million in
the third quarter of 1996 to $17.0 million in the third quarter of 1997. The
decrease in gross profit in the third quarter of 1997 as compared to the same
period in 1996 was primarily the result of lower average selling prices ("ASPs")
on existing products arising from highly competitive market conditions.
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The Company's gross profit decreased from $80.7 million in the first
nine months of 1996 to $74.6 million in the first nine months of 1997. The
decrease in gross profit was primarily the result of lower ASPs in existing
products arising from highly competitive market conditions.
Research and Development. Research and development expenses were $8.3
million and $21.0 million in the third quarter and first nine months of 1997,
respectively, compared to $5.6 million and $13.8 million in the third quarter
and first nine months of 1996, respectively. Research and development expenses
exclude one-time pre and post-tax charges of $22.2 million related to acquired
research and development in-process from the acquisition of Platform
Technologies, Inc. ("Platform") in the second quarter of 1997, and $30.4 million
related to acquired research and development in-process from the acquisition of
VideoCore Technology, Inc. ("VideoCore") and OSEE Technology, Inc. ("OSEE") in
the first quarter of 1996. The increase in absolute dollars was primarily due to
the increase in the Company's engineering staff, engineering test runs, masks,
internal and external consulting expenses associated with increased research and
development efforts to support the introduction of new PC audio and multimedia
products as well as the expenses for the amortization of assets from the
acquisition of Platform, VideoCore and OSEE.
Selling, General and Administrative. Selling, general and administrative
expenses were $6.3 million and $17.5 million in the third quarter and first nine
months of 1997, respectively, compared to $4.4 million and $10.5 million in the
third quarter and first nine month of 1996, respectively. The increase in
absolute dollars was primarily due to added personnel and related expenses and,
to a lesser extent, promotional expenses and costs associated with the expansion
of the Company's sales activities.
Non-Operating Income, Net. Non-operating income, net was $417,000 and
$1.9 million in the third quarter and first nine months of 1997, respectively,
compared to $418,000 and $1.8 million in the third quarter and first nine months
of 1996, respectively. Non-operating income, net consisted of interest income
and gains on sale of securities, net of interest expense.
Provision for Income Taxes. The Company's effective tax rate was 39.0%
and 37.4% for the third quarter of 1996 and 1997, respectively. Excluding the
one-time pre and post-tax charge of $22.2 million related to acquired research
and development in-process from the acquisition of Platform, the Company's pro
forma tax rate for the first nine months of 1997 was lower than the combined
federal and state statutory rates as a result of tax exempt interest income and
research and development credits.
LIQUIDITY AND CAPITAL RESOURCES
Since its inception, the Company has financed its cash requirements from
cash generated from operations, the sale of equity securities, bank lines of
credit and long-term and short-term debt. At September 30, 1997, the Company had
cash and cash equivalents and short-term investments of $44.7 million and
working capital of $87.6 million. As of September 30, 1997, the Company had two
lines of credit. One line of credit is for $20 million and will expire on May
31, 1999. The second line of credit is for $10 million and will expire on June
10, 1998. These lines of credit require the Company to achieve certain financial
ratios and operating results. There were no borrowings under these lines of
credit as of September 30, 1997.
In the first nine months of 1997, the Company generated cash of $28.4
million from operating activities consisting of net income of $23.4 million and
depreciation and amortization of $5.0 million after excluding a one-time pre and
post-tax charge of $22.2 million related to the acquired research and
development in-process from the acquisition of Platform. The Company received
net proceeds of $17.9 million from sale of marketable equity securities and $2.4
million from issuance of common stock from exercise of stock options and
employee stock purchase plan. Approximately $47.5 million was used to finance
working capital, primarily due to increase in accounts receivable, reflecting a
growth in sales, coupled with a decrease in accounts payable and accrued
liabilities. $10.4 million was used to purchase property, plant and equipment.
Additionally, the Company received $2.5 million on the acquisition of Platform.
The Company believes that its existing cash and cash equivalents as of
September 30, 1997, 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 $17.0 million of which
approximately $8.2 million will be used to fund construction of additional
facilities and approximately $8.8 million will be used to acquire capital
equipment. In addition, the Company will invest approximately $5.0 million over
the next 2 months in exchange for an equity ownership in a joint venture with
UMC to build a new
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foundry and for certain wafer capacity commitments. In addition, on April 29,
1997, the Company's board of directors authorized the repurchase of up to two
million of the Company's common shares at market prices and as market and
business conditions warrants. Such repurchases will be made at management's
discretion. At September 30, 1997, the Company had not repurchased shares. 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.
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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 which
involve risks and uncertainties that could cause actual results to differ from
those indicated by such forward looking statements. Such risks and uncertainties
include but are not limited to those set forth below. In any event, the matters
set forth below should be carefully considered when evaluating the Company's
business and prospects.
RISK FACTORS
Potential Fluctuations in Operating Results. The Company's operating
results are subject to quarterly and other fluctuations due to a variety of
factors, including the gain or loss of significant customers, increased
competitive pressures, changes in pricing policies by the Company, its
competitors or its suppliers, including decreases in unit average selling prices
("ASPs") of the Company's products, the timing of new product announcements and
introductions by the Company or its competitors and market acceptance of new or
enhanced versions of the Company's and its customers' products. Other factors
include seasonal customer demand, 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, 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 card suppliers and semiconductor manufacturers. The Company expects
competition to increase in the future from existing competitors and from other
companies that may enter the Company's existing or future markets with products
that may be at lower costs or provide higher levels of integration, higher
performance or additional features. The Company is unable to predict the timing
and nature of any such competitive product offerings. The announcement and
commercial shipment of competitive products could adversely affect sales of the
Company's products and may result in increased price competition that would
adversely affect the 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 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, as well as a
number of smaller and emerging companies. The Company's principal competitors
include C-Cube, Cirrus Logic, Creative Technology, LSI Logic, Lucent, Oak
Technology, OPTi, Rockwell, SGS Thompson, Texas Instruments, Winbond 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
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 multimedia 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
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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 PC and consumer markets. In the third quarter of 1997, sales
of PC audio semiconductors accounted for a majority of the Company's net
revenues, and the Company expects that sales of audio semiconductors will
continue to account for a significant portion of its net revenues for the
foreseeable future. Similarly, the Company is receiving significant revenues
from Video Compact Disk ("VCD") semiconductors in the consumer market. Any
reduction in ASPs for products or demand for the Company's semiconductors,
whether because of a reduction in demand for PCs or VCD's in general, increased
competition or otherwise, would have a material adverse effect on the Company's
business, financial condition and results of operations.
The Company is currently engaged in the development and introduction of new
multimedia products for the PC and consumer markets that provide capabilities
such as audio, video and fax/modem/voice applications. There can be no assurance
that the Company will be able to identify market trends or new product
opportunities, develop and market new products, achieve design wins or respond
effectively to new technological changes or product announcements by others. A
failure in any of these areas would have a material adverse effect on the
Company's business, financial condition and results of operations.
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 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 operation.
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
a foundry arrangement with UMC, which has been manufacturing certain of the
Company's products since 1995. 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. During the third quarter, the Company paid
approximately $16 million to TSMC in exchange for certain wafer capacity
commitments. If the Company is not able to use, assign, or sell the additional
wafer quantities, a portion of the deposits may be forfeited. In addition, the
Company expects to
12
<PAGE> 13
invest approximately $5.0 million in one installment over the next two 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 substantially all of the Company's products for
the foreseeable future. In the event that TSMC and UMC are unable to continue to
manufacture the Company's key products in required volumes, the Company will
have to identify and secure additional foundry capacity. In such an event, the
Company may be unable to identify or secure additional foundry capacity from
another manufacturer, particularly at the levels that the Company currently
expects TSMC and UMC to provide. Even if such capacity is available from another
manufacturer, the qualification process could take six months or longer. The
loss of any of its foundries as a supplier, the inability of the Company to
acquire additional capacity at its current suppliers or qualify other wafer
manufacturers for additional foundry capacity should additional capacity be
necessary, or any other circumstances causing a significant interruption in the
supply of semiconductors to the Company would have a material adverse effect on
the Company's business, financial condition and results of operations.
To address potential foundry capacity constraints in the future, ESS will
continue to consider and may be required to enter into additional arrangements,
including equity investments in or loans to independent wafer manufacturers in
exchange for guaranteed production capacity, joint ventures to own and operate
foundries, or "take or pay" contracts that commit the Company to purchase
specified quantities of wafers over extended periods. Any such arrangements
could require the Company to commit substantial capital and grant licenses to
its technology. The need to commit substantial capital may require the Company
to obtain additional debt or equity financing, which could result in dilution to
the Company's shareholders. There can be no assurance that such additional
financing, if required, will be available when needed or, if available, will be
obtained on terms acceptable to the Company.
All of the Company's semiconductor products are assembled and tested by
third-party vendors, primarily Amkor ANAM in Korea, Advanced Semiconductor
Engineering in Taiwan, ASAT in Hong Kong, Astra Microtronics in Indonesia and
OSE in Taiwan. The Company has internally designed and developed its own test
software and certain test equipment which is provided to the Company's test
vendors. Shortages of raw materials or disruptions in the provision of services
by the Company's assembly vendors could lead to supply constraints or delays in
the delivery of the Company's products. Such constraints or delays might result
in the loss of customers, limitations or delays in the delivery of the Company's
revenues or other material adverse effects on the Company's business, financial
conditions and results of operations. The Company's reliance on third-party
assembly and testing vendors involves a number of other risks, including reduced
control over delivery schedules, quality assurance and costs. The inability of
such third parties to deliver products of acceptable quality and in a timely
manner could have a material adverse effect on the Company's business, financial
condition and results of operations.
Customer Concentration. A limited number of customers have accounted for a
substantial portion of the Company's net revenues. The Company has expanded its
distribution activities to better address the China market. Sales to
distributors are generally subject to agreements allowing limited rights of
return and price protection with respect to unsold products. While the Company
has not experienced returns and allowances in excess of the Company's reserves,
returns and allowances in excess of reserves could have a material adverse
impact on the Company's business, financial condition and results of operation.
In addition, the Company has decided to defer revenue recognition to
distributors who resell into the China market. The Company expects that a
limited number of customers may account for a substantial portion of its net
revenues for the foreseeable future. The Company has experienced changes from
year to year in the composition of its major customer base and believes this
pattern may continue. The Company does not have long-term purchase agreements
with any of its customers. The reduction, delay or cancellation of orders from
one or more major customers for any reason or the loss of one or more of such
major customers could materially and adversely affect the Company's business,
financial condition and results of operation. In addition, since the Company's
13
<PAGE> 14
products are often sole sourced to its customers, the Company's operating
results could be materially and adversely affected if one or more of its major
customers were to develop other sources of supply. There can be no assurance
that the Company's current customers will continue to place orders with the
Company, that orders by existing customers will not be canceled or will continue
at the levels of previous periods or that the Company will be able to obtain
orders from new customers. The Company currently places noncancelable orders to
purchase its products from independent foundries on an approximately three-month
rolling basis, while its customers generally place purchase orders with the
Company less than four weeks prior to delivery that may be canceled without
significant penalty. Consequently, if anticipated sales and shipments in any
quarter are canceled or do not occur as quickly as expected, expense and
inventory levels could be disproportionately high and the Company's business,
financial condition and results of operations could be materially adversely
affected.
Management Growth. The Company has recently experienced significant growth
in revenues and the addition of multiple product lines that require additional
management systems and processes. To manage its future operations and growth
effectively, the Company will need to continue to improve its operational,
financial and management information systems, implement additional systems and
controls, and hire, train, motivate, manage and retain its employees. There can
be no assurance that the Company will be able to manage such growth effectively,
and the failure to do so could have a material adverse effect on the Company's
business, financial condition and results of operations.
International Operations. In the third quarter of 1997, international
sales, accounted for substantially all of the Company's net revenues.
Substantially all of the Company's international sales were to customers in Hong
Kong, Taiwan, Korea, Singapore and Japan. 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 Untied 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, Hong Kong, which represents a large market for the Company's
products, has recently been returned to mainland China. Should the transition
result in instability in Hong Kong, it is possible that sales to Hong Kong could
be affected. Such instability could also lead to disruption in the Company's
ability to trade with Taiwan, which represents a large portion of the Company's
sales and is the location of its major foundries and two test facilities. Should
such disruption occur, it is possible that purchases by Taiwanese customers will
decline and semiconductor manufacturing in Taiwan will be impeded, cutting off
the Company's main supply of guaranteed wafer production. This could 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 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
14
<PAGE> 15
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.
Patents and Proprietary Rights. The Company relies on a combination of
patents, trademarks, copyrights, trade secret laws and confidentiality
procedures to protect its intellectual property rights. As of September 30,
1997, the Company had 9 patents granted in the United States, which expire over
time, commencing in 1999 and ending in 2013, and 10 corresponding foreign
patents. In addition, the Company intends to seek further United States and
international patents on its technology. There can be no assurance that patents
will be issued from any of the Company's pending applications or applications in
preparation or that any claims allowed from pending applications or applications
in preparation will be of sufficient scope or strength, or be issued in all
countries where the Company's products can be sold, to provide meaningful
protection or any commercial advantage to the Company. Also, competitors of the
Company may be able to design around the Company's patents. 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. Although the Company is not aware of the
development, distribution or sales of any illegal copies of the Company's
hardware or software, any infringements of its patents, copyrights or
trademarks, or any violation of its trade secrets, confidentiality procedures or
licensing agreements to date, there can be no assurance that the steps taken by
the Company to protect its proprietary information will be adequate to prevent
misappropriation of its technology or that the Company's competitors will not
independently develop technologies that are substantially equivalent or superior
to the Company's technology.
The semiconductor industry is characterized by vigorous protection and
pursuit of intellectual property rights or positions, which have resulted in
significant and often protracted and expensive litigation. There is no pending
intellectual property litigation against the Company. However, the Company or
its foundries may from time to time receive notice of claims that the Company
has infringed patents or other intellectual property rights owned by others. The
Company may seek licenses under such patents or other intellectual property
rights. However, there can be no assurance that licenses will be offered or that
the terms of any offered licenses will be acceptable to the Company. The failure
to obtain a license from a third party for technology used by the Company could
cause the Company to incur substantial liabilities and to suspend the
manufacture of products or the use by the Company's foundries of processes
requiring the technology. Furthermore, the Company may initiate claims or
litigation against third parties for infringement of the Company's proprietary
rights or to establish the validity of the Company's proprietary rights.
Litigation by or against the Company could result in significant expense to the
Company and divert the efforts of the Company's technical and management
personnel, whether or not such litigation results in a favorable determination
for the Company. In the event of an adverse result in any such litigation, the
Company could be required to pay substantial damages, cease the manufacture, use
and sale of infringing products, expend significant resources to develop
noninfringing technology, discontinue the use of certain processes or obtain
licenses for the infringing technology. There can be no assurance that the
Company would be successful in such development or that such licenses would be
available on reasonable terms, or at all, and any such development or license
could require expenditures by the Company of substantial time and other
resources. Although patent disputes in the semiconductor industry have often
been settled through crosslicensing arrangements, there can be no assurance
that, in the event that any third party makes a successful claim against the
Company or its customers, a cross-licensing arrangement could be reached. In
such a case, if a
15
<PAGE> 16
license is not made available to the Company on commercially reasonable, terms,
the Company's business, financial condition and results of operations could be
materially adversely affected.
The Company currently licenses certain of the technology utilized by the
Company in its products, and expects to continue to do so in the future. The
Company has no current plans to grant licenses with respect to its products or
technology; however, it may become necessary for the Company to enter into
product licenses in the future in order, among other things, to secure foundry
capacity. Although the Company has in the past granted licenses to certain of
its technology, some of which have expired, such licenses have been limited and
the Company has not derived material revenues from such licenses in recent
periods.
Dependence on Key Personnel. The Company's success depends to a significant
degree upon the continued contributions of Fred S.L. Chan, the Company's
President, Chief Executive Officer and Chairman of the Board of Directors. As of
September 30, 1997, Mr. Chan, together with his spouse, Annie M.H. Chan, a
director of the Company and certain trusts for the benefit of the Chan's
children and certain charities beneficial owned, in the aggregate, approximately
38% of the Company's Common Stock. The future success of the Company depends on
its ability to continue to attract, retain and motivate qualified senior
management, sales and technical personnel, particularly highly skilled
semiconductor design personnel and software engineers, for whom competition is
intense. Recently, the Company has hired a number of key executives and
management personnel. The loss of Mr. Chan, other key executive officers, key
design personnel or software engineers or the inability to hire and retain
sufficient qualified personnel could have a material adverse effect on the
Company's business, financial condition and results of operations. There can be
no assurance that the Company will be able to retain these employees. The
Company currently does not maintain any key man life insurance on the life of
any of its key employees.
Control by Existing Shareholders. As of September 30, 1997, Fred S.L. Chan,
the Company's President, Chief Executive Officer and Chairman of the Board of
Directors, together with his spouse, Annie M.H. Chan, a director of the Company,
and certain other shareholders related to Mr. and Mrs. Chan owned, in the
aggregate, approximately 38% of the Company's outstanding Common Stock. As a
result, these shareholders, acting together, possess significant voting power
over the Company, giving them the ability among other things to influence
significantly the election of the Company's Board of Directors and approve
significant corporate transactions. Such control could delay, defer or prevent a
change in control of the Company, impede a merger, consolidation, takeover or
other business combination involving the Company, or discourage a potential
acquiror from making a tender offer or otherwise attempting to obtain control of
the Company.
Possible Volatility of Stock Price. The price of the Company's Common Stock
has in the past and may continue in the future to fluctuate widely. Future
announcements concerning the Company, its competitors or its principal
customers, including quarterly operating results, changes in earnings estimates
by analysts, technological innovations, new product introductions, governmental
regulations or litigation may cause the market price of the Common Stock to
continue to fluctuate substantially. Further, in recent years the stock market
has experienced extreme price and volume fluctuations that have particularly
affected the market prices of equity securities of many high technology
companies and that often have been unrelated or disproportionate to the
operating performance of such companies. These fluctuations, as well as general
economic, political and market conditions such as recessions or international
currency fluctuations, may materially adversely affect the market price of the
Common Stock.
PART II. OTHER INFORMATION
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 September 30, 1997.
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: November 14, 1997 By: /s/ FRED S.L. CHAN
--------------------------------------------
Fred S.L. Chan
President, Chief Executive Officer
and Chairman of the Board
Date: November 14, 1997 By: /s/ JOHN H. BARNET
--------------------------------------------
John H. Barnet
Vice President,
Chief Financial Officer and Secretary
Date: November 14, 1997 By: /s/ HOWARD N. HIDESHIMA
--------------------------------------------
Howard N. Hideshima
Controller and Principal Accounting Officer
17
<PAGE> 18
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NO. DESCRIPTION
------- -----------
<S> <C>
27.01 Financial Data Schedule
</TABLE>
18
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JUL-01-1997
<PERIOD-END> SEP-30-1997
<CASH> 42,273
<SECURITIES> 2,280
<RECEIVABLES> 37,497
<ALLOWANCES> (486)
<INVENTORY> 36,513
<CURRENT-ASSETS> 126,502
<PP&E> 37,860
<DEPRECIATION> 8,203
<TOTAL-ASSETS> 218,323
<CURRENT-LIABILITIES> 38,875
<BONDS> 0
0
0
<COMMON> 133,755
<OTHER-SE> 0
<TOTAL-LIABILITY-AND-EQUITY> 218,323
<SALES> 52,172
<TOTAL-REVENUES> 52,172
<CGS> 35,200
<TOTAL-COSTS> 35,200
<OTHER-EXPENSES> 14,646
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (417)
<INCOME-PRETAX> 2,743
<INCOME-TAX> 1,025
<INCOME-CONTINUING> 1,718
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 1,718
<EPS-PRIMARY> 0.04
<EPS-DILUTED> 0.04
</TABLE>
