<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X} Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
For the quarterly period ended March 31, 1998.
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 April 3, 1998, the registrant had 40,885,528 shares of common stock
outstanding.
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ESS TECHNOLOGY, INC.
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Part I. FINANCIAL INFORMATION Page
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<S> <C>
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets - March 31, 1998 3
and December 31, 1997, unaudited
Condensed Consolidated Statements of Operations - three months 4
ended March 31, 1998 and 1997, unaudited
Condensed Consolidated Statements of Cash Flows - three 5
months ended March 31, 1998 and 1997, unaudited
Notes to Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition and 8
Results of Operations
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 15
Item 6. Exhibits and Reports on Form 8-K 16
SIGNATURES 17
</TABLE>
<PAGE> 3
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ESS TECHNOLOGY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(in thousands)
<TABLE>
<CAPTION>
Mar. 31, Dec. 31,
1998 1997
-------- --------
ASSETS
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 18,580 $ 27,760
Short-term investments 14,524 14,524
Accounts receivable, net 32,920 36,265
Inventories 44,470 47,285
Deferred income taxes 4,899 4,898
Prepaid expenses and other assets 15,952 4,053
-------- --------
Total current assets 131,345 134,785
Property and equipment, net 37,986 32,922
Other assets 51,423 63,947
-------- --------
$220,754 $231,654
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LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses $ 51,629 $ 50,858
Income taxes payable 178 183
Deferred income taxes 9,506 9,506
-------- --------
Total current liabilities 61,313 60,547
-------- --------
Commitments and contingencies (See Notes 5 and 6)
Shareholders' equity:
Preferred stock, no par value, 10,000 shares
authorized; none issued and outstanding -- --
Common stock, no par value, 100,000 shares
authorized; 40,886 and 40,674 shares
issued and outstanding 138,139 137,452
Retained earnings 21,302 33,655
-------- --------
Total shareholders' equity 159,441 171,107
-------- --------
Total liabilities and shareholders' equity $220,754 $231,654
======== ========
</TABLE>
See notes to condensed consolidated financial statements.
<PAGE> 4
ESS TECHNOLOGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(in thousands, except per share data)
<TABLE>
<CAPTION>
Three Months Ended
Mar. 31, 1998 Mar. 31, 1997
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<S> <C> <C>
Net revenues $ 52,876 $ 81,468
Cost of revenues 49,146 41,772
-------- --------
Gross profit 3,730 39,696
Operating expenses:
Research and development 8,092 5,571
Selling, general and administrative 9,029 5,611
-------- --------
Operating income (loss) (13,391) 28,514
Nonoperating income, net 369 640
-------- --------
Income (loss) before provision for
income taxes (13,022) 29,154
Provision for (benefit from) income taxes (669) 11,327
-------- --------
Net income (loss) $(12,353) $ 17,827
======== ========
Net income (loss) per share - basic $ (0.30) $ 0.46
======== ========
Net income (loss) per share - diluted $ (0.30) $ 0.43
======== ========
Shares used in calculating net income
(loss) per share - basic 40,776 38,440
======== ========
Shares used in calculating net
income (loss) per share - diluted 40,776 41,469
======== ========
</TABLE>
See notes to condensed consolidated financial statements.
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ESS TECHNOLOGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(in thousands)
<TABLE>
<CAPTION>
Three Months Ended
------------------
Mar. 31, Mar. 31,
1998 1997
-------- --------
<S> <C> <C>
Cash flows from operating activities:
Net income (Loss) ($12,353) $ 17,827
Adjustments to reconcile net income (loss)
to net cash used in operating activities:
Depreciation and amortization 3,127 1,077
Changes in assets and liabilities:
Accounts receivable 3,345 (11,912)
Inventories 2,815 (1,347)
Prepaid expenses and other assets (732) 1,603
Accounts payable and accrued expenses 771 (18,648)
Income taxes payable (5) 6,726
-------- --------
Net cash used in operating activities (3,032) (4,674)
-------- --------
Cash flows from investing activities:
Acquisition of property and equipment (6,835) (775)
Sale of marketable equity securities and
short-term investments 3,500 3,204
Purchase of marketable equity
securities and short-term investments (3,500) --
-------- --------
Net cash provided by (used in)
investing activities (6,835) 2,429
-------- --------
Cash flows from financing activities:
Issuance of common stock, net 697 1,281
-------- --------
Net cash provided by
financing activities 697 1,281
-------- --------
Net decrease in cash and cash equivalents (9,180) (964)
Cash and cash equivalents at beginning of period 27,760 49,055
-------- --------
Cash and cash equivalents at end of period $ 18,580 $ 48,091
======== ========
Supplemental disclosures of cash flow information:
Income taxes $ 0 $ 4,600
======== ========
</TABLE>
See notes to condensed consolidated financial statements.
<PAGE> 6
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, 1997 and 1996, 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, 1998.
NOTE 2. BALANCE SHEET COMPONENTS (IN THOUSANDS)
<TABLE>
<CAPTION>
Mar. 31, Dec. 31,
1998 1997
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<S> <C> <C>
Accounts receivable:
Accounts receivable $ 34,098 $ 37,251
Less: Allowance for doubtful accounts (1,178) (986)
-------- --------
$ 32,920 $ 36,265
======== ========
Inventories:
Raw materials $ 3,725 $ 1,776
Work-in-process 18,076 18,237
Finished goods 22,669 27,272
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$ 44,470 $ 47,285
======== ========
</TABLE>
NOTE 3. REVENUE RECOGNITION
Revenue from products sales is recognized at the time of shipment except for
certain shipments to distributors with rights of return and allowances, 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 4. NET INCOME PER SHARE
Basic net income per share is computed using the weighted average number of
common shares outstanding during the period. Diluted net income per share is
computed using the weighted average number of common and potential common shares
outstanding during the period, except if anti-dilutive. Potential common shares
consist of the incremental common shares issuable upon the exercise of stock
options (using the treasury stock method).
<PAGE> 7
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 during 1996
and 1997 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 which were cancelled subsequent to the payments in 1996 and 1997. The
payments can be applied to offset wafers purchased from 1996 to 1999 provided
that the Company purchases not less than a certain specified number of wafers
during each of the four years ended December 31, 1999. As of March 31, 1998,
$11.8 million of the payment was applied, $10.1 million was included in long
term other assets and $10.0 million in short term prepaid assets.
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 has completed its investment commitment of $24.6 million
in the joint venture. Under the terms of the agreement, the Company receives a
5% equity ownership in the joint venture company and certain capacity rights.
The facility was expected to open during 1998, but several fires during
construction have delayed construction. UMC has stated that it expects insurance
will cover its recent fire losses at the joint venture foundry.
NOTE 6. LITIGATION
In March 1998, Creative Technology, Ltd. ("Creative") and E-mu Systems
Incorporated ("E-mu") filed a lawsuit against the Company and Diamond Multimedia
Incorporated alleging that the Company's Maestro family of products infringe
upon an E-mu patent which has been exclusively licensed by Creative. The
complaint seeks an injunction against future infringement, damages for past
infringement, fees and costs. If the Company were found to be infringing a valid
E-mu patent, then the Company could be required to cease sales of the infringing
products. The Company is vigorously contesting Creative's claims. In connection
with the Creative litigation, the Company has incurred and will continue to
incur legal and other expenses. While the outcome of such lawsuits cannot be
accurately predicted, based on the facts currently known, management does not
believe the ultimate resolution of this matter will have a material adverse
impact on the Company's financial position or results of operation.
NOTE 7. REPRICING OF OUTSTANDING OPTIONS TO PURCHASE SHARES OF COMMON STOCK
On February 13, 1998, the Compensation Committee of the Company's Board of
Directors announced that it had reviewed the status of outstanding options
issued to non-officers and officers of the Company and offered to exchange those
options held by non-officers with an exercise price exceeding the closing price
of the Company's common stock on February 13, 1998 (the "New Price") for options
with an exercise price equal to the New Price and with the same original vesting
start date and vesting schedule as the exchanged option, but with a restriction
on the exercisability of such repriced options until February 13, 1999. In
addition, the Compensation Committee offered to exchange those options held by
the executive officers of the Company (excluding Mr. Chan) with an exercise
price exceeding the New Price for options with an exercise price equal to the
New Price but with a restriction on the exercisability of such repriced options
until the later of February 17, 1999 or the earlier of the day following the
tenth consecutive trading day in which the closing price of the Company's common
stock is at or above $15.00 per share or February 17, 2001. Pursuant to the
offer, those repriced options held by officers that were not vested as of
February 17, 1998 will have a new vesting schedule of one-third of such unvested
repriced options at the end of each year commencing on February 17, 1998. If a
non-officer or officer voluntarily terminates his or her employment prior to the
end of the term of the applicable restriction on exercisability, the exchanged
options will be forfeited. Pursuant to the repricing, approximately 3,380,000
options with an exercise price greater than $7.69 were exchanged for options
with an exercise price of $7.69.
NOTE 8. SUBSEQUENT EVENTS
On April 28, 1998, the Company's Chief Executive Officer and Chairman of the
Board of Directors, Fred S. L. Chan, and his spouse, Annie M. H. Chan, a
director of the Company, and certain trusts for the benefit of the Chan's
children and certain charities beneficially owned in the aggregate, 37% of the
common stock of the Company as of March 31, 1998, announced that they would
jointly purchase between $5 million and $10 million of the Company's common
stock on the open market. As of May 8, 1998, such purchases had totaled $0.9
million, representing 136,500 shares at prices ranging from $6.31 to $6.56.
<PAGE> 8
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 multimedia capabilities for the PC
marketplace as well as the market for consumer electronic products; the
Company's ability to take advantage of new markets; increased competition and
pricing pressures; general economic conditions specific to the semiconductor
industry; the timing and market acceptance of new product introductions; the
timely development of new products; continued availability of quality foundry
capacity; and other risks set forth in this filing and in the Company's filings
from time to time with the Securities and Exchange Commission.
This information should be read along with the unaudited Condensed
Consolidated Financial Statements and notes thereto included in Item I of this
Quarterly Report and the audited Consolidated Financial Statements and notes
thereto and Management's Discussion and Analysis of Financial Condition and
Results of Operations for the fiscal years ended December 31, 1997 and 1996,
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>
<CAPTION>
Three Months Ended
------------------
Mar. 31, 1998 Mar. 31, 1997
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<S> <C> <C>
Net revenues 100.0% 100.0%
Cost of revenues 92.9 51.3
----- -----
Gross margin 7.1 48.7
Operating expenses:
Research and development 15.3 6.8
Selling, general and administrative 17.1 6.9
------ ------
Operating income (loss) (25.3) 35.0
Nonoperating income, net 0.7 0.8
------ ------
Income (loss) before provision for income taxes (24.6) 35.8
Provision for (benefit from) income taxes (1.2) 13.9
------ ------
Net income (loss) (23.4%) 21.9%
====== ======
</TABLE>
Net Revenues. The Company's net revenues decreased 35% to $52.9 million in
the first quarter of 1998, from $81.5 million in the first quarter of 1997. The
decrease in net revenues was a result of extensive price competition in markets
served. Lower unit selling prices more than offset the gains in overall unit
shipments. International revenues accounted for approximately 87% and 95% of the
Company's net revenues in the first quarter of 1998 and 1997, respectively.
Gross Profit. The Company's gross profit decreased from $39.7 million in the
first quarter of 1997 to $3.7 million in the first quarter of 1998. The 91%
decrease in gross profit was the result of lower unit selling prices on
increased unit shipments of the Company's PC audio and video semiconductor
products as well as increased inventory reserves for video products to reflect a
reduced valuation on inventory as of March 31, 1998. The Company's overall gross
margin is subject to change due to various factors, including among others,
competitive product pricing, yields, wafer costs and product mix. The Company
continues to experience significant price competition in the marketplace. The
Company expects that overall
<PAGE> 9
average selling prices for its existing products will continue to decline over
time and that selling prices for each product will decline significantly over
the life of the product. The Company believes that in order to maintain or
increase gross profit, it must achieve higher unit volume shipments, cost
reductions, new features and product introductions. However, no assurance can be
given that the Company will be able to ship higher volumes, reduce costs, add
new features or introduce new products that gain market acceptance.
Research and Development. Research and development expenses were $8.1 million
in the first quarter of 1998, or 15% of net revenues, compared to $5.6 million,
or 7% of net revenues in the first quarter of 1997. The increase in absolute
dollars was primarily due to the increase in the Company's engineering staff and
related expenses including bonuses, depreciation and amortization, and outside
expenses associated with increased research and development efforts to support
the introduction of new products.
Selling, General and Administrative. Selling, general and administrative
expenses were $9.0 million in the first quarter of 1998, or 17% of net revenues,
compared to $5.6 million, or 7% of net revenues, in the first quarter of 1997.
The increase in absolute dollars was primarily due to added personnel and
related expenses including bonuses, professional consulting, depreciation and
amortization, and a $1.0 million charge for a legal issue associated with the
patent litigation with Creative Technology, Ltd. See the legal proceeding
described below in "Factors that May Affect Future Results -- Patent Litigation
with Creative Technology, Ltd."
Non-Operating Income, Net. Non-operating income, net was $0.4
million in the first quarter of 1998 compared to $0.6 million in the first
quarter of 1997. Non-operating income, net consisted of interest
income net of interest expense and gains on sale of securities. The decrease in
interest income is in direct relationship to the Company's cash balance
holdings.
Provision for Income Taxes. The Company's effective tax rate was 5% and 36%
for the first quarter of 1998 and 1997, respectively. The tax rate for the first
quarter of 1997 of 36% reflects the statutory tax rates applied to the Company's
profits during that quarter. The effective tax rate for the first quarter of
1998 was affected by inventory reserves taken in the Company's offshore
subsidiary at a zero tax benefit.
LIQUIDITY AND CAPITAL RESOURCES
Since its inception, the Company has financed its cash requirements from cash
generated from operations, the sale of equity securities, bank lines of credit
and long-term and short-term debt. At March 31, 1998, ESS had cash and cash
equivalents and short-term investments of $33.1 million and working capital of
$70.0 million. As of March 31, 1998, the Company had a $20.0 million bank line
of credit expiring on May 31, 1999 and a $10.0 million bank line of credit
expiring on June 10, 1998. These lines of credit require the Company to achieve
certain financial ratios and operating results. As of March 31, 1998, a criteria
on one of these lines was not met. The Company is currently negotiating a waiver
of the covenants, however, there can be no assurance that the Company will be
able to obtain such a waiver. There were no borrowings under these lines of
credit as of March 31, 1998.
In the first three months of 1998, the Company used cash of $3.0 million to
finance operating activities consisting of a net loss of $12.4 million, offset
by depreciation of $3.1 million and decrease in working capital of $6.3 million.
The Company invested $6.8 million in property and equipment, primarily for the
construction of a new building adjacent to the Company's headquarters in Fremont
California and for the purchase of software for the installation of a
Company-wide software system. The Company received net proceeds of $0.7 million
from the exercise of stock options.
<PAGE> 10
The Company continues to face competitive pricing pressures. The Company
believes that, as of March 31, 1998, it has cash available, along with lines of
credit and/or collateral for credit accommodation and other assets that could be
converted to cash to fund operations, 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 $10.0 million of which approximately $1.0 million will be used to
fund construction of additional facilities and approximately $9.0 million will
be used to acquire capital equipment. 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.
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.
Potential Fluctuations in Operating Results. The Company's operating results
are subject to quarterly and other fluctuations due to a variety of factors,
including the gain or loss of significant customers, increased competitive
pressures, changes in pricing policies by the Company, its competitors or its
suppliers, including decreases in unit Average Selling Prices ("ASPs") of the
Company's products, the timing of new product announcements and introductions by
the Company or its competitors and market acceptance of new or enhanced versions
of the Company's and its customers' products. Other factors include the
availability of foundry capacity, fluctuations in manufacturing yields,
availability and cost of raw materials, changes in the mix of products sold, the
cyclical nature of both the semiconductor industry and the market for PCs,
seasonal customer demand, the timing of significant orders and significant
increases in expenses associated with the expansion of operations. The Company's
operating results could also be adversely affected by economic conditions
generally in various geographic areas where the Company or its customers do
business, or order cancellations or rescheduling. 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. 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.
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 other 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. The Company's competitors also
include a number of smaller and emerging companies. The Company's principal
audio competitors include Cirrus Logic, Creative Technology and Yamaha. The
Company's principal video competitors include C-Cube, Windbond, LSI Logic and
SGS Thompson. The Company's principal modem competitors include Cirrus Logic,
Lucent, Rockwell, 3Com and Texas Instruments. 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 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 the PC and Consumer Markets. In the first quarter of 1997 and
1998, sales of PC audio semiconductor chips 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. In the first quarter 1997 and 1998, sales
of video semiconductor chips to the VCD player market accounted for a
significant portion of the Company's revenues. Any reduction in ASPs or demand
for the Company's semiconductor chips, whether because of a reduction in demand
for PCs or
<PAGE> 11
VCD players 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
PC audio, video and modem semiconductor devices for the PC and consumer
markets. 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.
The Company's products are sold for incorporation into desktop and notebook
computers and VCD players. Therefore, the Company is heavily dependent on the
continued growth of the markets and the cost requirements for desktop and
notebook computers and VCD players. There can be no assurance that these markets
will be able to sustain continued growth. A slowing in unit volume and a
decrease in ASPs could result in a decline in revenues which would have a
material adverse effect on the Company's business, financial condition and
results of operations.
Importance of New Products and Technological Change. The markets for the
Company's products are characterized by evolving industry standards, rapid
technological change and product obsolescence. The Company's success is highly
dependent upon the successful development and timely introduction of new
products at competitive price and performance levels. The success of new
products depends on a number of factors, including timely completion of product
development, market acceptance of the Company's and its customers' new products,
securing sufficient foundry capacity for volume manufacturing of wafers,
achievement of acceptable wafer fabrication yields by the Company's independent
foundries and the Company's ability to offer new products at competitive prices.
In order to succeed in having the Company's products incorporated into new
products being designed by its customers, the Company must anticipate market
trends and meet performance, quality and functionality requirements of such OEMs
and must successfully develop and manufacture products that adhere to 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. 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 UMC, which has manufactured certain of the Company's products
since 1995. These relationships provide 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, in certain cases,
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.
While the Company has entered into long-term agreements with its two
foundries, the Company's reliance on these 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
<PAGE> 12
below. In addition, the Company has pre-negotiated certain of its purchase
orders and could be unable to benefit from enhanced yields realized by its
vendors. 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. 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.
Customer Concentration. A limited number of customers have accounted for a
substantial portion of the Company's net revenues. In the first quarter of 1997,
sales to the Company's top five customers, including sales to a distributor,
accounted for approximately 53% of the Company's net revenues. In the first
quarter of 1998, the top five customers, including sales to three distributors,
accounted for approximately 62% of the Company's net revenues. Sales to
distributors are generally subject to agreements allowing limited rights of
return and price protection with respect to unsold products. Returns and
allowances in excess of reserves could have a material adverse impact on the
Company's business, financial condition and results of operation. During 1997,
the Company adopted a policy of deferring revenue recognition on sales of
devices to distributors in Hong Kong and Taiwan until devices are sold to the
end customers. This has led to increased operational visibility on product
moving through the channel. 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 operations. In addition, since the Company's 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.
Management of Growth. The Company has experienced significant growth in unit
shipments 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.
<PAGE> 13
International Operations. During the first quarter of 1998 and 1997,
international sales accounted for approximately 87% and 95% of the Company's net
revenues, respectively. Substantially all of the Company's international sales
were to customers in Hong Kong, Taiwan, Japan, Korea and Singapore. 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 provide for pricing and payment in U.S.
dollars. In 1997, the effect of significant currency fluctuations in Asia had no
material impact on the Company. There can be no assurance that future
fluctuations in currency exchange rates will not have a material adverse effect
on the Company's business, financial condition and results of operations. 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.
Uncertainty Regarding Patents and Protection of 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 March 31, 1998, 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 designed, 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 Untied 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, copy rights 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. Except for the
Creative Technology litigation described below, 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 non-infringing
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
cross-licensing 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 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 Chief
Executive Officer and Chairman of the Board of Directors. As of March 31, 1998,
Mr. Chan, together with his spouse, Annie M.H. Chan, a director of the Company,
and certain trusts for the benefit of the Chan's children and certain charities
beneficially owned in the aggregate, 37% of the Company's Common Stock.
Additionally, Fred S.L.Chan and Annie M.H. Chan announced on April 28, 1998,
that they would be purchasing between $5 and $10 million of the Company's common
stock on the open market. As of May 9, 1998, such purchases had totaled $0.9
million representing 136,500 shares at prices ranging from $6.31 to $6.56. See
Item 1. Notes to Condensed Consolidated Financial Statements - Note 8 Subsequent
Events.
<PAGE> 14
The present and 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. 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 March 31, 1998, Fred S.L. Chan, the
Company's 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 trusts for the benefit of the Chan's children and certain charities
beneficially owned, in the aggregate, 37% 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 acquirer from making a tender offer or otherwise attempting to obtain
control of the Company. Additionally, Fred S.L.Chan and Annie M.H. Chan
announced on April 28, 1998, that they would be purchasing between $5 and $10
million of the Company's common stock on the open market. As of May 8, 1998,
such purchases had totaled $0.9 million representing 136,500 shares at prices
ranging from $6.31 to $6.56. See Item 1. Notes to Condensed Consolidated
Financial Statements - Note 8 Subsequent Events.
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.
Year 2000 Compliance. Many currently installed computer systems and software
products are coded to accept only two digit entries in the date code field.
These date code fields will need to accept four digit entries to distinguish
21st century dates from 20th century dates. As a result, many companies'
software and computer systems may need to be upgraded or replaced in order to
comply with such "Year 2000" requirements. Certain of the Company's internal
computer systems are not Year 2000 compliant, and the Company utilizes
third-party equipment and software that may not be Year 2000 compliant. Failure
of the Company's internal computer systems or of such third-party equipment or
software, or of systems maintained by the Company's suppliers, to operate
properly with regard to the Year 2000 and thereafter could require the Company
to incur unanticipated expenses to remedy any problems, which could have a
material adverse effect on the Company's business, operating results and
financial condition. Furthermore, the purchasing patterns of customers or
potential customers may be affected by Year 2000 issues as companies expend
significant resources to correct their current systems for Year 2000 compliance.
These expenditures may result in reduced funds available to purchase the
Company's products, which could have a material adverse effect on the Company's
business, operating results and financial condition.
Patent Litigation with Creative Technology, Ltd. On March 11, 1998, Creative
Technology Ltd. and its subsidiary E-mu Systems, Inc. (together, "Creative")
filed a lawsuit against the Company and one of its customers, Diamond Multimedia
Systems, Inc. ("Diamond"), alleging infringement of U.S. Patent No. 5,698,803
(the "803 patent"), by the Company's Maestro products, one of which is included
in products sold by Diamond. The complaint requests preliminary and permanent
injunctions, and unspecified
<PAGE> 15
damages. Creative also claims willful infringement and requests treble damages
and attorney's fees. The lawsuit, entitled Creative Technology Ltd. et al v. ESS
Technology, Inc. et al, is pending in the U.S. District Court for the Central
District of California.
No date has been set for any hearing or for trial of the matter. The Company
is still engaged in investigating the claim. Although the Company believes that
it does not infringe any valid claim of the 803 patent, the Company cannot
predict the ultimate resolution of the lawsuit.
The grant of a preliminary or permanent injunction enjoining the sale of
Maestro products could result in a material adverse effect on the Company's
business, financial condition and results of operations, including a reduction
in the Company's revenues and income, losses for an extended period of time and
a depletion in the Company's financial resources. In addition, the Company could
be required to pay monetary damages to Creative, which are subject to trebling
in the event of a finding of willful infringement. Further, the Company may have
to indemnify Diamond from liability with respect to claimed infringements of the
803 patent and, in the event of a determination of infringement and the grant of
an injunction, the Company may have to compensate Diamond for damages related to
such determination and secure a license for Diamond to continue using the
enjoined chips, replace the chips with non-infringing chips or remove the chips
and refund the purchase price of such chips. Such indemnification could increase
the Company's exposure to, and amount of, potential costs and liability in such
event, and could have a material adverse effect on the Company's business,
financial condition and results of operations.
In connection with the Creative litigation, the Company may incur substantial
legal and other expenses. In response to this, the Company has reserved $1.0
million during the first quarter of 1998. In addition, the Creative litigation
may divert the efforts and attention of the Company's management and technical
personnel. Patent litigation is highly complex and can extend for a protracted
period of time, which can substantially increase the cost of such litigation.
Accordingly, the expenses and diversion of resources associated with the
Creative litigation could have a material adverse effect on the Company's
business, financial condition and results of operations.
PART II
Item 1. Legal Proceedings
See the description of the legal proceedings described in "Factors That May
Affect Future Results -- Patent Litigation with Creative Technology, Ltd." in
Part 1.
<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 March 31, 1998.
<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: May 15, 1998 By: /s/ FRED S.L. CHAN
---------------------------------
Fred S.L. Chan
President, Chief Executive Officer
and Chairman of the Board
Date: May 15, 1998 By: /s/ JOHN H. BARNET
---------------------------------
John H. Barnet
Vice President, Chief
Financial Officer and Secretary
Date: May 15, 1998 By: /s/ HOWARD N. HIDESHIMA
---------------------------------
Howard N. Hideshima
Controller and Chief
Accounting Officer
<PAGE> 18
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
Exhibit
Number Description
- ------ -----------
<S> <C>
27.01 Financial Data Schedule
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<CURRENCY> U.S. DOLLARS
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> MAR-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> MAR-31-1998
<EXCHANGE-RATE> 1
<CASH> 18,580
<SECURITIES> 14,524
<RECEIVABLES> 34,098
<ALLOWANCES> (1,178)
<INVENTORY> 44,470
<CURRENT-ASSETS> 131,345
<PP&E> 49,477
<DEPRECIATION> (11,491)
<TOTAL-ASSETS> 220,754
<CURRENT-LIABILITIES> 61,313
<BONDS> 0
0
0
<COMMON> 138,139
<OTHER-SE> 0
<TOTAL-LIABILITY-AND-EQUITY> 220,754
<SALES> 52,876
<TOTAL-REVENUES> 52,876
<CGS> 49,146
<TOTAL-COSTS> 49,146
<OTHER-EXPENSES> 17,121
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (369)
<INCOME-PRETAX> (13,022)
<INCOME-TAX> (669)
<INCOME-CONTINUING> (12,353)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (12,353)
<EPS-PRIMARY> (0.30)
<EPS-DILUTED> (0.30)
</TABLE>
