<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 June 30, 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 July 31, 1998, the registrant had 41,065,615 shares of common stock
outstanding.
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ESS TECHNOLOGY, INC.
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Part I. FINANCIAL INFORMATION Page
----
<S> <C>
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets - June 30, 1998 3
and December 31, 1997, unaudited
Condensed Consolidated Statements of Operations - three and 4
six months ended June 30, 1998 and 1997, unaudited
Condensed Consolidated Statements of Cash Flows - six 5
months ended June 30, 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 14
Item 6. Exhibits and Reports on Form 8-K 15
SIGNATURES 16
</TABLE>
<PAGE> 3
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ESS TECHNOLOGY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(in thousands)
<TABLE>
<CAPTION>
June 30, Dec. 31,
1998 1997
-------- --------
ASSETS
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 32,972 $ 27,760
Short-term investments 7,513 14,524
Accounts receivable, net 21,097 36,265
Inventories 32,645 47,285
Deferred income taxes 4,899 4,898
Prepaid expenses and other assets 16,583 4,053
--------- ---------
Total current assets 115,709 134,785
Property and equipment, net 38,106 32,922
Other assets 50,069 63,947
--------- ---------
$ 203,884 $ 231,654
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses $ 48,346 $ 50,858
Income taxes payable (555) 183
Deferred income taxes 9,506 9,506
--------- ---------
Total current liabilities 57,297 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; 41,046 and 40,674 shares
issued and outstanding 138,247 137,452
Retained earnings 8,340 33,655
--------- ---------
Total shareholders' equity 146,587 171,107
--------- ---------
Total liabilities and shareholders' equity $ 203,884 $ 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 Six Months Ended
June 30, 1998 June 30, 1997 June 30, 1998 June 30, 1997
------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
Net revenues $ 34,835 $ 45,142 $ 87,711 $126,610
Cost of revenues 33,262 27,220 82,408 68,992
-------- ------- -------- -------
Gross profit 1,573 17,922 5,303 57,618
Operating expenses:
Research and development 6,933 7,057 15,025 12,628
Research and development in-process -- 22,200 -- 22,200
Selling, general and administrative 8,632 5,560 17,661 11,172
-------- ------- --------- -------
Operating income (loss) (13,992) (16,895) (27,383) 11,618
Nonoperating income, net 347 806 716 1,446
-------- ------- --------- -------
Income (loss) before provision for
income taxes (13,645) (16,089) (26,667) 13,064
Provision for (benefit from) income taxes (683) 2,284 (1,352) 13,610
-------- ------- -------- -------
Net loss $ (12,962) $(18,373) $ (25,315) $ (546)
======== ======= ======== =======
Net loss per share - basic $ (0.32) $ (0.47) $ (0.62) $ (0.01)
======== ======= ======== =======
Net loss per share - diluted $ (0.32) $ (0.47) $ (0.62) $ (0.01)
======== ======= ======== =======
Shares used in calculating net
loss per share - basic 40,967 38,990 40,870 38,559
======== ======= ======== =======
Shares used in calculating net
loss per share - diluted 40,967 38,990 40,870 38,559
======== ======= ======== ========
</TABLE>
See notes to condensed consolidated financial statements.
<PAGE> 5
ESS TECHNOLOGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(in thousands)
<TABLE>
<CAPTION>
Six Months Ended
------------------
June 30, June 30,
1998 1997
-------- --------
<S> <C> <C>
Cash flows from operating activities:
Net loss $(25,315) $ (546)
Adjustments to reconcile net loss
to net cash used in operating activities:
Depreciation and amortization 6,156 2,590
Charges for research and development in-process -- 22,200
Changes in assets and liabilities:
Accounts receivable 15,168 (12,238)
Inventories 14,640 3,904
Prepaid expenses and other assets (1,364) 447
Accounts payable and accrued expenses (2,512) (14,922)
Income taxes payable (739) (4,690)
-------- --------
Net cash provided by (used in) operating activities 6,034 (3,255)
-------- --------
Cash flows from investing activities:
Acquisition of property and equipment (8,628) (3,237)
Sale of marketable equity securities and
short-term investments 10,511 15,429
Purchase of marketable equity
securities and short-term investments (3,500) (1,020)
Cash received from acquisitions -- 2,529
-------- --------
Net cash provided by (used in) investing activities (1,617) 13,701
Cash flows from financing activities:
Issuance of common stock, net 795 2,199
-------- --------
Net cash provided by financing activities 795 2,199
-------- --------
Net increase in cash and cash equivalents 5,212 12,645
Cash and cash equivalents at beginning of period 27,760 49,055
-------- --------
Cash and cash equivalents at end of period $ 32,972 $ 61,700
======== ========
Supplemental disclosures of cash flow information:
Common stock issued for acquisitions -- $ 32,703
======== ========
Income taxes $ -- $ 18,300
======== ========
</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 the fiscal year which ends December 31,
1998 or for any other period.
NOTE 2. BALANCE SHEET COMPONENTS (IN THOUSANDS)
<TABLE>
<CAPTION>
June 30, Dec. 31,
1998 1997
-------- --------
<S> <C> <C>
Accounts receivable:
Accounts receivable $ 22,707 $ 37,251
Less: Allowance for doubtful accounts (1,610) (986)
-------- --------
$ 21,097 $ 36,265
======== ========
Inventories:
Raw materials $ 984 $ 1,776
Work-in-process 14,839 18,237
Finished goods 16,822 27,272
-------- --------
$ 32,645 $ 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 June 30, 1998,
$11.8 million of the payment had been applied, $10.1 million was included in
long term other assets and $10.1 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 received an
approximate 5% equity ownership in the joint venture company and certain
capacity rights. The facility was expected to open during 1998, but fires during
construction have delayed the opening. UMC has stated that it expects insurance
will cover its fire losses.
NOTE 6. LITIGATION
On March 11, 1998, Creative Technology, Ltd. and E-mu Systems Incorporated
(together "Creative") filed a lawsuit against the Company and Diamond Multimedia
Incorporated ("Diamond") 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. CEO PURCHASE OF SHARES
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 June 30, 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 June 30, 1998, such purchases had totaled $1.4
million, representing 241,000 shares at prices ranging from $5.15 to $6.56.
NOTE 8. SUBSEQUENT EVENT
On August 7, 1998, John H. Barnet, Vice President of Finance and
Administration, Chief Financial Officer and Secretary announced that he will
resign from the Company as of August 31, 1998. Mr. Barnet will remain with the
Company as a consultant through the end of 1998.
<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. 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 Six Months Ended
------------------------------- -------------------------------
June 30, 1998 June 30, 1997 June 30, 1998 June 30, 1997
------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
Net revenues 100.0% 100.0% 100.0% 100.0%
Cost of revenues 95.5 60.3 94.0 54.5
----- ----- ----- -----
Gross margin 4.5 39.7 6.0 45.5
Operating expenses:
Research and development 19.9 15.6 17.1 10.0
Research and development in-process -- 49.2 -- 17.5
Selling, general and administrative 24.8 12.3 20.1 8.8
----- ------ ----- -----
Operating income (loss) (40.2) (37.4) (31.2) 9.2
Nonoperating income, net 1.0 1.8 0.8 1.1
----- ------ ----- -----
Income (loss) before provision for income taxes (39.2) (35.6) (30.4) 10.3
Provision for (benefit from) income taxes (2.0) 5.1 (1.5) 10.7
----- ------ ----- -----
Net income (loss) (37.2)% (40.7)% (28.9)% (0.4)%
====== ====== ===== =====
</TABLE>
Net Revenues. The Company's net revenues decreased 23% to $34.8 million in
the second quarter of 1998 from $45.1 million in the second 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 a substantial majority of
the Company's net revenues in the second quarter of 1998 and 1997, respectively.
Gross Profit. The Company's gross profit decreased by 91% to $1.6 million in
the second quarter of 1998 from $17.9 million in the second quarter of 1997. The
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 obsolescence reserves for audio and modem
products. The Company's overall gross margin is subject to change due to various
factors, including among others, competitive product pricing, market demand,
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 increase gross
profit, it must ship higher unit volumes, reduce costs, add new features or
introduce new products that gain market acceptance. However, no assurance can be
given that the Company will be able to achieve these objectives.
Research and Development. Research and development expenses were $6.9 million
and $15.0 million in the second quarter and first six months of 1998,
respectively, compared to $7.1 million and $12.6 million in the second quarter
and first six months of 1997, respectively. Research and development in the
second quarter of 1997 excludes a one-time pre and post-tax charge of $22.2
million related to acquired research and development in-process from the
acquisition of Platform Technologies, Inc. The increase for the first six months
of 1998 was primarily due to the increase in the Company's engineering staff and
the amortization of acquisition expenses, offset by lower mask and engineering
test run charges.
Selling, General and Administrative. Selling, general and administrative
expenses were $8.6 million and $17.7 million in the second quarter and first six
months of 1998, respectively, compared to $5.6 million and $11.2 million in the
second quarter and first six months of 1997. The increase was due to higher
personnel expense and consulting expenses associated with the Company's
conversion to a new management information system and the amortization of
acquisition expenses.
Non-Operating Income, Net. Non-operating income, net was $0.3 million and
$0.7 million in the second quarter and first six months of 1998 compared to $0.8
million and $1.4 million in the second quarter and first six months 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 due to
lower balances of short term investments.
Provision for Income Taxes. The Company's effective tax rate was (5%) and 36%
for the second quarter and first six months of 1998 and 1997, respectively. The
tax rate for the second quarter and first six months of 1997 of 36% reflects the
statutory tax rates applied to the Company's profits during that quarter. The
effective tax rate for the second quarter and first six months 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 June 30, 1998, ESS had cash and cash
equivalents and short-term investments of $40.5 million and working capital of
$58.4 million. During 1998, the Company had lines of credit of $20 million and
$10 million at two banks. As of June 30, 1998 one of the Company's lines of
credit had been cancelled and the other expired. There were no borrowings under
these lines of credit as of June 30, 1998. The Company is currently negotiating
with a bank for a line of credit, however, there can be no assurance that the
Company will be able to obtain this credit line.
In the first six months of 1998, the Company increased its cash balances by
$5.2 million. Operating activities contributed cash of $6.0 million, consisting
of a net loss of $(25.3) million, offset by depreciation and amortization of
$6.1 million and changes in working capital and other assets of $25.2 million.
The Company invested $8.6 million in property and equipment, primarily for the
construction of new buildings and for the purchase of computer hardware and
software. The Company received $7.0 million from the sale of marketable equity
securities and short term investments and $0.8 million from the exercise of
stock options.
<PAGE> 10
The Company believes that, as of June 30, 1998, cash flows from
operations, along with cash available and other assets that could be converted
to cash will be sufficient to fund operations, acquisitions of property and
equipment and provide adequate working capital through the next twelve months.
Capital expenditures for the next twelve months are anticipated to be
approximately $8.0 million which will be used to acquire capital equipment. The
Company may also utilize cash to acquire or invest in complementary businesses
or products, to obtain the right to use complementary technologies or to
repurchase stock. 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 or forecasted sales levels are
not realized, 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 and operating system software
has provided increased performance, which could in the future result in a
microprocessor and/or operating system software 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. Additionally, Microsoft
Corporation may incorporate certain multimedia capabilities into its operating
system software. There can be no assurance that the increased capabilities of
microprocessors and operating system software will not adversely affect demand
for the Company's products.
Dependence on the PC and Consumer Markets. In the second quarter and first
six months 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 second quarter and first six
months of 1997 and 1998, sales of video semiconductor chips to the video compact
disk ("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
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 grow. 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 original equipment
manufacturers ("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 second quarter of
1997, sales to the Company's top five customers, including sales to a
distributor, accounted for approximately 41% of the Company's net revenues. In
the second quarter of 1998, the top five customers, including sales to its
distributors, accounted for approximately 52% 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 hire and retain management, hire, train,
motivate, manage and retain its employees, continue to improve its operational,
financial and management information systems and implement additional systems
and controls. 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.
In addition, the Company is currently implementing an enterprise-wide software
package that integrates its core business functions. Should the implementation
be incomplete or otherwise problematic, substantial disruption to the business
operations of the Company could result. There can be no assurance that the
software implementation currently underway will not cause business disruptions
to the Company.
<PAGE> 13
International Operations. During the first six months of 1998 and 1997,
international sales accounted for a substantial majority of the Company's net
revenues. Substantially all of the Company's international sales were to
customers in 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 and 1998, 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. 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 June 30, 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 June 30, 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 June 30, 1998, such purchases had totaled $1.4
million representing 241,000 shares at prices ranging from $5.15 to $6.56.
<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 June 30, 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 June 30, 1998,
such purchases had totaled $1.4 million representing 241,000 shares at prices
ranging from $5.15 to $6.56.
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. filed a lawsuit against
the Company and one of its customers, Diamond Multimedia Systems, Inc., 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
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 has
indemnified several customers and prospective customers 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 such customers and prospective customers for damages related
to such determination and secure a license for them 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 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> 15
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
27.01 -- Financial Data schedule
(b) Reports on Form 8-K. No reports were filed on Form 8-K for the quarter
ended June 30, 1998.
<PAGE> 16
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this amendment to report on Form 10-Q to be signed on
its behalf by the undersigned, thereunto duly authorized.
ESS TECHNOLOGY, INC.
(Registrant)
Date: August 7, 1998 By: /s/ FRED S.L. CHAN
---------------------------------
Fred S.L. Chan
President, Chief Executive Officer
and Chairman of the Board
Date: August 7, 1998 By: /s/ JOHN H. BARNET
---------------------------------
John H. Barnet
Vice President, Chief
Financial Officer and Secretary
Date: August 7, 1998 By: /s/ HOWARD N. HIDESHIMA
---------------------------------
Howard N. Hideshima
Controller and Chief
Accounting Officer
<PAGE> 17
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
Exhibit
Number Description
- ------ -----------
<S> <C>
27.01 Financial Data Schedule
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> APR-01-1998
<PERIOD-END> JUN-30-1998
<CASH> 32,972
<SECURITIES> 7,513
<RECEIVABLES> 22,707
<ALLOWANCES> (1,610)
<INVENTORY> 32,645
<CURRENT-ASSETS> 115,709
<PP&E> 51,270
<DEPRECIATION> (13,164)
<TOTAL-ASSETS> 203,884
<CURRENT-LIABILITIES> 57,297
<BONDS> 0
0
0
<COMMON> 138,247
<OTHER-SE> 0
<TOTAL-LIABILITY-AND-EQUITY> 203,884
<SALES> 34,835
<TOTAL-REVENUES> 34,835
<CGS> 33,262
<TOTAL-COSTS> 33,262
<OTHER-EXPENSES> 15,565
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (347)
<INCOME-PRETAX> (13,645)
<INCOME-TAX> (683)
<INCOME-CONTINUING> (12,962)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (12,962)
<EPS-PRIMARY> (0.32)
<EPS-DILUTED> (0.32)
</TABLE>
