<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 September 30, 2000.
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 October 31, 2000, the registrant had 43,969,380 shares of common
stock outstanding.
<PAGE> 2
ESS TECHNOLOGY, INC.
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C> <C>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements:
Consolidated Balance Sheets - September 30, 2000, unaudited and December 31,
1999, audited 3
Consolidated Statements of Operations - three and nine months ended September
30, 2000 and 1999, unaudited 4
Consolidated Statements of Cash Flows - three and nine months ended September
30, 2000 and 1999, unaudited 5
Notes to Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations 10
Item 3. Quantitative and Qualitative Disclosures About Market Risk 16
PART II. OTHER INFORMATION 16
Item 1 Legal Proceedings 16
Item 6. Exhibits and Reports on Form 8-K 16
SIGNATURES
</TABLE>
2
<PAGE> 3
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ESS TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)
<TABLE>
<CAPTION>
SEPT. 30, DEC. 31,
2000 1999
(UNAUDITED) (AUDITED)
-------- --------
ASSETS
<S> <C> <C>
Current assets:
Cash and cash equivalents .................................. $120,296 $130,913
Short-term investments ..................................... 89,722 50,618
Accounts receivable, net ................................... 78,573 34,362
Inventories ................................................ 63,847 42,347
Deferred income taxes ...................................... 10,758 10,758
Prepaid expenses and other assets .......................... 5,100 2,199
-------- --------
Total current assets ..................................... 368,296 271,197
Property, plant and equipment, net ........................... 37,874 40,564
Other assets ................................................. 8,666 9,266
-------- --------
Total assets ........................................ $414,836 $321,027
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses ...................... $ 72,331 $ 72,303
Income taxes payable and deferred income taxes ............. 36,265 12,285
-------- --------
Total current liabilities ................................ 108,596 84,588
-------- --------
Commitments and Contingencies (Note 5)
Minority Interest (Note 8) ................................... 75,869 52,860
-------- --------
Shareholders' equity:
Preferred stock, no par value, 10,000 shares authorized;
none issued and outstanding ............................. -- --
Common stock, no par value, 100,000 shares authorized;
43,231 and 41,372 shares issued and outstanding at
September 30, 2000 and December 31, 1999, respectively .. 129,153 140,597
Retained earnings .......................................... 102,439 42,982
Other comprehensive loss.................................... (1,221) --
-------- --------
Total shareholders' equity ............................... 230,371 183,579
-------- --------
Total liabilities and shareholders' equity ......... $414,836 $321,027
======== ========
</TABLE>
See notes to unaudited consolidated financial statements.
3
<PAGE> 4
ESS TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(in thousands, except per share data)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
------------------ -----------------
SEPT. 30, 2000 SEPT. 30, 1999 SEPT. 30, 2000 SEPT. 30, 1999
-------------- -------------- -------------- --------------
<S> <C> <C> <C> <C>
Net revenues ........................................ $ 87,714 $ 75,400 $250,898 $221,923
Cost of revenues .................................... 52,521 46,949 154,931 135,869
-------- -------- -------- --------
Gross profit .................................... 35,193 28,451 95,967 86,054
Operating expenses:
Research and development ........................ 10,752 9,637 33,619 27,304
In-process research and development ............. -- -- 2,625 --
Selling, general and administrative ............. 13,836 10,460 36,233 28,429
-------- -------- -------- --------
Operating income .................................... 10,605 8,354 23,490 30,321
Nonoperating income, net ............................ 36,841 1,202 42,589 3,412
-------- -------- -------- --------
Income before provision for income taxes ........... 47,446 9,556 66,079 33,733
Provision for income taxes .......................... 17,183 1,433 22,364 5,060
-------- -------- -------- --------
Net income before minority interest ................. 30,263 8,123 43,715 28,673
Minority interest ................................... 2,456 -- 6,186 --
Net income .......................................... $ 32,719 $ 8,123 $ 49,901 $ 28,673
======== ======== ======== ========
Net income per share:
Basic ........................................... $ 0.76 $ 0.20 $ 1.17 $ 0.71
======== ======== ======== ========
Diluted ......................................... $ 0.71 $ 0.18 $ 1.08 $ 0.63
======== ======== ======== ========
Shares used in calculating net income per share:
Basic ........................................... 43,310 40,545 42,535 40,485
======== ======== ======== ========
Diluted ......................................... 46,138 46,021 46,403 45,518
======== ======== ======== ========
</TABLE>
See notes to unaudited consolidated financial statements.
4
<PAGE> 5
ESS TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(in thousands)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
---------------------------
SEPT. 30, SEPT. 30,
2000 1999
--------- ---------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income ..................................................................... $ 49,901 $ 28,673
Adjustments to reconcile net income ............................................
to net cash provided by (used in) operating activities excluding net assets
and liabilities from acquisition:
Depreciation and amortization ................................................. 15,231 10,872
Gain on investment ............................................................ (35,045) --
Charges for in-process research and development ............................... 2,625 --
Minority interest loss ........................................................ (6,186) --
Change in assets and liabilities:
Accounts receivable ......................................................... (44,211) (67)
Inventories ................................................................. (21,500) (6,781)
Prepaid expenses and other assets ........................................... (4,535) 12,997
Accounts payable and accrued expenses ....................................... 28 (4,073)
Income taxes payable and deferred income taxes .............................. 23,980 (1,659)
--------- ---------
Net cash provided by (used in) operating activities .................... (19,712) 39,962
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of property and equipment, net excluding capital equipment
from acquisition .............................................................. (4,743) (9,234)
Cash paid for acquisition ...................................................... (3,733) --
Sale of short-term investments ................................................. 46,077 15,382
Purchase of short-term investments ............................................. (50,372) (44,174)
Purchase of long-term investment ............................................... (5,055) (3,000)
Sale of joint venture .......................................................... -- 2,183
--------- ---------
Net cash used in investing activities .................................. (17,826) (38,843)
--------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Cash received from minority interest .......................................... 29,195 --
Repurchase of common stock ..................................................... (11,422) (4,228)
Issuance of common stock ....................................................... 9,148 1,807
--------- ---------
Net cash provided by (used in) financing activities .................... 26,921 (2,421)
--------- ---------
Net decrease in cash and cash equivalents ........................................ (10,617) (1,302)
Cash and cash equivalents at beginning of period ................................. 130,913 65,752
--------- ---------
Cash and cash equivalents at end of period ....................................... $ 120,296 $ 64,450
========= =========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for income taxes ..................................................... $ 1,895 $ 6,616
========= =========
NON CASH TRANSACTION:
Exchange of Komodo shares for Cisco shares ..................................... $ 36,029 $ --
========= =========
</TABLE>
See notes to unaudited consolidated financial statements.
5
<PAGE> 6
ESS TECHNOLOGY, INC.
NOTES TO 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, 1999 and 1998, included in the Company's Form 10-K
filed with the SEC. The results of operations for this interim period are not
necessarily indicative of the results that may be expected for any other period
or for the fiscal year which ends December 31, 2000.
NOTE 2. BALANCE SHEET COMPONENTS (IN THOUSANDS)
<TABLE>
<CAPTION>
SEPT. 30, DEC. 31,
2000 1999
--------- ---------
<S> <C> <C>
Cash and cash equivalents:
Cash and money market accounts -- ESS ................................. $ 11,576 $ 25,867
Cash and money market accounts -- Vialta.com .......................... 4,293 992
U.S. government notes and bonds -- ESS ................................ 33,556 14,419
U.S. government notes and bonds -- Vialta.com ......................... 70,744 89,508
Certificates of deposit -- ESS ........................................ 127 127
--------- ---------
$ 120,296 $ 130,913
========= =========
Short-term investments:
U.S. government notes and bonds -- ESS ................................ $ 10,829 $ 28,274
U.S. corporate securities -- ESS ...................................... 34,808 --
U.S. government notes and bonds -- Vialta.com ......................... 44,085 22,344
--------- ---------
$ 89,722 $ 50,618
========= =========
Accounts receivable:
Accounts receivable ................................................... $ 81,221 $ 36,821
Less: allowance for doubtful accounts ................................. (2,648) (2,459)
--------- ---------
$ 78,573 $ 34,362
========= =========
Inventories:
Raw materials ......................................................... $ 11,737 $ 10,697
Work-in-process ....................................................... 18,506 10,208
Finished goods ........................................................ 33,604 21,442
--------- ---------
$ 63,847 $ 42,347
========= =========
</TABLE>
NOTE 3. REVENUE RECOGNITION
Revenue from product 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. EARNINGS PER SHARE
Earnings per share are calculated in accordance with the provisions of
Statement of Financial Accounting Standards No. 128 "Earnings per Share" (SFAS
No. 128). SFAS No. 128 requires the Company to report both basic earnings per
share, which are based on the weighted-average number of common shares
outstanding, and diluted earnings per share, which are based on the weighted
average number of common shares outstanding and all dilutive potential common
shares outstanding.
6
<PAGE> 7
<TABLE>
<CAPTION>
THREE MONTHS ENDED
-------------------------------------------------------------------------------
SEPTEMBER 30, 2000 SEPTEMBER 30, 1999
------------------------------------ ------------------------------------
PER PER
NET SHARE NET SHARE
INCOME SHARES AMOUNT INCOME SHARES AMOUNT
------- ------ ------- ------- ------ -------
<S> <C> <C> <C> <C> <C> <C>
Basic EPS ........... $32,719 43,310 $0.76 $ 8,123 40,545 $0.20
Effects of Dilutive
Securities:
Stock options ..... 2,828 5,476
------- ------ ------- ------
Diluted EPS ......... $32,719 46,138 $0.71 $ 8,123 46,021 $0.18
======= ====== ======= ======
</TABLE>
<TABLE>
<CAPTION>
NINE MONTHS ENDED
-------------------------------------------------------------------------------
SEPTEMBER 30, 2000 SEPTEMBER 30, 1999
------------------------------------ ------------------------------------
PER PER
NET SHARE NET SHARE
INCOME SHARES AMOUNT INCOME SHARES AMOUNT
------- ------ ------- ------- ------ -------
<S> <C> <C> <C> <C> <C> <C>
Basic EPS ............ $49,901 42,535 $1.17 $28,673 40,485 $0.71
Effects of Dilutive
Securities:
Stock options ...... 3,868 5,033
------- ------ ------- ------
Diluted EPS .......... $49,901 46,403 $1.08 $28,673 45,518 $0.63
======= ====== ======= ======
</TABLE>
NOTE 5. COMMITMENTS AND CONTINGENCIES
The Company is involved in litigation in the normal course of
operations. Management believes that the outcome of the litigation will not have
a material adverse effect on the Company's financial position or results of
operations.
NOTE 6. ACQUISITION AND RELATED CHARGES
In February 2000, the Company acquired all of the outstanding shares and
vested stock options of NetRidium Communications, Inc. for $5.3 million in cash,
of which 10% was paid in November 2000. NetRidium is a development stage company
which develops broadband communication products enabling high-speed networking
over existing phone lines in the home. NetRidium's assets, liabilities and
expenses were not material to the Company. The purchase price was allocated to
assets acquired and liabilities assumed based upon the book value of NetRidium's
current assets, equipment and liabilities, which management believes approximate
their fair market value and independent appraisal for all other identifiable
assets as follows:
<TABLE>
<CAPTION>
(IN THOUSANDS)
--------------
<S> <C>
In-process research and development $ 2,625
Technical infrastructure 797
Covenants not to compete 730
Current assets 1,071
Capital equipment, net 75
Other long-term assets 172
Current liabilities assumed (138)
-------
Value of consideration for acquisition $ 5,332
Less cash acquired from acquisition (1,066)
10% deferred payment (533)
-------
Business acquisition $ 3,733
=======
</TABLE>
The acquisition was recorded using the purchase method of accounting and
accordingly, the results of operations and cash flows of such acquisition have
been included from the date of acquisition. Acquired in-process research and
development aggregating $2.6 million for the NetRidium acquisition was charged
to operations in the second quarter of 2000. Technical infrastructure and
covenants not to compete will be amortized over four years. In connection with
the acquisition, the Company granted certain NetRidium employees stock options
to purchase 500,000 shares of the Company's stock at $17.68 per share, the fair
market value on the date of grant. In addition certain employees of NetRidium
have signed employment contracts which, among other things, provide that if the
employee stays with the Company for the four
7
<PAGE> 8
year term of the employment agreement, the employee's stock options will have a
value of at least $8.85 more than the exercise price when such options become
exercisable. Approximately 428,000 of the options issued upon acquisition are
subject to this guarantee. During the third quarter of 2000, the Company
recorded approximately $0.2 million as compensation expense under this
guarantee.
NOTE 7. RELATED PARTY TRANSACTION
In January 2000, the Company and its subsidiary, Vialta.com, Inc.
(Vialta) entered into an Assignment of Intellectual Property Agreement whereby
Vialta payed ESS $2.0 million for the transfer of the Videophone and
EnReach-based Web Browser technologies. The Company entered into a Research and
Development Service Agreement and a General and Administrative Service Agreement
with Vialta whereby ESS provides services to Vialta for a fee. During the third
quarter of 2000, inter-company service fees of $1.4 million were charged to
Vialta. Inter-company fees for the first three quarters of 2000 of $4.9 million
was charged to Vialta. Vialta also entered into a Purchase Agreement with the
Company for the procurement of ESS' chip-sets to be used in Vialta set-top
boxes. The amount of material purchased was approximately $0.2 million for the
third quarter of 2000. Vialta purchased approximately $1.0 million of materials
from ESS during the first three quarters of 2000. All inter-company transactions
were eliminated in the consolidated financial statements.
NOTE 8. VIALTA
In April 1999, the Company incorporated Vialta, a subsidiary, through
which ESS plans to introduce advanced, user-friendly products and applications
for the Internet. Vialta is incorporated in California and headquartered in
Fremont, California.
In September 1999, Vialta issued 40 million shares of Series A
Convertible Preferred Stock (Series A) at $0.25 per share to the Company for $10
million in cash. In October 1999, Mr. Fred Chan, Chairman of ESS and Vialta,
purchased 4 million shares of Vialta common stock at $0.25 per share by issuing
a full recourse promissory note to Vialta which bears interest at a market rate.
The principal and accrued interest under this promissory note were paid in full
in March 2000. Also in October 1999, Vialta issued 400,000 and 1,820,000 common
shares to the Company and certain employees, respectively, for full recourse
promissory notes in the aggregate principal amount of $555,000. These notes have
been fully paid in cash to Vialta in the first quarter of 2000.
In December 1999, Vialta issued 40.3 million shares of Series B
Convertible Preferred Stock (Series B) for $104.8 million at $2.60 per share; 20
million shares to the Company for $52.0 million and 20.3 million shares to third
party investors for $52.8 million in cash. In January 2000, Vialta received
$20.8 million in the form of a full recourse promissory note, which bears
interest at a market rate, from Mr. Chan for the purchase of 8 million shares of
Series B Preferred Stock at $2.60 per share. The principal and accrued interest
under this promissory note were paid in full in March 2000. During the first
quarter of 2000, Vialta received $7.0 million in cash from third party investors
for subscriptions to purchase 2.7 million shares of its Series B Preferred
Stock.
As of September 30, 2000, minority interest is comprised of Vialta
Series B Convertible Preferred Stock and Common Stock issued to third parties
and contractors of Vialta, net of net loss pertaining to the minority interest
shareholders.
As of September 30, 2000, the Company has a 62.13% voting interest in
Vialta.
According to Vialta's Second Amended and Restated Articles of
Incorporation, Vialta is authorized to issue two classes of stock to be
designated, respectively, "Common Stock" and "Preferred Stock".
CONVERTIBLE PREFERRED STOCK OF VIALTA
Convertible Preferred Stock of Vialta at September 30, 2000 consists of
the following:
<TABLE>
<CAPTION>
PROCEEDS
SHARES NET OF
---------------------------------- ISSUANCE
SERIES AUTHORIZED OUTSTANDING COSTS
------ ---------- ----------- ------------
<S> <C> <C> <C>
A 40,000,000 40,000,000 $ 10,000,000
B 51,000,000 51,000,000 $132,600,000
---------- ---------- ------------
91,000,000 91,000,000 $142,600,000
========== ========== ============
</TABLE>
8
<PAGE> 9
NOTE 9. SEGMENT INFORMATION
The Company operates in two reportable segments: the semiconductor segment and
the Internet segment. In the semiconductor segment, the Company designs,
develops, supports and manufactures highly integrated mixed-signal
semiconductor, hardware, software and system solutions for multimedia
applications in the internet, personal computer and the consumer marketplace.
The semiconductor segment offers solutions for audio, video and modem
applications. In the Internet segment, the Company, through Vialta, plans to
develop and market advanced, user-friendly products and applications and content
for the Internet.
<TABLE>
<CAPTION>
THREE MONTHS ENDED
-----------------------------------------------------------------------------------
SEPT. 30, 2000 SEPT. 30, 1999
---------------------------------------------------------------- --------------
SEMICONDUCTOR INTERNET ELIMINATION CONSOLIDATED CONSOLIDATED
------------- -------- ----------- ------------ ------------
<S> <C> <C> <C> <C> <C>
Net revenues - external customers 87,384 330 -- 87,714 75,400
Net revenues - intersegment 245 -- (245) -- --
Operating income (loss) 17,136 (6,484) (47) 10,605 8,354
Total assets 347,097 129,950 (62,211) 414,836 235,165
</TABLE>
<TABLE>
<CAPTION>
NINE MONTHS ENDED
-----------------------------------------------------------------------------------
SEPT. 30, 2000 SEPT. 30, 1999
---------------------------------------------------------------- --------------
SEMICONDUCTOR INTERNET ELIMINATION CONSOLIDATED CONSOLIDATED
------------- -------- ----------- ------------ ------------
<S> <C> <C> <C> <C> <C>
Net revenues - external customers 249,234 1,664 -- 250,898 221,923
Net revenues - intersegment 1,003 -- (1,003) -- --
Operating income (loss) 41,826 (20,272) 1,936 23,490 30,321
Total assets 347,097 129,950 (62,211) 414,836 235,165
</TABLE>
In the third quarter of 1999, the Company operated in a single segment.
NOTE 10. REPURCHASE OF COMMON STOCK
On July 15, 2000, the Company's Board of Directors authorized the repurchase,
at management's discretion, of up to two million shares of the Company's common
stock at market prices and as market and business conditions warrant. As of
September 30, 2000, the Company had repurchased 685,500 shares at market
prices ranging from $14.47 to $17.97 per share.
NOTE 11. RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued SFAS No.
133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS
133"). SFAS 133 establishes accounting and reporting standards of derivative
instruments, including certain derivative instruments embedded in other
contracts, and for hedging activities. In July 1999, the Financial Accounting
Standards Board issued SFAS No. 137, "Accounting for Derivative Instruments and
Hedging Activities -- Deferral of the Effective Date of FASB Statement No. 133"
("SFAS 137"). SFAS 137 deferred the effective date until fiscal year beginning
after June 15, 2000. The Company will adopt SFAS No. 133 in 2001. The Company is
assessing the effect of FAS 133 on the financial position and results of
operations of the Company.
In December 1999, the SEC issued Staff Accounting Bulletin (SAB) No. 101
"Revenue Recognition in Financial Statements" which provides guidance on the
recognition, presentation and disclosure of revenue in financial statements
filed with the SEC. SAB 101 outlines the basic criteria that must be met to
recognize revenue and provides guidance for disclosures related to revenue
recognition policies. In June 2000, the SEC issued SAB 101B, "Second Amendment:
Revenue Recognition in Financial Statements" ("SAB 101B"). SAB 101B deferred the
implementation date of SAB 101 until no later than the fourth fiscal quarter of
fiscal years beginning after December 15, 1999. The Company believes that
adopting SAB 101 will not have a material impact on the Company's financial
position and results of operations.
In March 2000, the Financial Accounting Standards Board issued
Interpretation No. 44 "Accounting for Certain Transactions Involving Stock
Compensation" an interpretation of APB Opinion No. 25 ("FIN 44"). FIN 44
establishes guidance for the accounting for stock option grants made after June
30, 2000. FIN 44 also establishes guidance for the repricing of stock options
and determining whether a grantee is an employee, for which guidance was
effective after December 15, 1998 and modifying a fixed option to add a reload
feature, for which guidance was effective after January 12, 2000. The adoption
of certain of the provisions of FIN 44 prior to March 31, 2000 did not have a
material effect on the financial statements. The Company does not expect that
the adoption of the remaining provisions will have a material effect on the
financial statements.
9
<PAGE> 10
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 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, 1999 and 1998, 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 NINE MONTHS ENDED
-------------------------------- --------------------------------
SEPT. 30, 2000 SEPT. 30, 1999 SEPT. 30, 2000 SEPT. 30, 1999
-------------- -------------- -------------- --------------
<S> <C> <C> <C> <C>
Net revenues 100.0% 100.0% 100.0% 100.0%
Cost of revenues 59.9 62.3 61.8 61.2
----- ----- ----- -----
Gross margin 40.1 37.7 38.2 38.8
Operating expenses:
Research and development 12.3 12.8 13.4 12.3
In-process research and development -- -- 1.0 --
Selling, general and administrative 15.8 13.8 14.4 12.8
----- ----- ----- -----
Operating income 12.1 11.1 9.4 13.7
Nonoperating income, net 42.0 1.6 17.0 1.5
----- ----- ----- -----
Income before income taxes 54.1 12.7 26.3 15.2
Provision for income taxes 19.6 1.9 8.9 2.3
----- ----- ----- -----
Net income before minority interest 34.5% 10.8% 17.4% 12.9%
----- ----- ----- -----
Minority interest 2.8 -- 2.5 --
Net income 37.3% 10.8% 19.9% 12.9%
===== ===== ===== =====
</TABLE>
Net Revenues. The Company's net revenues increased 16% to $87.7 million
in the third quarter of 2000, from $75.4 million in the third quarter of 1999.
The increase in net revenues was a result of higher overall unit shipments,
which were partially offset by lower average selling prices ("ASP").
International revenues accounted for approximately 96% and 93% of the Company's
net revenues in the third quarter of 2000 and 1999, respectively. The Company's
net revenues increased by 13% to $250.9 million in the first three quarters of
2000, from $221.9 million for the same period in 1999.
Gross Profit. The Company's gross profit increased from $28.5 million in
the third quarter of 1999 to $35.2 million in the third quarter of 2000. The
increase in gross profit was the result of higher favorable product mix during
the quarter of higher DVD sales and lower PC audio sales. The Company's gross
profit increased from $86.1 million in the first three quarters of 1999 to $96.0
million for the first three quarters of 2000.
Research and Development. Research and development expenses were $10.8
million in the third quarter of 2000, or 12% of net revenues, compared to $9.6
million, or 13% of net revenues in the third quarter of 1999. The increase in
absolute dollars was primarily due to increased expenses of $3.3 million
incurred by the Company's majority owned subsidiary, Vialta, partially offset by
lower consulting and outside services expenses. Research and development
expenses were $33.6 million excluding in-process research and development
expenses of $2.6 million for the nine months ending September 30, 2000, compared
to $27.3 million for the nine months ending September 30, 1999. The primary
reason for the absolute dollar increase was due to increased expense by Vialta.
Vialta incurred research and development expenses of $12.1 million for the nine
months ending September 30, 2000.
Selling, General and Administrative. Selling, general and administrative
expenses were $13.8 million in the third quarter of 2000, or 16% of net
revenues, compared to $10.5 million, or 14% of net revenues, in the third
quarter of 1999. The increase in absolute dollars was primarily due to increased
expenses of $2.8 million incurred by Vialta, increased bad debt expenses
partially offset by decreased legal expenses. Selling, general and
administrative expenses were $36.2 million for the first three quarters of 2000,
or 14% of net revenues, compared to $28.4 million, or 13% of net revenues for
the first three quarters of 1999. Vialta incurred selling, general and
administrative expenses of $6.8 million for the nine months ending September
30, 2000.
Nonoperating Income, Net. Nonoperating income, net was $36.8 million in
the third quarter of 2000 compared to $1.2 million in the third quarter of 1999.
Nonoperating income, net consisted primarily of a pretax gain of $35.0 million
on the gain from the Company's investment in Komodo Technology which was
purchased by Cisco Systems on September 25, 2000. Also included in Nonoperating
income, net is interest income. Nonoperating income, net was $42.6 million for
the first three quarters of 2000 compared to $3.4 million for the same period
in 1999.
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Provision for Income Taxes. The Company's effective tax rate excluding
the provision taken on the gain from investment, was 17% and 15% for the third
quarter of 2000 and 1999, respectively. The Company used an estimated 40% tax
rate on the gain from investment which netted a $21.0 million gain after tax.
The tax rate for the third quarter of 2000 of 17% was lower than the combined
federal and state statutory rate of 40% as a result of the lower foreign tax
rate on earnings from the Company's foreign subsidiary that were considered to
be permanently reinvested.
LIQUIDITY AND CAPITAL RESOURCES
Since its inception, the Company has financed its cash requirements from
cash generated from operations, the sale of equity securities, bank lines of
credit and long-term and short-term debt. At September 30, 2000, the Company had
cash and cash equivalents and short-term investments of $210.0 million (of which
$119.1 million belongs to Vialta) and working capital of $259.7 million. As of
September 30, 2000, the Company had a $15.0 million bank line of credit expiring
on October 1, 2001. The line of credit requires the Company to achieve certain
financial ratios and operating results. As of September 30, 2000, the Company
was in compliance with its borrowing criteria. The line of credit was secured by
land and buildings with a net book value of $22.1 million. There were no
borrowings under this line of credit as of September 30, 2000.
In the first nine months of 2000, the Company used $19.7 million in cash
from operating activities. This amount included net income of $49.9 million,
which includes a gain on the Company's investment in Komodo Technology of $21.0
million after tax. Cash from operating activities also included depreciation and
amortization of $15.2 million, charges for in-process research and development
of $2.6 million, a minority interest net loss of $6.2 million, an increase in
accounts receivable of $44.2 million, an increase in inventory of $21.5 million,
an increase in prepaid expenses and other assets of $4.5 million, offset in part
by an increase in income taxes payable of $23.9 million of which $14.0 million
of income tax payable relates to the Cisco gain.
In the first nine months of 2000, the Company used $17.8 million in
investing activities. The Company invested $4.3 million in net purchase of
short-term investments, $3.7 million in business acquisition, $5.1 million in
long-term investments, $4.7 million in property and equipment.
In the first nine months of 2000, net cash provided by financing
activities was $26.9 million. The Company's subsidiary, Vialta, received cash
for investment in Vialta of $29.2 million from outside investors (including
certain affiliates of the Company) for the sale of its Series B Convertible
Preferred Stock. The Company received $9.1 million in issuance of common stock
in connection with the exercise of employee stock options and employee stock
purchase plan, the Company used $11.4 million to repurchase shares of its common
stock.
The Company believes that its existing cash and cash equivalents as of
September 30, 2000 together with the cash generated from operations, available
borrowings under its line of credit and other financing options, will be
sufficient to fund acquisitions of property and equipment and provide adequate
working capital through at least the next twelve months. Capital expenditures
for the next twelve months are anticipated to be approximately $38.0 million of
which $8.0 million is to be used by ESS and $30.0 million is to be used by
Vialta primarily for the acquisition of 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.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued SFAS No.
133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS
133"). SFAS 133 establishes accounting and reporting standards of derivative
instruments, including certain derivative instruments embedded in other
contracts, and for hedging activities. In July 1999, the Financial Accounting
Standards Board issued SFAS No. 137, "Accounting for Derivative Instruments and
Hedging Activities -- Deferral of the Effective Date of FASB Statement No. 133"
("SFAS 137"). SFAS 137 deferred the effective date until fiscal year beginning
after June 15, 2000. The Company will adopt SFAS No. 133 in 2001. The Company is
assessing the effect of FAS 133 on the financial position and results of
operations of the Company.
In December 1999, the SEC issued Staff Accounting Bulletin (SAB) No. 101
"Revenue Recognition in Financial Statements" which provides guidance on the
recognition, presentation and disclosure of revenue in financial statements
filed with the SEC. SAB 101 outlines the basic criteria that must be met to
recognize revenue and provides guidance for disclosures related to revenue
recognition policies. In June 2000, the SEC issued SAB 101B, "Second Amendment:
Revenue Recognition in Financial Statements" ("SAB 101B"). SAB 101B deferred the
implementation date of SAB 101 until no later than the fourth fiscal quarter of
fiscal years beginning after December 15, 1999. The Company believes that
adopting SAB 101 will not have a material impact on the Company's financial
position and results of operations.
In March 2000, the Financial Accounting Standards Board issued
Interpretation No. 44 "Accounting for Certain Transactions Involving Stock
Compensation" an interpretation of APB Opinion No. 25 ("FIN 44"). FIN 44
establishes guidance for the accounting for stock option grants made after June
30, 2000. FIN 44 also establishes guidance for the repricing of stock options
and determining whether a grantee is an employee, for which guidance was
effective after December 15, 1998 and modifying a fixed option to add a reload
feature, for which guidance was effective after January 12, 2000. The adoption
of certain of the provisions of FIN 44 prior to March 31, 2000 did not have a
material effect on the financial statements. The Company does not expect that
the adoption of the remaining provisions will have a material effect on the
financial statements.
FACTORS THAT MAY AFFECT FUTURE RESULTS
This report contains certain forward-looking statements that are subject
to risk and uncertainties. For such statements, the Company desires to take
advantage of the "Safe Harbor" provisions of the Private Securities Litigation
Reform Act of 1995 and of Section 21E of and Rule 3b-6 under the Securities
Exchange Act of 1934. Such forward-looking statements include, without
limitation, statements regarding the Company's expectations, intentions or
future strategies and involve known and unknown risks, uncertainties and other
factors. All forward looking statements included in this document are based on
information available to the Company on the date hereof, and the Company assumes
no obligation to update such forward-looking statements.
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 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 non-cancelable 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. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
Competition and Pricing Pressures. The markets in which the Company
competes are intensely competitive and are characterized by rapid technological
change, price reductions and rapid product obsolescence. The Company currently
competes with add-in card suppliers and
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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
average selling prices ("ASPs") and margins of the Company's products. In
general, product prices in the semiconductor industry have decreased over the
life of a particular product. The markets for most of the applications for the
Company's products 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 may 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
Microsystems, Winbond, LSI Logic, Zoran and SGS Thomson. The Company's principal
modem competitors include Lucent Technologies, PC-TEL, Conexant, 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 result in microprocessors capable of performing
multimedia functions. In this regard, Intel Corporation includes MMX
Instructions (Multimedia Extensions) in its current generation of
microprocessors, which improve the microprocessor's performance for graphics,
image processing, and data computation applications. Intel is promoting the
processing power of the Pentium-III processor for data and signal intensive
functions such as graphics acceleration and other multimedia functions. The
microprocessor still requires analog and mixed-signal interface chips, such as
ESS-supplied IC products, to complete a multimedia subsystem; but there can be
no assurance that the increased capabilities of microprocessors will not
adversely affect demand for the Company's products
Dependence on the Consumer and PC Markets. During the third quarter of
2000, sales of video semiconductor chips to the video compact disk ("VCD") and
digital video disk ("DVD") player market accounted for a majority portion of the
Company's revenues. Sales of Consumer audio semi-conductor chips also accounted
for a significant portion of the Company's net revenues during Q3 of 2000. Any
reduction in ASPs or demand for the Company's semiconductor chips, whether
because of a reduction in demand for PCs, DVD or 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 Internet, 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, VCD and DVD players. Therefore, the Company is heavily
dependent on the growth of the markets and the cost requirements for desktop and
notebook computers VCD and DVD 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 Changes. 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
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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
New Business Venture. In 1999, the Company incorporated Vialta,
originally as a wholly-owned subsidiary of the Company, in order to develop and
market new products and applications for the Internet. The Company's investment
in Vialta involves all of the risks normally associated with investments in
development stage companies. In order for Vialta to begin earning revenues and
ultimately achieve profitability, it must successfully develop and market new
products and applications on a cost effective basis. There can be no assurance
that Vialta will be able to do so, since, among other things, the Company has
limited experience in starting new business ventures and there is intense
competition in the marketplace for Internet products and applications generally.
In addition, the Company's investment in Vialta may adversely affect the
Company's existing business, financial position and results of operations by
diverting management's attention, working capital and other resources from the
Company to the new Vialta business venture.
Dependence Third Parties Vendors. 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. The Company has secured wafer capacity
that it believes will be adequate to meet its growth plans for the next 12
months. In September 1999, Taiwan experienced a series of earthquakes. While the
Company did not experience any material effects from these earthquakes, there
can be no assurance that any future earthquakes will not have a material adverse
effect on the Company's business, financial condition and results of operations.
While the Company has entered into 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 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. During the third quarter
of 2000 and 1999 sales to the Company's top five customers including sales to
distributors, accounted for approximately 63% and 56% respectively, 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
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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 the 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.
International Operations. Substantially all of the Company's
international sales were to customers in Hong Kong, Taiwan, China, 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. 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. Furthermore, 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 September 30, 2000, the Company had 6 patents granted in the United
States, which expire over time, commencing in 2000 and ending in 2015, and 11
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 United States and thus
make the possibility of piracy of the Company's technology and products more
likely. Although the Company is not aware of the development, distribution or
sales of any illegal copies of the Company's hardware or software, any
infringements of its patents, copyrights or trademarks, or any violation of its
trade secrets, confidentiality procedures or
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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. As of September 2000,
there was pending intellectual property litigation against the Company. The
Company or its foundries 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 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 Chairman of the Board of Directors and Robert L. Blair, the Company's
President. 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, Mr. Blair, key executive officers, key design personnel or software
engineers or the inability to hire and retain sufficient qualified personnel
could have a material adverse effect on the Company's business, financial
condition and results of operations. There can be no assurance that the Company
will be able to retain these employees. The Company currently does not maintain
any key man life insurance on the life of any of its key employees.
Control by Existing Shareholders. As of September 30, 2000, Fred S.L.
Chan, the 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 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.
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 Company's 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.
Euro Conversion. The Company is in the process of addressing the issues
raised by the introduction of the Single European Currency ("Euro"). The Company
does not expect the cost of any system modifications to be material or result in
any material increase in transaction costs. The Company will continue to
evaluate the impact of the Euro; however, based on currently available
information management does not believe that the introduction of the Euro will
have a material adverse impact on the Company's financial condition or the
overall trends in results of operations.
15
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Foreign Exchange Risks: The Company funds its operations from cash
generated from its operations, the sale of marketable securities and short and
long-term debt. As the Company operates primarily in Asia, the Company is
exposed to market risk from changes in foreign exchange rates, which could
affect its results of operations and financial condition. In order to reduce the
risk from fluctuation in foreign exchange rates, the Company's product sales and
all of its arrangements with its foundry and test and assembly vendors are
denominated in U.S. dollars. The Company has not entered into any currency
hedging activities.
Interest Rate Risks: The Company also invests in short-term investments.
Consequently, the Company is exposed to fluctuation in rates on these
investments. Increases or decreases in interest rates generally translate into
decreases and increases in the fair value of these investments. In addition, the
credit worthiness of the issuer, relative values of alternative investments, the
liquidity of the instrument and other general market conditions may affect the
fair values of interest rate sensitive investments. In order to reduce the risk
from fluctuation in rates, the Company invests in highly liquid governmental
notes and bonds with contractual maturities of less than two years. All of the
investments have been classified as available for a sale, and at September 30,
2000, the fair market value of the Company's investments approximated their
costs.
PART II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On April 27, 1999, the Company and one other defendant were named in a
complaint by Dollinger-Fremont Associates in the Superior Court of California,
County of Alameda, Case No. H206962-7. The complaint alleges breach of contract
in connection with a contract for the sale of certain property to the plaintiff
and seeks specific performance requiring the Company to convey the property, as
well as damages for lost profits, expenses arising from delay and attorney's
fees. On April 21, 2000, the parties reached a settlement of the case, which
includes the sale of the land to the plaintiff. The sale of the land will result
in a one-time gain for the Company. The parties finalized the settlement
agreement in October of 2000.
On April 9, 1999, the Company filed a complaint in the United States
District Court for the Northern District of California, No. C-99 20292RMW,
against PC-Tel, Inc., alleging violations of the antitrust laws and other claims
relating to PC-Tel's failure to provide a license to the Company covering
certain patents that PC-Tel maintains are essential to the manufacture and sale
of modems. Among other things, the complaint alleges that through its
relationship with an industry standards organization, PC-Tel has an obligation
to offer such patents for license to anyone on a reasonable and
nondiscriminatory basis, and that it has failed to do this with respect to ESS.
On August 7, 2000, PC-Tel filed an answer and counterclaims alleging
infringement of such patents, and in an amended counterclaim filed October 4,
2000 it has asserted infringement of three additional patents. The counterclaims
seek unspecified damages and include claims of willful infringement. The Company
believes that it has adequate defenses to the PC-Tel counterclaims. The case is
in the early discovery stage and has not been set for trial.
On September 15, 2000, the Company was named, along with another
respondent, in a complaint filed by PC-Tel with the International Trade
Commission, requesting exclusion orders and other relief directed at products
imported into the United States which contain the Company's modem products
alleged to infringe two of the patents which also have been asserted in the
district court action, but which are described by PC-Tel as not essential to the
manufacture and sale of modems pursuant to industry standards. On October 18,
2000, the International Trade Commission initiated an investigation into the
matter. The action is in the initial stages of discovery, and an initial
conference is scheduled for November 13, 2000. the Company believes that it does
not infringe any valid claim of either of the patents asserted by PC-Tel.
Gateway, Inc., a computer company, sued ESS in October 1999. Gateway's
suit alleges that an audio chip previously sold by ESS using the name "solo"
infringed Gateway's trademark, SOLO, used for laptop computers sold by Gateway.
The suit was filed and is pending in the United States District Court for the
Northern District of California, case number C-99-4732. The complaint filed by
Gateway asserts claims for federal and state trademark infringement and
trademark dilution against ESS.
Before the suit was filed, ESS voluntarily stopped placing the work
"solo" on any audio chips manufactured by ESS. Further, ESS modified all
existing marketing materials by deleting any reference to "solo."
Notwithstanding these changes by ESS, Gateway filed suit.
The parties proceeded to a non-binding mediation in June 2000, but no
settlement was reached. The matter is in the early stages of discovery. The
trial date is October 2001. ESS intends to vigorously defend the litigation and
does not believe that any infringement of Gateway's trademarks has occurred.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
-------- -----------
<S> <C>
27.01 Financial Data Schedule
</TABLE>
(b) Reports on Form 8-K. No reports were filed on Form 8-K for the quarter ended
September 30, 2000.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report on Form 10-Q to be signed on its behalf
by the undersigned, thereunto duly authorized.
ESS TECHNOLOGY, INC. (Registrant)
Date: November 14, 2000 By: /s/ Robert L. Blair
------------------------------------------
Robert L. Blair
President, Chief Executive Officer
Date: November 14, 2000 By: /s/ James B. Boyd
------------------------------------------
James B. Boyd
Chief Financial Officer
and Chief Accounting Officer
17
<PAGE> 18
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
-------- -----------
<S> <C>
27.01 Financial Data Schedule
</TABLE>
18
