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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 1997
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _______ to ________
Commission File Number 0-25580
DIAMOND MULTIMEDIA SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 77-0390654
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
2880 JUNCTION AVENUE, SAN JOSE, CALIFORNIA 95134
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (408) 325-7000
Indicate by check mark 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
--- ---
The number of shares outstanding of the registrant's common stock at
March 31, 1997 was 34,172,229.
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DIAMOND MULTIMEDIA SYSTEMS, INC.
INDEX TO FORM 10-Q
<TABLE>
<CAPTION>
<S> <C>
PART I - FINANCIAL INFORMATION:
ITEM 1- Financial Statements
Consolidated Condensed Balance Sheets as of March 31, 1997
and December 31, 1996 3
Consolidated Condensed Statements of Operations for the three
months ended March 31, 1997 and 1996 4
Consolidated Condensed Statements of Cash Flows
for the three months ended March 31, 1997 and 1996 5
Notes to Consolidated Condensed Financial Statements 6
ITEM 2 - Management's Discussion and Analysis of
Financial Condition And Results of Operations 7
PART II - OTHER INFORMATION
ITEM 1 - Legal proceedings 23
ITEM 2 - Changes in securities 23
ITEM 3 - Defaults Upon Senior Securities 23
ITEM 4 - Submission of Matters to a Vote of Security Holders 23
ITEM 5 - Other Information 23
ITEM 6 - Exhibits and Reports on Form 8-K 23
SIGNATURE(S) 24
</TABLE>
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PART I - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED BALANCE SHEETS
(UNAUDITED; IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
MARCH 31, 1997 DECEMBER 31, 1996
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ASSETS
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 98,067 $120,147
Trade accounts receivable, net of allowance for doubtful accounts
of $2,300 and $1,943 as of March 31, 1997 and
December 31, 1996 80,418 85,268
Inventories 66,363 63,704
Prepaid expenses, other current assets and deferred
income taxes 30,523 30,987
Total current assets 275,371 300,106
Property, plant and equipment, net 13,550 12,883
Other assets 3,121 3,222
Goodwill and other intangibles, net 14,911 16,227
-------- --------
Total assets $306,953 $332,438
======== ========
LIABILITIES
Current liabilities:
Current portion of long-term debt $23,809 $18,068
Trade accounts payable 46,845 68,770
Other accrued liabilities 14,585 17,740
------ -------
Total current liabilities 85,239 104,578
Long-term debt, net of current portion 2,493 2,730
Deferred income taxes 613 835
-------- --------
Total liabilities 88,345 108,143
-------- --------
STOCKHOLDERS' EQUITY
Preferred stock, par value $.001; Authorized - 8,000 shares at
March 31, 1997 and December 31, 1996; none issued and outstanding -- --
Common stock, par value $.001;
Authorized - 75,000 at March 31, 1997 and December 31, 1996
Issued and outstanding - 34,172 at March 31, 1997 and 34,673
at December 31, 1996 34 34
Additional paid-in capital 306,310 306,046
Distributions in excess of net book value (56,775) (56,775)
Accumulated deficit (30,961) (25,010)
-------- --------
Total stockholders' equity 218,608 224,295
-------- --------
Total liabilities and stockholders' equity $306,953 $332,438
======== ========
</TABLE>
The accompanying notes are an integral part of these consolidated
condensed financial statements.
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DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
(UNAUDITED; IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
----------------------------
MARCH 31, MARCH 31,
1997 1996
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<S> <C> <C>
Net sales $112,402 $187,605
Cost of sales 92,817 147,543
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Gross profit 19,585 40,062
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Operating expenses:
Research and development 5,692 4,803
Selling, general and administrative 22,511 15,983
Amortization of intangibles 1,316 1,207
-------- -------
Total operating expenses 29,519 21,993
-------- -------
Income (loss) from operations (9,934) 18,069
Interest income, net 543 225
Other expense, net (55) (93)
-------- -------
Income (loss) before provision for income taxes (9,446) 18,201
Provision (benefit) for income taxes (3,495) 7,007
-------- -------
Net income (loss) ($5,951) $11,194
-------- -------
Net income (loss) per share ($0.17) $0.32
======== =======
Shares used in computing per share amounts 34,179 35,342
</TABLE>
The accompanying notes are an integral part of these consolidated
condensed financial statements.
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DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(UNAUDITED; IN THOUSANDS)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
--------------------------------
MARCH 31, 1997 MARCH 31, 1996
-------------- --------------
(UNAUDITED)
<S> <C> <C>
Cash flows from operating activities:
Net income (loss) ($5,951) $11,194
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities
Depreciation and amortization 2,619 1,901
Provision for doubtful accounts 429 513
Provision for excess and obsolete inventories 556 1,680
Deferred income taxes (1,660) (9)
Changes in assets and liabilities:
Trade accounts and other receivables 4,421 10,489
Inventories (3,215) 10,125
Prepaid expenses and other assets 2,003 948
Trade accounts payable and other liabilities (25,080) (32,800)
Other -- (35)
--------- ---------
Net cash provided by (used in) operating activities (25,878) 4,006
--------- ---------
Cash flows from investing activities:
Purchases of property and equipment (1,970) (1,417)
Proceeds from the sale of short-term investments -- 6,023
--------- ---------
Net cash provided by (used in) investing activities (1,970) 4,606
--------- ---------
Cash flows from financing activities:
Proceeds from issuance of common stock 268 2
Repurchases of common stock (4) (14)
Proceeds from term loans and revolving credit facilities 7,064 3,939
Payments of term loans and revolving credit facilities (1,365) (12,562)
Repayments of capital lease financings (195) (135)
--------- ---------
Net cash provided by (used in) financing activities 5,768 (8,770)
--------- ---------
Net decrease in cash and cash equivalents (22,080) (158)
Cash and cash equivalents at beginning of period 120,147 93,971
--------- ---------
Cash and cash equivalents at end of period $98,067 $93,813
========= =========
Supplemental Disclosure of cash flow information:
Income taxes paid during the period $1,400 $640
========= =========
Interest paid during the period $155 $307
========= =========
</TABLE>
The accompanying notes are an integral part of these consolidated
condensed financial statements.
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DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Unaudited)
1. BASIS OF PRESENTATION
The accompanying consolidated financial statements have been prepared by the
Company without audit in accordance with generally accepted accounting
principles for interim financial information and pursuant to rules and
regulations of the Securities and Exchange Commission. In the opinion of
management, all adjustments (consisting only of normal recurring adjustments)
considered necessary for a fair presentation have been included. These
financial statements should be read in conjunction with the Company's
consolidated financial statements and notes thereto contained in the Company's
Form 10-K for the fiscal year ended December 31, 1996.
The Company operates under a 52-53 week fiscal year with thirteen week quarters
that end on the Sunday closest to calendar quarter end. For convenience of
presentation, the accompanying consolidated financial statements have been
shown as ending on March 31.
Operating results for the quarter ended March 31, 1997 may not necessarily be
indicative of the results to be expected for any other interim period or for
the full year.
2. INVENTORIES
Inventories are stated at the lower of cost (determined on a first-in,
first-out basis) or market. Inventories consisted of (in thousands):
<TABLE>
<CAPTION>
March 31, 1997 December 31, 1996
-------------- -----------------
<S> <C> <C>
Raw materials $20,508 $22,080
Work in process 19,712 20,847
Finished goods 26,143 20,777
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$66,363 $63,704
======= =======
</TABLE>
The Company has approximately $7 million of inventory in excess of its normal
short-term needs for certain product lines at March 31, 1997. Management has
developed a program to reduce this inventory to desired levels over the near
term; however, it is reasonably possible that the program will not be wholly
successful and a material loss could ultimately result on the disposal of this
inventory. No estimate can be made of the range of amounts of such loss.
3. LITIGATION
The Company has been named as a defendant in several putative class action
lawsuits which were filed in 1996 in the California Superior Court for Santa
Clara County and the U.S. District Court for the Northern District of
California. Certain executive officers and directors of the Company are also
named as defendants. The plaintiffs purport to represent a class of all
persons who purchased the Company's Common Stock between October 18, 1995 and
June 20, 1996 (the "Class Period"). The complaints allege claims under the
federal securities laws and California law. The plaintiffs allege that the
Company and the other defendants made various material misrepresentations and
omissions during the Class Period. The complaints do not specify the amount of
damages sought. The Company believes that it has good defenses to the claims
alleged in the lawsuits and will defend itself vigorously against these
actions. These cases are in the early stages and no schedule for the
litigation has been set. The ultimate outcome of these actions cannot be
presently determined. Accordingly, no provision for any liability or loss that
may result from adjudication or settlement thereof has been made in the
accompanying consolidated financial statements.
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4. RECENT ACCOUNTING PRONOUNCEMENTS
In February 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 128, "Earnings Per Share" (SFAS 128), which
specifies the computation, presentation and disclosure requirements for
earnings per share. SFAS 128 supersedes Accounting Principles Board Opinion
No. 15 and is effective for financial statements issued for periods ending
after December 15, 1997. SFAS 128 requires restatement of all prior-period
earnings per share data presented after the effective date. SFAS will not have
a material impact on the Company's financial position, results of operations or
cash flows.
5. SUBSEQUENT EVENTS
On April 16, 1997, the Board of Directors approved the repricing of all
employee stock options granted after July 17, 1996 and before April 16, 1997
with exercise prices higher than $7.625 per share. Approximately 1,162,000
options are eligible to be repriced. The Board of Directors approved the
repricing with the condition that these options cannot be exercised at the new
price of $7.625 until after March 31, 1998; however, the options are
exercisable at the higher price if exercised prior to April 1, 1998.
The Board of Directors also approved a "bonus" stock option, except for
executive officers, of approximately 250,000 shares at an exercise price of
$7.625 per share. The bonus options will become 100% vested and exercisable on
January 1, 1998.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The discussion and analysis below contains trend analysis and other
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual
results could differ materially from those projected in the forward-looking
statements as a result of the risk factors set forth under "Certain Factors
That May Affect Future Performance" below and elsewhere in this report.
The following discussion should be read in conjunction with the
Company's consolidated financial statements and the notes thereto. All
references to years represent fiscal years unless otherwise noted.
OVERVIEW
The Company develops, manufactures, markets and supports multimedia and
connectivity solutions for home, business and professional desktop computer
users, enabling them to create, access and experience compelling new media
content from their desktops and through the Internet. Products include the
Stealth and Monster 3D(TM) series of media accelerators, the Fire series of
professional 3D graphics accelerators, and the Supra(R) series of fax/modems
and ISDN and SCSI I/O adapters. Diamond also markets multimedia and video phone
upgrade kits. Headquartered in San Jose, CA, Diamond has sales, marketing and
technical facilities in Vancouver (Wash.), Singapore, Hong Kong, Seoul, Tokyo,
Starnberg (Germany), Paris, Winnersh (U.K.) and Sweden. Diamond's products are
sold through regional, national and international distributors as well as
directly to major computer retailers, VARs and OEMs worldwide.
NET SALES
Net sales for the first quarter of 1997 decreased $75.2 million
(40.1%) to $112.4 million compared to the first quarter of 1996. The decrease
in net sales was primarily attributable to three factors. First, lower demand
and increased competition in the high end of the mainstream graphics market
contributed to the decline in sales of the Stealth series of graphic
accelerator cards. Second, the transition from 33.6Kbps to 56Kbps modems
contributed to a decline in sales of 33.6 Kbps modems. Third, there was much
lower product demand in Europe, Korea and Japan, and there were price declines
in both the modem and the graphics markets. The decline was
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slightly offset in the first quarter of 1997 by shipments of the Fire GL family
of products and the SCSI I/O host adapters, for which there were no sales in
the first quarter of 1996.
Because of lower demand in overseas markets, particularly in Europe,
Korea and Japan, international sales represented only 30% of sales in the first
quarter of 1997 compared to 46% in the first quarter of 1996.
Inventory levels of the Company's products in the two-tier
distribution channels used by the Company ("Channel Inventory Levels")
generally are maintained in a range of one to three months of customer demand.
These Channel Inventory Levels tend toward the low end of the months-of-supply
range when demand is stronger, sales are higher and products are in short
supply. Conversely, when demand is slower, sales are lower and products are
abundant, then Channel Inventory Levels tend toward the high end of the
months-of-supply range. Frequently, in such situations, the Company attempts
to ensure that distributors devote their working capital, sales and logistics
resources to the Company's products to a greater degree than to those of
competitors. Similarly, the Company's competitors attempt to ensure that their
own products are receiving a disproportionately higher share of the
distributors' working capital and logistics resources. The Company believes
that it is currently operating in a period of slower demand, lower sales and
abundant products, leading to existing Channel Inventory Levels that are
higher than desirable. Consequently, the Company, in taking steps to bring its
Channel Inventory Levels down to a more desirable level, may cause a shortfall
in revenue during one or more accounting periods, including during the second
quarter of 1997.
GROSS PROFIT
Gross profit for the first quarter of 1997 decreased $20.5 million
(51.1%) to $19.6 million compared to the first quarter of 1996. Gross margin
(gross profit as a percentage of sales) decreased to 17.4% of net sales during
the first quarter of 1997 from 21.4% for the first quarter of 1996 primarily
due to competitive pricing pressures across most product lines, price
protection credits granted to customers as a result of sales price decreases,
and large customer payment term discounts. Further, the gross margin was
adversely impacted by significantly lower shipment volume levels over which to
absorb indirect manufacturing costs.
RESEARCH AND DEVELOPMENT
Research and development (R&D) expenses for the first quarter of 1997
increased $0.9 million (18.5%) compared to the corresponding period in 1996.
These increases were due primarily to higher personnel-related expenses and, to
a lesser extent, the material and outside service costs associated with new
product development, including products that will offer various functions or
combinations of functions including graphics, digital video, 3D animation, 3D
CAD, sound, ISDN adapter, analog modem, telephony, television, MPEG-2 and other
functions increasingly being implemented on personal computers. As a
percentage of sales, R&D expenses were 5.1% and 2.6% in the first quarters of
1997 and 1996, respectively. The increase in expenses as a percentage of net
sales resulted primarily from the large decline in net sales and, to a lesser
extent, increases in engineering efforts.
SELLING, GENERAL AND ADMINISTRATIVE
Selling, general and administrative (SG&A) expenses for the first
quarter of 1997 increased $6.5 million (40.8%) compared to the corresponding
period in 1996. The increase is primarily due to higher costs related to sales
incentive and promotion programs, including a channel sales incentive program
that was first implemented during the third quarter of 1996, and to higher
advertising, marketing and personnel-related expenses associated with increased
sales efforts. The Company intends to continue selected channel sales
incentive programs for the foreseeable future.
As a percentage of sales, SG&A expenses were 20.0% and 8.5% in the
first quarters of 1997 and 1996, respectively. The increase in expenses, as a
percentage of sales, resulted primarily from the significant decline in net
sales in the first quarter of 1997, and from an increase in sales and marketing
costs associated primarily with
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greater sales incentive program costs, increased marketing development costs,
increased advertising, and increased sales personnel headcount in the first
quarter of 1997.
AMORTIZATION OF INTANGIBLE ASSETS
The Company incurred amortization expense of $1.3 million in the first
quarter of 1997 compared to $1.2 million in the first quarter of 1996. These
expenses relate to amortization of purchased technology and goodwill from the
Supra and Spea acquisitions which occurred in the third and fourth quarters of
1995, respectively.
INTEREST INCOME, NET
Interest income was $0.5 million in the first quarter of 1997 compared to
$0.2 million in the first quarter of 1996. The increase in net interest income
resulted from a decrease in interest expense due to lower average debt
borrowings during the first quarter of 1997 compared to the corresponding
period of 1996.
PROVISION (BENEFIT) FOR INCOME TAXES
The Company's effective tax rate was 37.0% for the first quarter of 1997
and 38.5% for the first quarter of 1996. Differences from the statutory rate
consisted principally of the effect of state income taxes, federal tax-exempt
interest income and the research and development tax credit. The rate for the
first quarter of 1997 incorporates the impact of a decline in the estimated
annual rate from that of the first quarter of 1996 resulting primarily from
lower state income taxes.
RECENT ACCOUNTING PRONOUNCEMENTS
In February 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 128, "Earnings Per Share" (SFAS
128), which specifies the computation, presentation and disclosure requirements
for earnings per share. SFAS 128 supersedes Accounting Principles Board
Opinion No. 15 and is effective for financial statements issued for periods
ending after December 15, 1997. SFAS 128 requires restatement of all
prior-period earnings per share data presented after the effective date. SFAS
will not have a material impact on the Company's financial position, results of
operations or cash flows.
LIQUIDITY AND CAPITAL RESOURCES
Cash and equivalents decreased by $22.1 million during the first three
months of 1997. Operating activities used $25.9 million in cash and the
primary uses of cash were as follows: a net loss of $6.0 million; a decrease in
trade payables and other accrued liabilities of $25.1 million; and an increase
in inventories, net of provision for excess and obsolete inventories, of $3.2
million. These uses of cash from operating activities were offset, in part,
by a decrease in trade receivables, net of the allowance for doubtful accounts
of $4.4 million, depreciation and amortization expense of $2.6 million and an
decrease of $2.0 million in prepaid expenses and other assets.
The Company used $2.0 million in cash from investing activities due to
purchases of property and equipment. Net cash provided by financing activities
was $5.8 million, primarily due to proceeds of $7.1 million on term loans and
revolving credit facilities, offset in part by $1.6 million of payments on debt
financings and facilities.
At March 31, 1997, the Company had $98.1 million of cash and cash
equivalents. Further, as of such date, the Company had lines of credit and
bank credit facilities totaling $54.0 million, of which $27.7 million was
unused and available.
The Company currently expects to spend approximately $7 million for capital
equipment in 1997, principally relating to computer and office equipment. The
Company believes that its cash balances, short-term investments and available
credit under existing bank lines will be sufficient to meet anticipated
operating and
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investing requirements for the foreseeable future. There can be no assurance
that additional capital beyond the amounts currently forecasted by the Company
will not be required nor that any such required additional capital will be
available on reasonable terms, if at all, at such time or times as required by
the Company.
CERTAIN FACTORS THAT MAY AFFECT FUTURE PERFORMANCE
In addition to other information in this Form 10-Q, the following are
important factors that should be considered carefully in evaluating the Company
and its business.
POTENTIAL FLUCTUATIONS IN FUTURE OPERATING RESULTS
The Company's future operating results may vary significantly from
period to period as a result of a number of factors. The Company's revenue in a
given period depends on the volume and timing of orders received during the
period, the timing of new product introductions by the Company and its
competitors, product line maturation, the impact of price competition on the
Company's average selling prices, the availability of components for the
Company's products, changes in product or distribution channel mix, the level
of inventory carried by the Company's distribution and retail channel
customers, and product returns and price protection charges from customers.
The Company's gross margins are also impacted by short product life
cycles, the mix of products sold, the mix of distribution channels, competitive
price pressures, the availability and cost of components from the Company's
suppliers, component price inflation or deflation, end- of-life inventory write
downs and general economic conditions. For example, the Company intends to
increase the proportion of its revenue generated by sales to OEMs, which
historically have yielded lower gross margins, and to the retail/mass merchant
channel, which typically provides higher gross margins than OEM sales but
requires higher sales and marketing expenses and carries price-protection,
stock-rotation and customer-return liabilities. Individual product lines
generally provide higher margins at the beginning of the typical
six-to-twelve-month product life cycle, and lower margins as the product line
matures. Product lines with less technology value-added, however, such as
multimedia upgrade kits, generally provide lower margins than product lines
with higher technology value-added. Moreover, if a product's life should end
prior to expectations, then there is also a risk of unexpected end-of-life and
obsolete inventory charges, which could depress the Company's gross margin in
the affected period.
Many of these factors are beyond the Company's control. For example,
the Company's operating results in the second and third quarters of 1996 and
the first quarter of 1997 were adversely impacted by significantly lower unit
prices as a result of competitive pricing pressures, and, in the second quarter
of 1996, lower unit volumes due in part to weak market conditions, and there
can be no assurance that lower unit prices or volumes will not affect the
Company's operating results in the future. In addition, due to the short
product life cycles that characterize the Company's markets, the Company's
failure to successfully introduce competitive products in a timely manner would
adversely affect operating results for one or more product cycles.
Due to the foregoing factors, it is likely that the operating results
of the Company for some future quarter or quarters will fall below the
expectations of securities analysts and investors. In such an event, the
trading price of the Company's Common Stock could be materially and adversely
affected.
REVENUE VOLATILITY AND DEPENDENCE ON ORDERS RECEIVED AND SHIPPED IN A QUARTER
The volume and timing of orders received during a quarter are
difficult to forecast. Customers generally order on an as-needed basis and,
accordingly, the Company has historically operated with a relatively small
backlog. Moreover, the Company has emphasized its ability to respond quickly to
customer orders as part of its competitive strategy. This strategy, combined
with current industry supply-demand conditions and emphasis on just-in-time
inventory management, has resulted in customers placing orders with relatively
short delivery schedules. This has the effect of increasing such short-lead
orders ("turns orders") as a portion of the Company's business and reducing the
Company's ability to accurately forecast net revenue. Because turns orders are
more difficult to predict, there can be no assurance that the combination of
turns orders and backlog in any quarter
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will be sufficient to achieve growth in net revenue during that quarter. If the
Company does not achieve a sufficient level of turns orders in a particular
quarter, the Company's revenues and operating results would be materially
adversely affected.
Also, at any time and with no advance notice, during periods of
uncertainty in the personal computer industry's outlook for future demand or
pricing, the Company's customers may choose to draw down their inventory levels
thereby adversely impacting the Company's revenue during the period of
adjustment. The second or third quarter of 1997 may comprise such a period
since a transition from older legacy 33.6 kilobits per second (Kbps) modems and
2D graphics products to new 56 Kbps modems and 3D graphics products is expected
to occur during this time. Also, as is common and frequent in the personal
computer industry, a disproportionate percentage of the Company's revenue in
any quarter may be generated in the last month or weeks of a quarter. As a
result, a shortfall in sales in any quarter as compared to expectations may not
be identifiable until at or near the end of the quarter. In addition, from time
to time, a significant portion of the Company's revenue may be derived from a
limited number of customers, the loss of one or more of which could adversely
impact operating results.
Notwithstanding the difficulty in forecasting future sales and the
relatively small level of backlog at any given time, the Company generally must
plan production, order components and undertake its development, sales and
marketing activities and other commitments months in advance. Accordingly, any
shortfall in revenue in a given quarter may materially impact the Company's
operating results and cash balances in a magnified way due to the Company's
inability to adjust expenses or inventory levels during the quarter to match
the level of revenue for the quarter. Excess inventory could also result in
cash flow difficulties as well as added expenses associated with inventory
write-offs or sell- offs. Conversely, in its efforts to adjust inventory levels
to a slower order rate, the Company may overcorrect its component purchases and
inventory levels, thereby experiencing periodic shortages of inventory and
delivery delays and negatively impacting its revenue, market share and customer
satisfaction.
DECLINING SELLING PRICES
The Company's markets are characterized by intense ongoing competition
and coupled with a past history and a current trend of declining average
selling prices. A decline in selling prices may cause the revenue in a quarter
to be lower than the revenue of a preceding quarter or corresponding prior
year's quarter even if more units were sold during such quarter than in the
preceding or corresponding prior year's quarter. Accordingly, it is likely that
the Company's average selling prices will decline, and the Company's revenue
and margins may decline in the future, from the levels experienced to date. The
Company's gross margins may also be adversely affected by shortages of, or
higher prices for, key components for the Company's products, including its
modems and telephony/modem products, its 3-D accelerators, its SCSI I/O
adapters and its planned DVD/MPEG-2 and DirectSound 3D accelerator products,
some of which have been impacted from time-to-time by a scarcity in the supply
of associated chipsets and other components. In addition, the Company's
revenues, average selling prices and gross margins will be adversely affected
if the market prices for certain components used or expected to be used by the
Company, such as DRAMs, VRAMs, CD-ROMs, DVD drives, multimedia controller chips
or bundled software, decline more rapidly than the Company is able to process
component inventory bought earlier at higher prices into finished products,
book and ship the related orders, and move such products through third-party
distribution channels, some of which may be price protected, to the final
customer. For example, operating results were negatively impacted in the second
and third quarters of 1996 by declining market prices for the Company's
products, caused in part by a sharp reduction in the market price for DRAMs.
Conversely, an increase in the price of semiconductor components may adversely
impact the Company's gross margin due to higher unit costs, and a decrease in
the supply of semiconductor components may adversely impact the Company's
shipments and revenue.
SEASONALITY
The Company believes that, due to industry seasonality, demand for its
products is strongest during the fourth calendar quarter of each year. This
seasonality may become more pronounced and material in the future to the extent
that a greater proportion of the Company's sales consist of sales into the
retail/mass merchant
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channel, that PCs become more consumer-oriented and entertainment-driven
products, or that the Company's revenue becomes increasingly based on
entertainment products. Also, to the extent the Company is successful in
expanding its European operations, both internally and through its acquisition
of Spea, it may experience relatively weak demand in third calendar quarters
due to historically weak summer sales in Europe. The potential material effect
of seasonality on the Company's revenue is illustrated through market research
results published by International Data Corporation (Worldwide Quarterly PC
Market Tracker, 1997) showing that worldwide personal computer shipments in the
world were spread across the four (4) calendar quarters of 1996 in the ratio of
23%, 23%, 24% and 30%, respectively. The foregoing example is merely an
illustration of historical trends, and in no way is intended to be a prediction
or any indication of how the Company's sales will develop.
MANAGEMENT OF GROWTH; INTEGRATION OF SUPRA AND SPEA
In recent years, the Company has experienced a significant expansion
in the overall level of its business and the scope of its operations, including
manufacturing, research and development, marketing, technical support, customer
service, sales and logistics. In addition, through its acquisitions of Supra in
September 1995 and Spea in November 1995, the Company increased the scope of
its product lines and multinational operations. This expansion in scope has
resulted in a need for significant investment in infrastructure and systems, as
well as the integration of Supra and Spea into the Company's infrastructure.
This requirement includes, without limitation, securing adequate financial
resources to successfully integrate and manage the acquired businesses,
retention of key employees, integration of management information, control and
telecommunications systems, consolidation of geographically dispersed
manufacturing and distribution facilities, consolidation and coordination of
suppliers, rationalization of distribution channels, and integration of various
functions and groups of employees, each of which could pose significant,
material challenges. Moreover, Spea historically has not been profitable and
the Company's management has taken significant steps to reduce expenses at Spea
and integrate its operations with those of the Company. Accordingly, the
Company has reorganized Spea to function as a product localization and
marketing operation for Europe; a sales, technical support and customer service
operation for Germany; and a product development and launch facility for
professional 3D graphics, CAD and digital video capture for the Company's
worldwide markets. The Company discontinued manufacturing, test, packaging and
logistics operations at Spea effective October 1, 1996. Since the acquisition
of Spea in November 1995, the Company's efforts to improve Spea's financial
performance have been adversely impacted by economic recession in Germany and
the associated downturn in the German computer market, and there can be no
assurance that the Company will be successful in improving the financial
performance of its operations in Europe. Moreover, prior to its acquisition by
the Company, Spea made certain investments including entering into the shared
ownership (at 49.5%) with Philips Semiconductor (at 50.5%) of a 3D graphics
semiconductor design subsidiary, SP3D. The Company's 49.5% ownership of SP3D
is carried on the Company's balance sheet at the same approximately $3.4
million value as it was on Spea's balance sheet prior to the acquisition.
Philips Semiconductor has full day-to-day operating management control of SP3D,
and holds the majority of seats on the SP3D board. There can be no assurance
that the Company will be able to achieve a reasonable return on this asset, or
that the asset will not need to be written down, in whole or in part, during
subsequent accounting periods.
The Company's future operating results will depend in large measure on
its success in implementing operating, manufacturing and financial procedures
and controls, improving communication and coordination among the different
operating functions, integrating certain functions of Supra and Spea such as
sales, procurement and manufacturing, strengthening management information and
telecommunications systems, and continuing to hire additional qualified
personnel in all areas. There can be no assurance that the Company will be able
to manage these activities and implement these additional systems and controls
successfully, and any failure to do so could have a material adverse effect
upon the Company's short-term and long-term operating results.
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SHORT PRODUCT LIFE CYCLES; DEPENDENCE ON NEW PRODUCTS
The market for the Company's products is characterized by frequent new
product introductions and rapid product obsolescence. These factors typically
result in short product life cycles, frequently ranging from six to twelve
months. The Company must develop and introduce new products in a timely manner
that compete effectively on the basis of price and performance and that address
customer needs and meet customer requirements. To do this, the Company must
continually monitor industry trends and make difficult choices regarding both
the selection of new technologies and features to incorporate into its new
products and the timing of when to introduce such new products, all of which
may impair orders for, or prices of, the Company's existing products. The
success of new product introductions depends on various factors, some of which
are outside the Company's direct control. Such factors may include selection
of new products, selection of controller or memory chip architectures, timely
completion and introduction of new product designs, development of supporting
content by independent software vendors (ISVs), development and production of
collateral product literature, and coordination of advertising, press
relations, channel promotion and OEM and VAR evaluation programs.
In the current transition in mainstream PC graphics subsystem
architectures from 2D graphics and the PCI bus to 3D graphics and the
accelerated graphics port (AGP), expected to occur during 1997 and 1998,
controller and memory chip selection and timely introduction of new products
will be key factors in achieving market success. In addition, in the current
transition from the widely accepted V.34 modem protocol (33.6Kbps) to the new
higher speed V.PCM protocol (56Kbps), including its initial proprietary
implementations under the K56flex and x2 versions, selection of the proper
protocol version or versions to support, the timing of such support, and the
chip selection to implement and deploy such support will all be key factors in
achieving market success. There can be no assurance that the Company will
select the proper chips to implement and support its efforts in the markets or
that the Company will execute it strategy in a timely manner during this
transition period.
Each new product cycle presents new opportunities for current or
prospective competitors of the Company to gain a product advantage or increase
their market share. If the Company does not successfully introduce new products
within a given product cycle, the Company's sales will be adversely affected
for that cycle and possibly for subsequent cycles. Any such failure could also
impair the Company's brand name and ability to command retail shelf space in
future periods. Moreover, because of the short product life cycles coupled with
the long lead times for procuring many of the components used in the Company's
products, the Company may not be able, in a timely manner, or at all, to reduce
its component procurement commitments, software license commitments, production
rates or inventory levels in response to unexpected delays in product launch,
shortfalls in sales, technological obsolescence or declines in prices or,
conversely, to increase production in response to unexpected increases in
demand, particularly if such demand increases are in a new product or new
technology area where component supply may be hard to secure. Therefore,
changes in actual or expected demand could result in excess inventory,
inventory write downs, price protection and gross margin compression or,
conversely, in lost sales and revenue compression due to product
unavailability.
NEW OPERATING SYSTEMS
The PC industry has recently been characterized by significant
operating system changes, such as the introduction of OS/2 Warp in 1994,
Windows 95 in 1995 and Windows NT 4.0 in 1996, and the introduction of
significant new operating systems components, such as Microsoft's Direct X and
ActiveX for Windows 95. While new operating systems can provide new market
opportunities, such as the growing market for graphical user interface ("GUI")
accelerators that occurred with the introduction of Windows 3.0 and the
expected growth in the PC games market with the introduction of Windows95, new
operating systems and operating systems components also place a significant
research and development burden on the Company. New drivers, applications and
user interfaces must be developed for the new operating systems and operating
systems components in order to maintain revenue levels and customer
satisfaction. Perhaps more significantly, such drivers, applications and
interfaces customarily are ported to the recently shipped portion of the
Company's installed base. This effort involves a substantial software
engineering, compatibility testing and customer technical support investment
with only limited near-term incremental revenue return since these driver
updates are usually provided via electronic distribution free to the Company's
installed customer base. In addition, the
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installation of this software may result in technical support calls, thereby
generating expenses that do not have offsetting revenue. Moreover, during the
introductory period of a major new operating system release such as Windows 95,
such installed base support may reduce the research and development and
customer technical support resources available for launching new products. For
example, after substantial investment in porting the Company's software,
graphics accelerator and modem products over to Windows 95, the Company was at
year-end 1996 still developing for final release improved, accelerated Windows
95 drivers for the Viper Pro Video series of accelerator add-in cards. While
this product line does not represent a current or future revenue opportunity
for the Company, the Company nevertheless believes that it is important to make
the significant software development investment represented by this effort in
order to maintain relations with its installed customer base and its reputation
for reliable on-going product support. Furthermore, new operating systems for
which the Company prospectively develops driver support may not be successful,
or the drivers themselves may not be successful or accepted by customers, and a
reasonable financial return on the corollary research and development
investment may not be achieved.
DEPENDENCE ON THIRD PARTY SOFTWARE DEVELOPERS
The Company's business strategy includes developing relationships
with major ISVs that serve the 3D graphics and 3D audio markets, including the
3D computer games market and the professional 3D graphics market. The Company
believes that the availability of a sufficient number of high quality,
commercially successful entertainment 3D software titles will be a significant
factor in the sale of multimedia hardware to the PC-based interactive 3D
entertainment market. The Company also believes that compelling professional
3D graphics applications developed for PCs or ported from traditional
workstations, such as those supplied by Silicon Graphics and Sun Microsystems,
to PCs based on advanced Intel microprocessors and Microsoft's NT 4.0
operating system will be significant factors in the sale of 3D graphics
hardware to the PC-based NT workstation market. The Company depends on third
party software developers and publishers to create, produce and market software
entertainment titles and professional graphics applications that will operate
with the Company's 3D products, such as Monster 3D, Stealth 3D and Fire GL.
Only a limited number of software developers are capable of creating high
quality professional 3D and entertainment 3D software. Competition for these
resources is intense and is expected to increase. There can be no assurance
that the Company will be able to attract the number and quality of software
developers and publishers necessary to develop a sufficient number of high
quality, commercially successful software titles and applications that are
compatible with the Company's 3D products.
Further, in the case of the Company's entertainment 3D products, there
can be no assurance that third parties will publish a substantial number of
entertainment 3D software titles or, if entertainment 3D software titles are
available, that they will be of high quality or that they will achieve market
acceptance. The development and marketing of game titles that do not fully
demonstrate the technical capabilities of the Company's entertainment 3D
products could create the impression that the Company's products offer less
compelling performance over competing 3D games platforms, such as TV games
console platforms. This may slow or stop any migration from the current
widespread use of TV games consoles to the use of computer games on PCs, or the
enhancement of PCs to operate such games. Further, because the Company has no
control over the content of the entertainment titles produced by software
developers and publishers, the entertainment 3D software titles developed may
represent only a limited number of game categories and are likely to be of
varying quality.
SEMICONDUCTOR OR SOFTWARE DEFECTS
Product components may contain undetected errors or "bugs" when first
supplied to the Company that, despite testing by the Company, are discovered
only after certain of the Company's products have been installed and used by
customers. There can be no assurance that errors will not be found in the
Company's products due to errors in such products' components, or that any such
errors will not impair the market acceptance of these products or require
significant product recalls. Problems encountered by customers or product
recalls could materially adversely affect the Company's business, financial
condition and results of operations. Further, the Company continues to upgrade
the firmware, software drivers and software utilities that are incorporated
into or included with its hardware products. The Company's software products,
and its hardware products incorporating such software, are extremely complex as
a result of factors including advanced functionality, the
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diverse operating environments in which the products may be deployed, the need
for interoperability, and the multiple versions of such products that must be
supported for diverse operating platforms, languages and standards. These
products may contain undetected errors or failures when first introduced or as
new versions are released. The Company generally provides a five-year warranty
for its products and, in general, the Company's return policies permit return
within thirty days after receipt of products that do not meet product
specifications. There can be no assurance that, despite testing by the
Company, by its suppliers and by current or potential customers, errors will
not be found in new products after commencement of commercial shipments,
resulting in loss of or delay in market acceptance or product acceptance or in
warranty returns. Such loss or delay would likely have a material adverse
effect on the Company's business, financial condition and results of
operations.
Additionally, new versions or upgrades to operating systems or ISV
titles or applications may require upgrades to the Company's software products
to maintain compatibility with these new versions or upgrades. There can be no
assurance that the Company will be successful in developing new versions or
enhancements to its software or that the Company will not experience delays in
the upgrade of its software products. In the event that the Company
experiences delays or is unable to maintain compatibility with operating
systems and ISV titles or applications, the Company's business, financial
condition and results of operations could be materially adversely affected.
MARKET ANTICIPATION OF NEW PRODUCTS, NEW TECHNOLOGIES OR LOWER PRICES
Since the environment in which the Company operates is characterized
by rapid new product and technology introductions and generally falling prices
for existing products, the Company's customers may from time to time postpone
purchases in anticipation of such new product introductions or lower prices. If
such anticipated changes are viewed as significant by the market, such as the
introduction of a new operating system or microprocessor architecture, then
this may have the effect of temporarily slowing overall market demand and
negatively impacting the Company's operating results. For example, the
substantial pre-release publicity surrounding the release of Windows 95 may
have contributed to a slowing of the consumer PC market in the summer of 1995.
Similarly, there may have been a slowing in the corporate PC market prior to
the recent release of Windows NT 4.0 and the Pentium Pro. Moreover, a similar
reaction may have occurred in the modem market as a result of the recent
announcements of modems based on 56 Kbps technology which became available in
1997, or in the overall PC market in anticipation of Intel Corporation's
transition to MMX-based microprocessors during 1997. Additionally, the
substantial publicity by Intel Corporation on its MMX technology may have
confused and slowed the market for add-in multimedia accelerators, such as
those sold by the Company, during the first quarter of 1997. If so, this
effect may continue into future periods. Other anticipated new product releases
that may influence future market growth or the timing of such growth include
Microsoft's release of its "Memphis" upgrade to Windows 95 and Intel's release
of its new Pentium II CPU supporting the AGP architecture.
The potential negative impact on the Company's operating results as a
result of customer decisions to postpone purchases in favor of new and
"publicized" technology can be further magnified if products or components
based on such new technology are not available in a timely manner or in
sufficient supply to meet the demand caused by the market's shift to the new
technology from an older technology. For example, the Company believes that the
PC market may have slowed in early 1997 in part as customers waited for the
availability of Intel's new MMX-enabled Pentium CPUs. Further, the Company's
operating results could be adversely affected if the Company makes poor
selections of chip architectures to pursue 3D, AGP or 56Kbps market
opportunities and, as a result, is unable to achieve market acceptance of new
products.
Also, if the Company announces a product that the market views as
having more desirable features or pricing than the Company's existing products,
demand for existing products may be curtailed even though the new product is
not yet available. Similarly, if the Company's customers anticipate that the
Company may reduce its prices in the near term, they may postpone their
purchases until such price reductions are effected, reducing the Company's
near-term shipments and revenue. In general, market anticipation of new
products, new technologies or lower prices, even though potentially positive in
the longer term, can negatively impact the Company's operating results in the
short term.
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COMPONENT SHORTAGES; RELIANCE ON SOLE OR LIMITED SOURCE SUPPLIERS
The Company is dependent on sole or limited source suppliers for
certain key components used in its products, particularly application specific
integrated circuit ("ASIC") chipsets that provide graphics, digital video, 3D
CAD, television (TV), sound, 3D animation and other multimedia functions,
random access memory (including VRAM, DRAM and SGRAM), and speakerphone and
fax/modem chipsets, including voice modem, K56flex, and simultaneous voice and
data ("SVD") modem chipsets. Although the price and availability of
semiconductor components improved during 1996, these components are
periodically in short supply and on allocation by semiconductor manufacturers.
For example, it is expected that high-performance DRAMs may be in short supply
from time to time, and components for K56flex modems will also likely be in
short supply. The Company's dependence on sole or limited source suppliers,
and the risks associated with any delay or shortfall in supply, can be
exacerbated by the short life cycles that characterize multimedia and
communications ASIC chipsets and the Company's products in general. Although
the Company maintains ongoing efforts to obtain required supplies of
components, including working closely with vendors and qualifying alternative
components for inclusion in the Company's products, component shortages
continue to exist from time to time, and there can be no assurances that the
Company can continue to obtain adequate supplies or obtain such supplies at
their historical or competitive cost levels. Conversely, in its attempt to
counter actual or perceived component shortages, the Company may overpurchase
certain components, resulting in excess inventory and reducing the Company's
liquidity or, in the event of unexpected inventory obsolescence or a decline in
the market value of such inventory, causing inventory write-offs or sell-offs
that adversely affect the Company's gross margin and profitability.
As noted above, supply-demand conditions for semiconductor components
are unpredictable and may change from time to time. During periods of
oversupply, prices are likely to fall and certain vendors of such semiconductor
chips may liquidate their inventories in a rapid manner. If such semiconductor
vendors are suppliers to the Company's competitors, then such actions could
enable competitors of the Company to enjoy a cost advantage vis-a-vis the
Company, and any resultant price reduction for such competitors' products could
require the Company to reduce its prices, thereby depressing the Company's
margins or revenues in one or more operating periods.
During periods of component oversupply and associated price deflation,
customers of the Company, particularly those comprising channels that do not
receive price protection from the Company, may seek to draw down the inventory
they hold since such inventory likely would bear a price deflation risk. As a
consequence, the Company may see its orders, unit shipments and average selling
prices depressed from time to time during such price-deflation and
inventory-reduction periods, which could adversely affect revenues or gross
margin in the related operating period or periods.
Conversely, when the PC or PC peripherals markets emerge from a period
of oversupply, it is normal for most manufacturers, distributors and resellers
that have substantially drawn down their inventory levels to be unprepared for
a possible rapid increase in sales. Accordingly, the Company may not have
enough inventory, scheduled component purchase orders or available
manufacturing capacity to meet market demand, thereby missing orders and
revenue opportunities, and perhaps losing market share. Moreover, the
inability of the Company to obtain product components at their historical cost
levels would directly affect the cost of the Company's products.
DEPENDENCE ON SUBCONTRACTORS
The Company relies on surface mount technology ("SMT") and printed
circuit board ("PCB") independent subcontractors to manufacture, subassemble or
test the Company's products. The Company procures its components and products
through purchase orders and does not have specific requirement agreements with
any of its subcontractors. Each of the Company's subcontractors can cease
supplying the services, products or components at any time with no penalty. In
the event that it becomes necessary for the Company to replace a key
subcontractor, the Company could incur significant manufacturing set-up costs
and delays. There can be no assurance that the Company would be able to find
suitable replacement subcontractors, if necessary. In addition, the Company's
emphasis on maintaining low inventory may accentuate the effects of any
shortages that may
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result from sole source subcontractors. The Company's ability to respond to
greater than anticipated market demand may be constrained by availability of
SMT or PCB subcontracting services. Further, various of the Company's
subcontractors are located in international locations that, while offering low
labor costs, may comprise political, infrastructure, transportation, tariff,
regulatory, legal, import, export, economic or supply risks.
DEPENDENCE ON GRAPHICS AND MULTIMEDIA ACCELERATOR MARKET
Sales of graphics and multimedia accelerator subsystems accounted for
greater than 65% and 75% of the Company's revenues in the first quarters of
1997 and 1996, respectively. Although the Company has introduced audio
subsystems, ISDN adapters subsystems and SCSI host adapters, entered the modem
market through the acquisition of Supra Corporation and is developing
DVD/MPEG-2 products, graphics accelerator subsystems are expected to continue
to account for a majority of the Company's sales for the foreseeable future. A
decline in demand or average selling prices for graphics accelerator
subsystems, whether as a result of new competitive product introductions, price
competition, excess supply, widespread cost reduction, technological change,
incorporation of the products' functionality onto personal computer
motherboards or otherwise, would have a material adverse effect on the
Company's sales and operating results.
MIGRATION TO PERSONAL COMPUTER MOTHERBOARDS
The Company's graphics and multimedia accelerator subsystems are
individual products that function within personal computers to provide
additional multimedia functionality. Historically, as a given functionality
becomes technologically stable and widely accepted by personal computer users,
the cost of providing such functionality is typically reduced by means of large
scale integration into semiconductor chips, which can be subsequently
incorporated onto personal computer motherboards. The Company expects that such
migration will not occur with 3D graphics or Intel's accelerated graphics port
(AGP) in the near term, although the Company recognizes that such migration
could nonetheless occur with respect to the functionality provided by the
Company's current products. While the Company believes that a market will
continue to exist for add-in subsystems that provide advanced or multiple
functions and offer flexibility in systems configuration--such as 3D graphics
acceleration, 3D audio and MPEG-2 digital video accelerators, high-speed SCSI
host adapters and analog and digital modems--there can be no assurance that the
incorporation of new multimedia functions onto personal computer motherboards
or into the CPU microprocessor, such as under Intel's MMX or accelerated
graphics port technologies, will not adversely affect the future market for the
Company's products. In large part, the continuation of a robust market for
add-in graphics and video subsystems may depend on the timing and market
acceptance of 3-D graphics and digital video MPEG-2 acceleration. This, in
turn, may depend on the availability of compelling 3-D and MPEG-2 content,
including games and entertainment, broadcast digital video, PC video phones,
desktop video conferencing, and digital video, audio and VRML on the Internet.
Similarly, the robustness of the modem market may depend largely on the
widespread adoption of 56 Kbps and, later, digital subscriber line (xDSL)
technology in both client-side modems attached to the PC and server-side modem
connections provided by Internet Service Providers. The timing of major
technology introductions and the market acceptance of these new technologies
and standards is largely out of the control of the Company. For example, the
new 56 Kbps modem technology has two competing standards: K56flex supported by
Rockwell Semiconductor and Lucent Technologies and x2 supported by U.S.
Robotics. The Company believes that most industry experts are of the opinion
that the International Telecommunications Union will not ratify a standard
until late 1997 or early 1998, thereby causing market confusion and potentially
slowing market acceptance of new 56 Kbps modems.
COMPETITION
The market for the Company's products is highly competitive. The
Company competes directly against a large number of suppliers of add- in visual
and audio subsystems and data communications products for the PC, and
indirectly against PC systems OEMs to the extent that they manufacture their
own add-in subsystems or incorporate on PC motherboards the functionality
provided by the Company's products. In certain markets where the Company is a
relatively new entrant, such as modems, sound cards and SCSI host adapters, the
Company may face dominant competitors including U.S. Robotics (modems),
Creative Technology (sound cards) and
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Adaptec (SCSI host adapters). In addition, the Company's markets are expected
to become increasingly competitive as multimedia functions continue to converge
and companies that previously supplied products providing distinct functions
(for example, companies primarily in the sound, fax/modem, telephony, digital
signal processing, central processing unit or motherboard markets) emerge as
competitors across broader or more integrated product categories.
In addition, manufacturers of chipsets or other components used in the
Company's products could become future competitors of the Company to the extent
that such manufacturers elect to integrate forward into the add-in subsystem or
value-added software market, or as such multimedia chipset manufacturers
provide increasingly higher quality and more sophisticated software to their
chipset customers, including subsystem suppliers competitive to the Company.
Also, certain of the Company's current and potential competitors have
significantly greater market presence, name recognition and financial and
technical resources relative to the Company, and many have long-standing market
positions and established brand names in their respective markets. In addition,
certain of the Company's current and potential competitors also have a
competitive cost advantage as a result of being located in areas that impose
significantly lower taxes than the United States or offer a substantially lower
cost of labor or provide governmental subsidies, such as research and
development and training funds. Many of the Company's current and potential
competitors also design and manufacture their own graphics acceleration, video,
sound, fax/modem or other multimedia processing chipsets. While the Company
believes that its semiconductor vendor flexibility enables it to select, within
certain limits, from among the most advanced and price competitive chipsets
available on the open market, the captive semiconductor operations of certain
of the Company's current and potential competitors could provide them with
significant advantages, including greater control over semiconductor
architecture and technology, component design, component performance, systems
and software design, availability and cost.
The Company also believes that the strategy of certain of its current
and potential competitors is to compete largely on the basis of price, which
may result in significant price competition and lead to lower margins for the
Company's products or otherwise adversely affect the market for the Company's
products. To the extent that semiconductor availability is relatively robust
and software drivers and reference hardware designs from multimedia chipset
manufacturers are of high quality and sophistication, then competitors who sell
such reference designs and compete largely on price with little valued added
engineering may have a competitive cost advantage relative to the Company.
There can be no assurance that the Company will be able to continue to compete
successfully in its current and future markets, or will be able to compete
successfully against current and new competitors, as the Company's technology,
markets and products continue to evolve.
DISTRIBUTION RISKS
The Company sells its products through a network of domestic and
international distributors, and directly to major retailers/mass merchants,
VARs and OEM customers. The Company's future success is dependent on the
continued viability and financial stability of its customer base. The computer
distribution and retail channels historically have been characterized by rapid
change, including periods of widespread financial difficulties and
consolidation and the emergence of alternative sales channels, such as direct
mail order and telephone sales by manufacturers and electronic commerce on the
World Wide Web. The loss of, or reduction in, sales to certain of the Company's
key customers as a result of changing market conditions, competition, or
customer credit problems could have a material adverse effect on the Company's
operating results. Likewise, changes in distribution channel patterns, such as
increased commerce on the Internet or increased use of mail-order catalog or
consumer-electronics channels for personal computer sales, could affect the
Company in ways not yet known. Moreover, additions to or changes in the types
of products the Company sells, such as the introduction of professional-grade
products, or migration toward more communications- centric products, may
require specialized value-added reseller channels, relations with which the
Company has only begun to establish.
Inventory levels of the Company's products in the two-tier
distribution channels used by the Company ("Channel Inventory Levels")
generally are maintained in a range of one to three months of customer demand.
These Channel Inventory Levels tend toward the low end of the months-of-supply
range when demand is stronger, sales are higher and products are in short
supply. Conversely, when demand is slower, sales are lower and products are
abundant, then Channel Inventory Levels tend toward the high end of the
months-of-supply
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range. Frequently, in such situations, the Company attempts to ensure that
distributors devote their working capital, sales and logistics resources to the
Company's products to a greater degree than to those of competitors.
Similarly, the Company's competitors attempt to ensure that their own products
are receiving a disproportionately higher share of the distributors' working
capital and logistics resources. The Company believes that it is currently
operating in a period of slower demand, lower sales and abundant products,
leading to existing Channel Inventory Levels that are higher than desirable.
Consequently, the Company, in taking steps to bring its Channel Inventory
Levels down to a more desirable level, may cause a shortfall in revenue during
one or more accounting periods, including during the second quarter of 1997.
PRODUCT RETURNS; PRICE PROTECTION
The Company frequently grants limited rights to customers to return
certain unsold inventories of the Company's products in exchange for new
purchases ("Stock Rotation"), as well as price protection on unsold inventory.
Moreover, certain of the Company's retail customers will readily accept
returned product from their own retail customers, and these returned products
are, in turn, returned to the Company for credit. The Company estimates
returns and accrues for potential price protection on unsold inventory.
However, there can be no assurance that these estimates or accruals will be
sufficient, or that any future returns or price reductions will not have a
material adverse effect on operating results, including through the mechanisms
of Stock Rotation or price protection, particularly in light of the rapid
product obsolescence which often occurs during product transitions. The short
product life cycles of the Company's products, the evolving markets for new
multimedia and connectivity technologies such as the new 56 Kbps modem and 3D
graphics technologies, and the difficulty in predicting future sales through
the distribution channels to the final end customer all increase the risk that
new product introductions, price reductions by the Company or its competitors,
or other factors affecting the personal computer and add-in subsystems industry
could result in significant and unforeseen product returns, with such returns
creating a material adverse affect on the Company's financial performance. In
addition, there can be no assurance that new product introductions by
competitors or other market factors, such as the integration of graphics
acceleration or modem connectivity by OEMs onto system motherboards, will not
require the Company to reduce prices in a manner or at a time that gives rise
to significant price protection charges and has a material adverse impact upon
the Company's gross margins.
Furthermore, the markets that the Company serves include end users who
buy from computer retail and consumer electronics mass merchant outlets to
upgrade their existing PCs. Such customers frequently decide to return
products to the retail outlets from which they earlier purchased the product.
Such returns are made for a variety of reasons, including the customer changing
his or her mind regarding his or her purchase decision, the customer has
difficulty with the installation or use of the product, the product does not
offer the features, functions, or performance that the customer expected or the
customer experiences incompatibilities between the product and his or her
existing PC hardware or software. Since many of the products that the Company
sells incorporate advanced computer technology, the Company expects that end
user customer returns, including warranty returns, will be a continuing
negative attribute of the PC installed base upgrade market.
OEM CUSTOMER RISKS
The Company currently has only a limited number of OEM customers.
While the Company is seeking to increase its sales to OEMs, certain OEMs
maintain internal add-in subsystem design and manufacturing capabilities or
have long-standing relationships with competitors of the Company, and there can
be no assurance that the Company will be successful in its efforts to increase
its OEM sales. Moreover, developing supplier relationships with major PC
systems OEMs and installing the process and procedures required by such OEMs
can be an expensive and time- consuming process, and there can be no assurance
that the Company will achieve an acceptable financial return on this
investment. It is expected that OEM revenue will carry a lower gross margin
percentage compared to sales to other channels due to perceived lower expenses
to support such OEM revenue and the buying power exercised by large OEMs.
Furthermore, the Company's products are priced for and generally aimed at the
higher performance and higher quality segment of the market. Therefore, to the
extent that OEMs focus on low-cost solutions rather than high-performance
solutions, an increase in the proportion of the Company's sales to OEMs may
result in an increase in the proportion of the Company's revenue that is
19
<PAGE> 20
generated by lower-selling-price or lower-gross-margin products, which could
adversely affect future operating results.
RAPID TECHNOLOGICAL CHANGE
The markets for the Company's products are characterized by rapidly
changing technology, evolving industry standards, frequent new product
introductions and rapid product obsolescence. For example, 3D technology is
evolving rapidly in the graphics and audio markets, DVD and MPEG-2 decryption
techniques and navigation technologies are still being refined, and at least
two competing 56 Kbps proprietary protocols are expected to be rapidly deployed
by the modem industry during 1997. Product life cycles in the Company's markets
frequently range from six to twelve months. The Company's success will be
substantially dependent upon its ability to continue to develop and introduce
competitive products and technologies on a timely basis with features and
functionalities that meet changing customer requirements in a cost-effective
manner. Further, if the Company is successful in its development and market
introduction of new products, it must correctly forecast customer demand for
such new products so as to avoid either excessive unsold inventory or excessive
unfilled orders related to the products. Moreover, when the Company is
successful in launching competitive new products, it must also successfully
manage the corollary obsolescence and price erosion of those of its products
that are impacted by the new products, as well as any resulting price
protection charges and Stock Rotations from its distribution channels.
CAPITAL NEEDS
There can be no assurance that additional capital beyond the amounts
currently forecasted by the Company will not be required or that any required
additional capital will be available on reasonable terms, if at all, at such
time or times as required by the Company. Any shortfall in capital resources
compared to the Company's level of operations or any inability to secure
additional capital as needed could impair the Company's ability to finance
inventory, accounts receivable and other operational needs. Such capital
limitations could also impair the Company's ability to invest in research and
development, improve customer service and support, deploy information
technology systems, and expand manufacturing and other operations. Failure to
keep pace with competitive requirements in any of these areas could have a
material adverse effect on the Company's business and operating results.
Moreover, any need to raise additional capital through the issuance of equity
securities may result in additional dilution to earnings per share.
RISKS OF INTERNATIONAL SALES
The Company's international sales are subject to a number of risks
generally associated with international business operations, including the
effect on demand for the Company's products in international markets as a
result of a strengthening or weakening U.S. dollar, the effect of currency
fluctuations on consolidated multinational financial results, any state-imposed
restrictions on the repatriation of funds, any import and export duties and
restrictions, certain international economic conditions, the expenses, time and
technical resources required to localize the Company's various products and to
support local languages, the logistical difficulties of managing multinational
operations and dispersed product inventory designed or manufactured to meet
specific countries' requirements, and the delays and expenses associated with
homologating the Company's telecommunications products and securing the
necessary governmental approvals for shipment to various countries.
The Company's international sales can also be affected if inventory
sold by the Company to its international distributors and OEMs and held by them
or their customers does not sell through to final end customers, which may
impact international distributor or OEM orders in the succeeding periods. The
Company believes that at this stage of its development it has generally less
information with respect to the inventory levels held by its international OEMs
and distributors vis-a-vis their domestic counterparts, and therefore generally
less visibility on how this held inventory might affect future orders to and
sales by the Company.
20
<PAGE> 21
INFORMATION TECHNOLOGY AND TELECOMMUNICATIONS SYSTEMS
The Company is currently making significant investments in
establishing systems, processes and procedures to more efficiently and
effectively manage its worldwide business and enable communications and data
sharing among its employees and various business units. This effort comprises a
significant investment of expense and capital funds for the installation of
information technology ("IT") and telecommunications equipment, as well as a
drain on management resources. As part of this program to install IT systems
throughout the Company, management believes that the Company will be required
to install an enhanced and more robust client-server based financial, order
entry, materials planning, inventory, bill of materials and operations
management IT application. In order to more effectively manage the Company's
business and avert Year 2000 issues, the Company believes that this new
application will need to be installed and operational by 1999. Such an effort
is expected to comprise a further substantial investment of expenses and
management resources by the Company.
PROPRIETARY RIGHTS
While the Company had 1 issued U.S. Patent and 15 pending U.S. Patent
Applications at March 31, 1997, it nonetheless relies primarily on a
combination of trademark, copyright and trade secret protection together with
licensing arrangements and nondisclosure and confidentiality agreements to
establish and protect its proprietary rights. There can be no assurance that
the Company's measures to protect its proprietary rights will deter or prevent
unauthorized use of the Company's technology, brand or other proprietary or
intellectual property. In addition, the laws of certain foreign countries may
not protect the Company's proprietary rights to the same extent as do the laws
of the United States or the EC. As is typical in its industry, the Company from
time to time is subject to legal claims asserting that the Company has violated
intellectual property rights of third parties. In the event that a third party
was to sustain a valid claim against the Company, and any required licenses
were not available on commercially reasonable terms, the Company's operating
results could be materially and adversely affected. Litigation, which could
result in substantial cost to and diversion of the resources of the Company,
may also be necessary to enforce intellectual property rights of the Company or
to defend the Company against claimed infringement of the rights of others.
STOCK PRICE VOLATILITY
The trading price of the Company's Common Stock has been subject to
significant fluctuations to date, and could be subject to wide fluctuations in
the future in response to quarter-to-quarter variations in operating results,
announcements of technological innovations, new products or significant OEM
systems design wins by the Company or its competitors, general conditions in
the markets for the Company's products or the computer industry, the price and
availability of purchased components, general financial market conditions,
market conditions for technology, PC or semiconductor stocks, changes in
earnings estimates by analysts, or other events or factors. In this regard, the
Company does not endorse and accepts no responsibility for the estimates or
recommendations issued by stock research analysts from time to time. In
addition, the public stock markets in general, and technology stocks in
particular, have experienced extreme price and trading volume volatility. This
volatility has significantly affected the market prices of securities of many
high technology companies for reasons frequently unrelated to the operating
performance of the specific companies. These broad market fluctuations may
adversely affect the market price of the Company's Common Stock.
DEPENDENCE ON KEY PERSONNEL
The Company's future success will depend to a significant extent upon
the efforts and abilities of its senior management and professional, technical,
sales and marketing personnel. The competition for such personnel is intense,
particularly in the San Jose, CA area ("Silicon Valley"). There can be no
assurance that the Company will be successful in retaining its existing key
personnel or in attracting and retaining the additional key personnel that it
requires. The loss of services of one or more of its key personnel or the
inability to add or replace key personnel could have a material adverse effect
on the Company. The salary, performance bonus and stock option packages
necessary to recruit or retain key personnel, particularly in Silicon Valley,
may significantly increase the Company's expense levels or result in dilution
to the Company's earnings per share.
21
<PAGE> 22
The Company does not carry "key person" life insurance on any of its employees
except for William J. Schroeder, its President and Chief Executive Officer.
LEGAL MATTERS
The Company has been named as a defendant in several putative class
action lawsuits which were filed in 1996 in the California Superior Court for
Santa Clara County and the U.S. District Court for the Northern District of
California. Certain executive officers and directors of the Company are also
named as defendants. The plaintiffs purport to represent a class of all persons
who purchased the Company's Common Stock between October 18, 1995 and June 20,
1996 (the "Class Period"). The complaints allege claims under the federal
securities laws and California law. The plaintiffs allege that the Company and
the other defendants made various material misrepresentations and omissions
during the Class Period. The complaints do not specify the amount of damages
sought. The Company believes that it has good defenses to the claims alleged in
the lawsuits and will defend itself vigorously against these actions. These
cases are in the early stages and no schedule for the litigation has been set.
The ultimate outcome of these actions cannot be presently determined.
Accordingly, no provision for any liability or loss that may result from
adjudication or settlement thereof has been made in the accompanying
consolidated financial statements.
22
<PAGE> 23
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company has been named as a defendant in several putative class
action lawsuits which were filed in June and July 1996 in the California
Superior Court for Santa Clara County and the U.S. District Court for the
Northern District of California. Certain executive officers and directors of
the Company are also named as defendants. The plaintiffs purport to represent
a class of all persons who purchased the Company's Common Stock between October
18, 1995 and June 20, 1996 (the "Class Period"). The complaints allege claims
under the federal securities laws and California law. The plaintiffs allege
that the Company and the other defendants made various material
misrepresentations and omissions during the Class Period. The complaints do
not specify the amount of damages sought. The Company believes that it has
good defenses to the claims alleged in the lawsuits and will defend itself
vigorously against these actions. These cases are in the early stages and no
schedule for the litigation has been set.
ITEM 2. CHANGES IN SECURITIES
Not applicable.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
ITEM 5. OTHER INFORMATION
Not applicable.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
A. Exhibit
Exhibit # Description of Document
11.1 Statement Regarding Computation of Net Income
(Loss) per Share
27 Financial Data Schedule
B. Reports on Form 8-K
The Company did not file any reports on Form 8-K during the
quarter ended March 31, 1997.
23
<PAGE> 24
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
DIAMOND MULTIMEDIA SYSTEMS, INC.
Date: May 12, 1997 /s/ William J. Schroeder
----------------------------------
William J. Schroeder
President and Chief Executive Officer
Date: May 12, 1997 /s/ James M. Walker
-----------------------------------
James M. Walker
Chief Financial Officer
24
<PAGE> 25
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NO. DESCRIPTION
- ------- -----------
<S> <C>
11.1 Statement Regarding Computation of Net Income (Loss)
per share
27 Financial Data Schedule
</TABLE>
<PAGE> 1
EXHIBIT 11.1
DIAMOND MULTIMEDIA SYSTEMS, INC.
STATEMENT REGARDING COMPUTATION OF NET INCOME (LOSS) PER SHARE
(in thousands, except per share data)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
------------------------
1997 1996
------- -------
<S> <C> <C>
Weighted average common shares outstanding for period 34,179 34,493
Dilutive employee stock options -- 849
------- -------
Shares used in per share calculations 34,179 35,342
======== ========
Net income (loss) ($5,951) $11,194
Net income (loss) per share ($0.17) $0.32
======= ========
</TABLE>
The difference between the calculation of net income (loss) per share
calculated on the primary and fully diluted basis is not material.
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<CURRENCY> U.S. DOLLARS
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> MAR-31-1997
<EXCHANGE-RATE> 1
<CASH> 98,067
<SECURITIES> 0
<RECEIVABLES> 82,718
<ALLOWANCES> 2,300
<INVENTORY> 66,363
<CURRENT-ASSETS> 275,371
<PP&E> 20,496
<DEPRECIATION> 6,946
<TOTAL-ASSETS> 306,953
<CURRENT-LIABILITIES> 85,239
<BONDS> 2,493
0
0
<COMMON> 34
<OTHER-SE> 218,574
<TOTAL-LIABILITY-AND-EQUITY> 306,953
<SALES> 112,402
<TOTAL-REVENUES> 112,402
<CGS> 92,817
<TOTAL-COSTS> 92,817
<OTHER-EXPENSES> 7,008
<LOSS-PROVISION> 429
<INTEREST-EXPENSE> (543)
<INCOME-PRETAX> (9,446)
<INCOME-TAX> (3,495)
<INCOME-CONTINUING> (5,951)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (5,951)
<EPS-PRIMARY> (0.17)
<EPS-DILUTED> (0.17)
</TABLE>
