<PAGE> 1
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 1998
or
[ ] 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
incorporation or organization) Identification No.)
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
June 30, 1998 was 35,171,716.
<PAGE> 2
DIAMOND MULTIMEDIA SYSTEMS, INC.
INDEX TO FORM 10-Q
<TABLE>
<CAPTION>
Page
----
<S> <C>
PART I - FINANCIAL INFORMATION:
ITEM 1- Financial Statements
Consolidated Balance Sheets as of June 30, 1998
and December 31, 1997 3
Consolidated Statements of Operations for the three
and six months ended June 30, 1998 and 1997 4
Consolidated Statements of Cash Flows
for the six months ended June 30, 1998 and 1997 5
Notes to Consolidated Financial Statements 6
ITEM 2 - Management's Discussion and Analysis of
Financial Condition and Results of Operations 8
PART II - OTHER INFORMATION
ITEM 1 - Legal proceedings 29
ITEM 2 - Changes in securities 30
ITEM 3 - Defaults Upon Senior Securities 30
ITEM 4 - Submission of Matters to a Vote of Security Holders 30
ITEM 5 - Other Information 31
ITEM 6 - Exhibits and Reports on Form 8-K 31
SIGNATURES 32
</TABLE>
2
<PAGE> 3
PART I - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(UNAUDITED; IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
1998 1997
--------- ---------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 109,137 $ 85,929
Short-term investments 6,073 4,136
Trade accounts receivable, net of allowance for doubtful accounts
of $2,232 and $2,440 as of June 30, 1998 and
December 31, 1997 102,149 98,777
Inventories 93,859 78,647
Prepaid expenses and other current assets 9,477 6,350
Income taxes receivable 6,621 24,929
Deferred income taxes 14,679 14,679
--------- ---------
Total current assets 341,995 313,447
Property, plant and equipment, net 30,375 15,216
Other assets 24,444 3,616
Goodwill and other intangibles, net 4,787 5,275
--------- ---------
Total assets $ 401,601 $ 337,554
========= =========
LIABILITIES
Current liabilities:
Current portion of long-term debt $ 49,954 $ 36,455
Trade accounts payable 100,812 98,764
Accrued liabilities 63,662 17,667
Income taxes payable 145 2,274
--------- ---------
Total current liabilities 214,573 155,160
Long-term debt, net of current portion 1,718 1,873
--------- ---------
Total liabilities 216,291 157,033
--------- ---------
STOCKHOLDERS' EQUITY
Preferred stock, par value $.001; Authorized - 8,000 shares at
June 30, 1998 and December 31, 1997; none issued and
outstanding -- --
Common stock, par value $.001;
Authorized - 75,000 at June 30, 1998 and December 31, 1997
Issued and outstanding - 35,171 at June 30, 1998 and 34,491
at December 31, 1997 36 34
Additional paid-in capital 313,021 307,877
Distributions in excess of net book value (56,775) (56,775)
Accumulated deficit (70,972) (70,615)
--------- ---------
Total stockholders' equity 185,310 180,521
--------- ---------
Total liabilities and stockholders' equity $ 401,601 $ 337,554
========= =========
</TABLE>
The accompanying notes are an integral part of these consolidated condensed
financial statements.
3
<PAGE> 4
DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED; IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
------------------ ----------------
JUNE 30, JUNE 30,
-------- --------
1998 1997 1998 1997
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
Net sales $ 172,347 $ 52,982 $ 358,543 $ 165,384
Cost of sales 151,884 76,100 296,454 168,917
--------- --------- --------- ---------
Gross profit 20,463 (23,118) 62,089 (3,533)
--------- --------- --------- ---------
Operating expenses:
Research and development 7,168 6,529 14,260 12,221
Selling, general and administrative 23,747 22,572 46,905 45,083
Amortization of intangibles 244 1,343 488 2,659
Write-off of intangibles -- 9,983 -- 9,938
Restructuring expenses 1,384 -- 1,384 --
--------- --------- --------- ---------
Total operating expenses 32,543 40,382 63,037 69,901
--------- --------- --------- ---------
Loss from operations (12,080) (63,500) (948) (73,434)
Interest income, net 157 494 493 1,037
Other income (expense), net 89 788 (55) 733
--------- --------- --------- ---------
Loss before benefit from income taxes (11,834) (62,218) (510) (71,644)
Benefit from income taxes (3,550) (18,109) (153) (21,604)
--------- --------- --------- ---------
Net loss ($ 8,284) ($ 44,109) ($ 357) ($ 50,060)
========= ========= ========= =========
Net loss per share:
Basic ($ 0.24) ($ 1.29) ($ 0.01) ($ 1.46)
Diluted ($ 0.24) ($ 1.29) ($ 0.01) ($ 1.46)
Shares used in per share calculations:
Basic 34,991 34,254 34,799 34,217
Diluted 34,991 34,254 34,799 34,217
</TABLE>
The accompanying notes are an integral part of these consolidated condensed
financial statements.
4
<PAGE> 5
DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED; IN THOUSANDS)
<TABLE>
<CAPTION>
SIX MONTHS ENDED JUNE 30,
-------------------------
1998 1997
--------- ---------
<S> <C> <C>
Cash flows from operating activities:
Net loss ($ 357) ($ 50,060)
Adjustments to reconcile net loss to net cash provided by
(used in) operating activities:
Depreciation and amortization 3,543 5,222
Provision for doubtful accounts (2,053) 772
Provision for excess and obsolete inventories (10,851) 6,200
Loss on disposal of fixed assets -- 232
Write-off of intangibles -- 9,938
Deferred income taxes -- (19,687)
Changes in assets and liabilities:
Trade accounts receivables (1,112) 41,050
Inventories (103) 4,722
Prepaid expenses and other assets (2,159) 2,205
Income taxes receivable 18,308 --
Trade accounts payable and other liabilities 1,560 (22,194)
--------- ---------
Net cash provided by (used in) operating activities 6,776 (21,600)
--------- ---------
Cash flows from investing activities:
Purchases of property and equipment (9,940) (4,130)
Liability for purchase of Micronics, net of net assets 10,970 --
acquired
Other equity investments (1,150) --
Purchases of short-term investments (1,937) --
--------- ---------
Net cash used in investing activities (2,057) (4,130)
--------- ---------
Cash flows from financing activities:
Proceeds from issuance of common stock 5,146 877
Repurchases of common stock (1) (5)
Proceeds from term loans and revolving credit Facilities 54,024 78,123
Payments and maturities of term loans and revolving
credit facilities (40,253) (71,716)
Repayments of capital lease financings (427) (460)
--------- ---------
Net cash provided by financing activities 18,489 6,819
--------- ---------
Net increase (decrease) in cash and cash equivalents 23,208 (18,911)
Cash and cash equivalents at beginning of period 85,929 120,147
--------- ---------
Cash and cash equivalents at end of period $ 109,137 $ 101,236
========= =========
Supplemental Disclosure of cash flow information:
Income taxes paid during the period $ 3,474 $ 1,400
========= =========
Interest paid during the period $ 1,077 $ 396
========= =========
</TABLE>
The accompanying notes are an integral part of these consolidated condensed
financial statements.
5
<PAGE> 6
DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been
prepared by the Company 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, 1997.
Operating results for the quarter ended June 30, 1998 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>
June 30, 1998 December 31, 1997
------------- -----------------
<S> <C> <C>
Raw materials $32,435 $29,876
Work in process 41,334 40,286
Finished goods 20,090 8,485
------- -------
$93,859 $78,647
======= =======
</TABLE>
The Company had approximately $6 million of inventory in excess of its
normal short-term needs for certain product lines at June 30, 1998. Management
has developed a program to reduce this inventory to desired levels over the near
term; however, it is reasonably possible that the program will not be wholly
successful and that a material loss could ultimately result on the disposal of
this inventory. No estimate can be made of the range of amounts of such loss.
3. COMPUTATION OF NET INCOME (LOSS) PER SHARE
Basic EPS is computed as net income (loss) divided by the weighted average
number of common shares outstanding for the period. Diluted EPS reflects the
potential dilution that could occur from common shares issuable through stock
options, warrants and other convertible securities. Common equivalent shares are
excluded from the computation of net loss per share where applicable as their
effect is antidilutive.
6
<PAGE> 7
DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The following is a reconciliation of the numerator (net loss) and
denominator (number of shares) used in the basic and diluted EPS calculation:
(Dollar amounts, in thousands)
<TABLE>
<CAPTION>
Three Months Ended June 30, Six Months Ended June 30,
--------------------------- -------------------------
1998 1997 1998 1997
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Basic:
Net loss ($ 8,284) ($44,109) ($ 357) ($50,060)
Average Common
Shares Outstanding 34,991 34,254 34,799 34,217
-------- -------- -------- --------
Basic EPS ($ 0.24) ($ 1.29) ($ 0.01) ($ 1.46)
======== ======== -------- --------
Diluted:
Net loss ($ 8,284) ($44,109) ($ 357) ($50,060)
Average Common
Shares Outstanding 34,991 34,254 34,799 34,217
Stock options -- -- -- --
Total Shares 34,991 34,254 34,799 34,217
-------- -------- -------- --------
Diluted EPS ($ 0.24) ($ 1.29) ($ 0.01) ($ 1.46)
======== ======== --------
</TABLE>
Common equivalent shares of 744,936 and 1,242,736 have been excluded from
the calculation of dilituve earnings per share for the three and six months
ended June 30, 1998, respectively, as their effect is anti-dilutive.
4. MICRONICS ACQUISITION
On June 26, 1998 the Company accepted for payment 11,616,380 shares of
common stock of Micronics Computers, Inc. ("Micronics") at a price of $2.45 per
share, or approximately $28.6 million. On July 9, 1998, the Company, through a
wholly owned subsidiary, effected a merger with Micronics pursuant to Section
253 of the Delaware General Corporation Law. The Company estimates the total
cost of the acquisition of all the shares of Micronics to be approximately $31.6
million. Cash payment for Micronics shares was delivered the first week of July
1998. Micronics is a supplier of high-performance system boards and multimedia
peripherals for personal computers. The acquisition was treated as a purchase
for accounting purposes. The Company's operating results for the three month and
six month periods ending June 30, 1998 include four days of Micronics results,
which were not material to the Company. As a result of the acquisition, the
Company recorded approximately $1.4 million in restructuring charges to reflect
severance and outplacement costs, the cost of closing the Micronics building and
moving certain employees to existing Company facilities, and other integration
expenses specifically associated with the acquisition. The Company's
consolidated balance sheet as of June 30, 1998 reflects a preliminary allocation
of the purchase price of Micronics. This resulted in an increase in cash,
inventory, accounts receivable, other current assets, fixed assets and current
liabilities. Assets acquired totaled $24.7 million while liabilities were $11.6
million. The difference between the acquisition cost, including approximately
$1.1 million in acquisition expenses, and the fair market value of the acquired
assets net of acquired liabilities will be allocated between in process
technology expense and goodwill upon the completion of a valuation study. At the
time of filing this Form 10-Q, the valuation
7
<PAGE> 8
DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
study is still in progress. When the study is completed, the results of
operations for the quarter ended June 30, 1998 will be amended to reflect this
in-process technology expense.
5. LITIGATION
The Company has been named as a defendant in several putative class action
lawsuits which were filed in June and July 1996 and June 1997 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 trial date 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.
The Company is also party to other claims and pending legal proceedings
that generally involve employment and trademark issues. These cases are, in the
opinion of management, ordinary and routine matters incidental to the normal
business conducted by the Company. In the opinion of management, the ultimate
disposition of such proceedings will not have a materially adverse effect on the
Company's consolidated financial position or future results of operations.
5. COMPREHENSIVE NET INCOME
The Company has adopted the provisions of Statement of Financial
Accounting Standards No. 130, "Reporting Comprehensive Income", effective
January 1, 1998. This statement requires the disclosure of comprehensive income
and its components in a full set of general-purpose financial statements.
Comprehensive income is defined as net income plus revenues, expenses, gains and
losses that, under generally accepted accounting principles, are excluded from
net income. The components of comprehensive income which are excluded from net
income are not significant, individually or in the aggregate, and therefore, no
separate statement of comprehensive income has been presented.
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
Diamond Multimedia Systems, Inc. ("Diamond" or the "Company") designs,
develops, manufactures and markets multimedia and connectivity products for
IBM-compatible personal computers ("PCs"). The Company is a leading supplier of
graphics and multimedia accelerator subsystems for PCs, and is expanding its
position
8
<PAGE> 9
in the interactive multimedia market by providing advanced 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. Diamond accelerates multimedia from the Internet to the
hard drive with products that include the Stealth series of media accelerators,
the Monster series of entertainment 3D and audio accelerators, the Fire series
of professional 3D graphics and SCSI accelerators, and the Supra(R) series of
modems. Headquartered in San Jose, CA, Diamond has sales, marketing and
technical facilities in several locations including Vancouver (WA), Albany (OR),
Atlanta (GA), Dallas (TX), Singapore, Sydney, Hong Kong, Seoul, Tokyo, Starnberg
(Germany), Saarbrecken (Germany), Paris, and Winnersh (U.K.). 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 second quarter of 1998 increased $119.4 million (225%) to
$172.3 million compared to $53 million for the second quarter of 1997 while
sales for the first six months of 1998 increased $193.2 million (117%) to $358.5
million compared to $165.4 million for the corresponding prior year period. The
increases in net sales for both periods were primarily attributable to shipments
of the Monster 3D series of graphic accelerator cards as well as sales of the
Company's other graphics products and modems.
As a percentage of total net sales, international net sales represented 46%
of net sales in the second quarter of 1998 compared to 47% of net sales in the
second quarter of 1997. For the first six months of 1998, international sales
were 46% of total net sales compared to 35% in the same period of 1997. Sales
growth in Europe was higher than the growth in Asian and Latin American markets
in both the second quarter of 1998 and the first six months of 1998 compared to
the corresponding periods of 1997. European sales were 35% of net sales in the
second quarter of 1998 and 35% of net sales in the first six months of 1998
compared to 23% and 21% of net sales, respectively, for the corresponding
periods of 1997.
The transition of mainstream PC graphics subsystem architectures from 2D
graphics and the PCI bus to 3D graphics and the accelerated graphics port (AGP),
which began in 1997 and is expected to continue through 1998, as well as the
SGRAM-to-SDRAM memory transition, has led to excess inventory of PCI and
SGRAM-based products at the Company and in certain distribution channels. When
combined with seasonal softness in the personal computer market and competitive
pricing pressures, the Company experienced lower average selling prices,
significant price protection charges and lower gross margins during the second
quarter of 1998 compared to the first quarter of 1998. In addition, higher than
planned selling and marketing expenses were incurred and the Company wrote-off
higher than normal amounts of excess and obsolete inventory.
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. In an environment of slower demand and abundant supply
of products, price declines are more likely to occur and, should they occur, are
more likely to be severe. Further, in such an event, high Channel Inventory
Levels may result in substantial price protection charges. Such price protection
charges have the effect of reducing net sales and gross profit. Consequently,
the Company, in taking steps to bring its Channel Inventory Levels down to a
more desirable level, may cause a shortfall in net sales during one or more
accounting periods. This situation may also result in price protection charges
as prices are decreased, having an adverse impact on operating results. Channel
sell through of Monster 3D II slowed at the end of the second quarter of 1998
and reduced the Company's revenue, margin and profitability results. Revenue was
further impacted by significant reductions in selling prices on many products
during the quarter. In addition, products shipped at higher prices that remained
9
<PAGE> 10
in the channel had to be price protected, further reducing revenues, margins and
profitability. While the Company believes that its Channel Inventory Levels for
many of its products are appropriate at this time, there are certain products
which currently have a Channel Inventory Level that is higher than desirable.
The Company estimates and accrues for potential price protection charges on
unsold channel inventory. However, there can be no assurance that these
estimates or accruals will be sufficient. Should the estimates or accruals not
be sufficient, additional price protection charges may be required, the result
of which could have a material adverse effect on operating results during the
third quarter of 1998.
GROSS MARGIN
Gross profit for the second quarter of 1998 increased $43.6 million to
$20.5 million (11.9% of net sales) compared to a negative $23.1 million in the
second quarter of 1997. For the first six months of 1998, gross profit increased
$65.6 million to $62.1 million (17.3% of net sales) compared to a negative $3.5
million in the first six months of 1997. Negative gross profit in the second
quarter of 1997 was caused by a number of factors including technology
transitions (2D only graphics to 2D/3D graphics, higher speed modems and
consumer uncertainty regarding connectivity standards), seasonal slowness, and
competitive pressures. While such factors again existed in the second quarter of
1998, the Company's gross profit was not impacted so severely. Products
contributing to the increase in gross profit included the Monster 3D series of
entertainment graphics accelerators and well as the Company's Supra series of
modems. Further, gross profit was positively impacted by significantly higher
shipment volume levels over which indirect manufacturing costs were absorbed.
Though gross profit and gross margin increased when compared to 1997, gross
profit and gross margin both declined from the first quarter of 1998 to the
second quarter of 1998. General pricing pressure on legacy graphics products was
the major contributing factor in the reduced gross profits and gross margins. In
addition, sales of the Company's Monster 3D II product, one of the Company's
best margin products during the second quarter, fell short of expectations
towards the end of the quarter.
RESEARCH AND DEVELOPMENT
Research and development (R&D) expenses increased $0.6 million (9.8%) to
$7.2 million for the first quarter of 1998, compared to the second quarter of
1997. For the first six months of 1998, R&D expenses increased $2.0 million
(16.7%) to $14.3 million, compared to the first six months of 1997. These
increases were primarily due to higher personnel-related expenses and 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, modem,
telephony and other functions increasingly being implemented on personal
computers. As a percentage of sales, R&D expenses were 4% and 12% in the second
quarter of 1998 and 1997, respectively, and 4% and 7% in the first six months of
1998 and 1997, respectively. The decreases in expenses as a percentage of net
sales were primarily attributable to the increases in net sales during the first
quarter and first six months of 1998 compared to the first quarter and first six
months of 1997. The decreases were partially offset by the increases in actual
R&D expenses.
SELLING, GENERAL AND ADMINISTRATIVE
Selling, general and administrative (SG&A) expenses increased $1.2 million
(5.2%) to $23.7 million for the second quarter of 1998, compared to the second
quarter of 1997. For the first six months of 1998, SG&A expenses increased $1.8
million (4.0%) to $46.9 million, compared to the first six months of 1997. These
increases are primarily due to increases in sales and promotional expenses
during the first six months of 1998. Certain of these expenses, especially
expenses attributable to channel sales incentive programs, are directly
proportional to increases in channel sales experienced between the two periods.
As a percentage of sales, SG&A expenses were 13.8% and 42.6% in the second
quarters of 1998 and 1997, respectively, and 13.1% and 27.3% of net sales for
the first six months of 1998 and 1997, respectively. The decreases in SG&A as a
percentage of sales were primarily attributable to the increases in net sales
during the first quarter and first six
10
<PAGE> 11
months of 1998 compared to the first quarter and first six months of 1997. The
decreases were partially offset by the increases in actual SG&A expenses.
RESTRUCTURING EXPENSES
The Company incurred restructuring expenses of $1.4 million in the second
quarter of 1998 associated with the purchase of Micronics. These expenses relate
to the integration of the Micronics business into Diamond, especially severance
and out placement fees as well as the cost of consolidating the remaining
Micronics employees into existing Diamond facilities.
AMORTIZATION OF INTANGIBLE ASSETS
The Company incurred amortization expense of $0.2 million in the second
quarter of 1998 compared to $1.3 million in the corresponding prior year period.
The decrease in amortization expense in the second quarter of 1998 is primarily
due to the write-off of $9.9 million of intangible assets during the second
quarter of 1997 which significantly reduced the remaining outstanding balance to
be amortized. These expenses relate to amortization of purchased technology and
goodwill from the Supra Corporation and SPEA Software AG acquisitions, which
occurred in the third and fourth quarters of 1995, respectively. This decrease
in expense was offset in part by amortization expense arising from the $2
million of goodwill created by the Company's acquisition of Binar Graphics, Inc.
which occurred in the fourth quarter of 1997. Amortization expense will increase
in future periods due to the purchase of Micronics. Exact amounts are not
currently available pending a valuation study to allocate the purchase price in
excess of net assets and liabilities between goodwill and in process technology
expense.
NET INTEREST INCOME AND OTHER EXPENSE
Net interest income was $0.2 million and $0.5 million in the second
quarters of 1998 and 1997, respectively. Net interest income was $0.5 million
and $1 million in the first six months of 1998 and 1997, respectively. Net
interest income declined due to higher interest expense incurred because of
larger average borrowings outstanding during the first and second quarters of
1998 compared to the first and second quarters of 1997. Net other income
decreased in the second quarter of 1998 from the second quarter of 1997 from
$0.8 million to $0.1 million. Net other expense was $0.1 million for the first
six months of 1998 compared to net other income of $0.7 million for the first
six months of 1997. The decreases in net other income and expense were primarily
due to the settlement of a lawsuit during the second quarter of 1997.
BENEFIT FROM INCOME TAXES
The Company's effective tax benefit rate in the second quarter of 1998 was
30% compared to an effective tax benefit rate of 29% for the corresponding
period in 1997. The Company's effective tax benefit rate in the first six months
of 1998 was 30% compared to an effective tax benefit rate of 30% for the first
six months of 1997. The effective tax rate in the second quarter of 1997 and the
first six months of 1997 would have been 35% if not for the write-off of
goodwill and existing technology which are not deductible for tax purposes.
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.
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents increased by $23.2 million during the first six
months of 1998, including $11 million in cash realized pursuant to the
acceptance of the tender of shares of Micronics as of June 26, 1998. Operating
activities provided $6.8 million in cash, and the primary source of cash was a
decrease in income taxes receivable of $20 million. Significant uses of cash
include an increase in prepaid assets as well as reductions to the provisions
for excess and obsolete inventory and doubtful accounts.
11
<PAGE> 12
The Company used $2.1 million in cash from investing activities. The
primary investment was the purchase of Micronics, including acquisition costs,
for $21.8 million net of cash acquired. However, this was offset by a liability
to Micronics shareholders. Cash payment for Micronics shares was funded in the
first week of July. In addition, the Company has purchased $9.9 million in fixed
assets during the first six months of 1998 compared to purchases of $4.1 million
in 1997. The increase is primarily due to the Company's ongoing investment in a
new enterprise-wide business management, resource planning and decision support
system. Incremental purchases of short term investments was $1.9 million. In
addition, other equity investments used $1.2 million, primarily for the
Company's investment in Not Limited, Inc., a developer of wireless data
communication technologies. Net cash provided by financing activities was $18.5
million. Primary sources of cash included $54.0 million from term loans and
revolving credit facilities and proceeds of $5.1 million from the issuance of
common stock. These proceeds were partially offset by payments and maturities of
term loans and revolving credit facilities of $40.3 million.
At June 30, 1998, the Company had $109.1 million of cash and cash
equivalents and $6.1 million of short-term investments. Further, as of such
date, the Company had lines of credit and bank credit facilities totaling $59.3
million, of which $7.7 million was unused and available. At June 30, 1998, the
Company was in default with its loan covenants regarding tangible net worth and
profitability. The Company has received waivers for these violations.
The Company expects to spend approximately $14 million for capital
equipment in 1998, principally relating to computer and office equipment and
including, in particular, an enhanced enterprise-wide business management,
resource planning and decision support system. In addition, the Company acquired
fixed assets with a fair market value estimated at $8.3 million as a result of
the purchase of Micronics.
The Company believes that its cash balances and available credit under
existing bank lines will be sufficient to meet anticipated operating and
investing requirements for the short term. 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.
YEAR 2000 COMPLIANCE
Many existing computer systems and applications, and other control devices,
use only two digits to identify a year in the date field, without considering
the impact of the upcoming change in the century. As a result, such systems and
applications could fail or create erroneous results unless corrected so that
they can process data related to the year 2000. The Company relies on its
systems, applications and devices in operating and monitoring all major aspects
of its business, including financial systems (such as general ledger, accounts
payable and payroll modules), customer services, infrastructure, embedded
computer chips, networks and telecommunications equipment and end products. The
Company also relies, directly and indirectly, on external systems of business
enterprises such as customers, suppliers, creditors, financial organizations,
and of governmental entities, both domestic and international, for accurate
exchange of data. The Company's current estimate is that the costs associated
with the year 2000 issue, and the consequences of incomplete or untimely
resolution of the year 2000 issue, will not have a material adverse effect on
the result of operations or financial position of the Company in any given year.
The Company is currently engaged in a project to upgrade the computer hardware
and software it uses to operate, monitor and manage its business on a day to day
basis. The vendors have indicated that their products accurately accommodate
dates beyond the year 1999. The Company is testing such capabilities as part of
its implementation process. However, despite the Company's efforts to address
the year 2000 impact on its internal systems, the Company has not fully
identified such impact or whether it can resolve it without disruption of its
business and without incurring significant expense. In addition, even if the
internal systems of the Company are not materially affected by the year 2000
issue, the Company could be affected through disruption in the operation of the
enterprises with which the Company interacts.
12
<PAGE> 13
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 operating results have fluctuated significantly in the past on
a quarterly and an annual basis and is likely to continue to fluctuate
significantly in the future depending on a number of factors. The accompanying
sections explain in greater detail certain important factors that the Company
has identified which may affect the future performance of the Company.
The Company develops products in the highly competitive multimedia graphics,
video, sound, modem and SCSI adapter markets. These products are very
susceptible to product obsolescence and typically exhibit a high degree of
volatility of shipment volumes over their relatively short product life cycles.
The timing of introductions of new products in one calendar quarter as opposed
to an adjacent quarter can materially affect the relative sales volumes in those
quarters. In addition, product releases by competitors and accompanying pricing
actions can materially and adversely affect the Company's revenues and gross
margins.
Similarly, the Company sells its products to retail customers (mass
merchandisers and large chains who sell products primarily off-the-shelf
directly to end users) retail distribution customers (distributors which resell
to smaller retail chains and large individual end users) and OEM customers
(customers which use the Company's products in conjunction with other products
to produce complete computer systems for sales through both direct and indirect
distribution channels to end users). Reliance on these customers for almost all
of the Company's sales means that the Company typically has little or no direct
visibility into end user customer demand. OEM customers tend to provide the
Company with forecasts for product requirements but actual order lead times
remain less than 90 days. Retail and retail distribution customers typically do
not forecast product requirements and order lead times are typically very short,
as these customers tend to reorder for stock in quantities that approximate
recent sales volumes. Accordingly, this means that future operating results are
dependent on continued sales to customers where the vast majority of the normal
volume of orders are placed with the Company within the same calendar quarter as
the requested date of shipment by the customer.
Because the lead times of firm orders are typically short, the Company does
not have the ability to predict with any certainty the future operating results
of the Company. Therefore, sudden changes that are out of the control of the
Company such as general economic conditions, the actions or inaction of
competitors, customers, third party vendors of operating system software,
central processing unit hardware, and independent software application vendors
can have and have had material adverse effects on the Company's performance.
Other factors which may have a material adverse effect on the Company's
future performance, include the management of growth of the Company, latent
defects that can exist in the Company's products, competition for the available
supply of components, dependence on subcontract manufacturers, dependence on and
development of adequate information technology systems, intellectual property
rights and dependence on key personnel.
Each of these factors is discussed more thoroughly in the accompanying
sections and all of these sections should be read carefully together to evaluate
the risks associated with the Company's Common Stock. Due to these factors, it
is likely that the operating results of the Company in 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. Retail and retail distribution customers generally order without
forecasts 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
13
<PAGE> 14
respond quickly to customer orders as part of its competitive strategy. This
strategy, combined with current industry supply and demand conditions as well as
the Company's emphasis on minimizing inventory levels, has resulted in customers
placing orders with relatively short delivery schedules and increased demand on
the Company to carry inventory for its customer base. This has the effect of
increasing such short lead time orders as a portion of the Company's business
and reducing the Company's ability to accurately forecast net sales. Because
retail and retail distribution customers' orders are more difficult to predict,
there can be no assurance that the combination of these orders, OEM's orders,
and backlog in any quarter will be sufficient to achieve either sequential or
year-over-year growth in net sales during that quarter. If the Company does not
achieve a sufficient level of retail and retail distribution 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 and third quarters of 1997 comprised such a period due to the transition
from older slower speed modems and 2D graphics products to new higher speed
modems and 3D graphics products. In the current transition of mainstream PC
graphics subsystem architectures from 2D graphics and the PCI bus to 3D graphics
and the accelerated graphics port (AGP), which began in 1997 and is continuing
through 1998, controller and memory chip selection and the timely introduction
of new products have been and will continue to be critical factors. The Company
was significantly affected by the PCI-to-AGP transition and the SGRAM-to-SDRAM
memory transition in the second quarter of 1998, which resulted in significant
pricing pressures on the Company's remaining PCI-based and SGRAM-based graphics
inventory and by significant price protection claims associated with such price
declines. Also, as is common in the personal computer industry, a
disproportionate percentage of the Company's net sales 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 this regard, the Company's results for the
second quarter of 1998 were less than expected due to less than expected
shipments of the Monster 3D II product at the end of the quarter. In addition,
from time to time, a significant portion of the Company's net sales 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 net sales 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 net sales for the quarter. Excess inventory could also result in cash
flow difficulties as well as added costs of goods sold and 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 net
sales, market share and customer satisfaction levels in the current quarter or
in future quarters. There can be no assurances that such an occurrence will not
adversely impact the Company operating results.
DECLINING SELLING PRICES AND OTHER FACTORS AFFECTING GROSS MARGINS
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 net sales 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 that the Company's net sales
and margins may decline in the future, from the levels experienced to date. (See
also Short Product Life Cycles; Dependence on New Products) 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, 3D graphics
accelerators, SCSI I/O host bus adapters and 3D audio accelerators products,
some of which have been impacted from time-to-time by a scarcity in the supply
of associated chipsets and other components. For example certain manufacturers
of
14
<PAGE> 15
3D graphics accelerators which are incorporated into the Company's products are
planning to release new versions of their products during the third quarter of
1998. Availability of the new products are typically restricted in volume early
in the products life cycle and should customers choose to wait for these new
versions, the ability of the Company to procure sufficient volumes of these
accelerators to meet customer demand is unlikely. Such a failure to meet demand
is likely to have a material adverse effect on the revenues and operating
margins of the Company.
In addition, the Company's net sales, 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 DRAM, SDRAM, SGRAM or RDRAM
memory, 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. The Company experienced
such declining prices and reduced margins in the second quarter of 1998 due to
the effect of product transitions, including the PCI-to-AGP transition and the
SGRAM-to-SDRAM memory transition. Competition from products based on the AGP bus
and SDRAM memory which have lower manufacturing costs than PCI bus SGRAM based
products resulted in sharply declining selling prices for SGRAM based products.
This led to material charges for declining inventory values and price protection
for channel inventory. These charges had a material adverse effect on revenues,
operating margins and operating results. Conversely, an increase in the price of
semiconductor components that are in scarce supply, such as high-speed DRAMs,
may adversely impact the Company's gross margin due to higher unit costs, and a
decrease in the supply of such semiconductor components may adversely impact the
Company's net sales due to lower unit shipments.
SEASONALITY
The Company believes that, due to industry seasonality, demand for its
products is strongest during the fourth quarter of each year and is generally
slower in the period from April through August. 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 channel, that
PCs become more consumer-oriented or entertainment-driven products, or that the
Company's net sales becomes increasingly based on entertainment-centric
products. Also, to the extent the Company is successful in expanding its
European operations, it may experience relatively weak demand in third calendar
quarters due to historically weak summer sales in Europe.
MANAGEMENT OF GROWTH
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. This expansion in scope has resulted in a need for
significant investment in infrastructure, processes and information systems.
This requirement includes, without limitation: securing adequate financial
resources to successfully integrate and manage the growing businesses and
acquired companies; retention of key employees; integration of management
information, product data management, control and telecommunications systems;
consolidation of geographically dispersed manufacturing and distribution
facilities; coordination of suppliers; rationalization of distribution channels;
establishment and documentation of business processes; and integration of
various functions and groups of employees. Each of these requirements poses
significant, material challenges.
The Company has a minority 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
approximately $3.4 million. 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.
15
<PAGE> 16
The Company completed a tender offer for Micronics, Inc. during the second
quarter of 1998. In addition to managing the growing business of the Company and
its previous acquisitions, the Company will be required to integrate and manage
the business of Micronics with that of the Company. Furthermore, Micronics is
primarily a manufacturer of computer motherboards, a line of products that the
Company has not previously offered for sale. The Company faces significant
challenges in terms of manufacturing, engineering, sales, marketing, and
logistics with respect to integrating the products and business of Micronics
with similar functions of the Company. There can be no assurance that the
Company will be able to successfully integrate the operations of Micronics. If
the Company fails to successfully integrate Micronics into the operations of the
Company there will likely be a material adverse impact on the operating results
of the Company. Even if the integration is successfully achieved, there can be
no assurance that the cost of such integration will not materially and adversely
effect the Company's operating results.
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 such as sales, procurement and
operations, strengthening management information and telecommunications systems,
and continuing to hire additional qualified personnel in all areas. Moreover,
the Company has selected and is implementing a new enterprise resource planning
(ERP) system to be fully operational in late 1998 in order to properly manage
the increasing complexity of its international multi-product business and avert
potential Year 2000 issues with its current management information system. There
can be no assurance that the Company will be able to manage these activities and
implement these additional systems, procedures 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.
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 the
selection of new technologies and features to incorporate into its new products,
as well as the timing of the introduction of such new products, all of which may
impair the orders for or the 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; trade-offs between the time
of first customer shipment and the optimization of software for speed, stability
and compatibility; development of supporting content by independent software
application vendors; development and production of collateral product
literature; prompt delivery to OEM accounts of prototypes; support of OEM
prototypes; ability to rapidly ramp manufacturing volumes; and coordination of
advertising, press relations, channel promotion and VAR evaluation programs.
In the current transition of mainstream PC graphics subsystem
architectures from 2D graphics and the PCI bus to 3D graphics and the
accelerated graphics port (AGP), which began in 1997 and is expected to continue
through 1998, controller and memory chip selection and the timely introduction
of new products have been and will continue to be critical factors. The Company
saw the effects of the PCI-to-AGP graphics bus transition and the SGRAM-to-SDRAM
memory transition in the second quarter of 1998, which resulted in significant
price reductions for the Company's remaining PCI-based and SGRAM-based graphics
inventory and the inventory of such products in the distribution channel. As a
result, the net sales and gross margins of the Company were materially and
adversely affected by declining prices for the PCI-based and SGRAM-based
products and there were significant price protection claims associated with such
price declines. In addition, in the current transition from the widely accepted
V.34 modem protocol (33.6Kbps) through the new higher speed proprietary K56flex
and x2 protocols (56Kbps) to the new international standard V.90 protocol
(56Kbps), the chip selection to implement and deploy such a standard and the
industry alliances to convert such support into revenue and market share have
been and will continue to be critical factors. There can be no assurance that
the Company
16
<PAGE> 17
will select the proper chips to implement and support its efforts in the various
markets or that the Company will execute its 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 and
OEM design wins 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 or
component unavailability. The timing and speed of the PCI-to-AGP bus transition
and the SGRAM-to-SDRAM memory transition led to an excess inventory of PCI and
SGRAM-based products at the Company and in the distribution channel which in
turn resulted in lower average selling prices, lower gross margins, end-of-life
inventory write-offs, and higher price protection charges during the second
quarter of 1998. As the Company still has PCI and SGRAM-based products in
inventory, this may affect third quarter 1998 results as well. The Company
estimates and accrues for potential inventory write-offs and price protection
charges. However, during the second quarter of 1998 and in the future, there can
be no assurance that these estimates and accruals will be sufficient, and
additional inventory write-offs and price protection charges may be required.
The result of these charges in the second quarter of 1998 were material and
adverse. Any similar occurrence in the future could have a material effect on
operating results in such future operating periods.
NEW OPERATING SYSTEMS
The PC industry has been characterized by significant operating system
changes, such as the introduction of Windows 95 in 1995 and Windows NT 4.0 in
1996, and the introduction of significant new operating system components, such
as Microsoft's Direct X and ActiveX for Windows 95. During the second quarter of
1998 Microsoft introduced Windows 98. While Windows 98 is not as compelling an
upgrade as Windows 95 was in relation to its predecessor, the uncertainty due to
legal challenges caused a significant portion of new computer purchasers to
delay purchase of a new system until after the release of Windows 98.
Additionally, further purchases were delayed to ensure that the new operating
system would be compatible with older applications and would operate at least as
reliably as Windows 95. The Company believes that this forward shift in time of
a significant number of computer purchasers had an adverse impact on the
revenues of the Company in the second quarter of 1998.
In addition, 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 growth
in the PC games market with the introduction of Windows 95, new operating
systems and operating system components also place a significant research and
development burden on the Company. New drivers, applications and user interfaces
must be developed for new operating systems and operating system components in
order to maintain net sales 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 at no cost to the Company's installed customer base. In addition,
the 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
17
<PAGE> 18
porting the Company's software, graphics accelerator and modem products 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 did not at that time represent
a revenue opportunity for the Company, the Company nevertheless believed that it
was 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 never be achieved.
DEPENDENCE ON THIRD PARTY SOFTWARE DEVELOPERS
The Company's business strategy includes developing relationships with
major independent software application vendors 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 the Microsoft
NT operating system will be significant factors in the sale of 3D graphics
hardware to the PC-based NT workstation market. The Company depends on
independent software application 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, Stealth,
Viper 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 due to a
number of factors including the products' advanced functionality, the 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
18
<PAGE> 19
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
independent software vendor 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 independent software vendor 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 declining 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. Moreover, a
similar reaction has likely occurred in the modem market as a result of the
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 for 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 half of 1997. Similarly, Microsoft's
launch of Windows 98 combined with the uncertainties surrounding such a launch
was a factor in slower PC sales in the second quarter of 1998. If so, these
effects may continue into future periods for these or similar events. Other
anticipated new product releases that may influence future market growth or the
timing of such growth include, Intel's release of its Pentium II CPU and the
associated chipsets supporting the 2x AGP and 4x AGP architectures, and Intel's
release of its "Merced" workstation CPU slated for first customer shipment in
1999.
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 or chip suppliers to pursue 3D graphics, AGP or 56Kbps modem
market opportunities and, as a result, is unable to achieve market acceptance of
its new products or is unable to secure enough supply of such components.
If the Company or any of its competitors were to announce a product that
the market viewed as having more desirable features or pricing than the
Company's existing products, demand for the Company's existing products could be
curtailed, even though the new product is not yet available. For example, the
Company's next-generation eight-megabyte SDRAM-based graphics accelerators, have
a memory cost component roughly equivalent to four-megabyte SGRAM-based graphics
accelerators. Market anticipation of this new product release and similar
competitive releases reduced demand for the Company's SGRAM based graphics
products
19
<PAGE> 20
and materially and adversely affected the Company's operating results for the
second quarter of 1998. Similar results may occur during the third quarter of
1998. Similarly, if the Company's customers anticipate that the Company may
reduce its prices in the near term, they might 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.
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 chipsets that provide graphics,
digital video, DVD, television (TV), sound or other multimedia functions, random
access memory (including DRAM, RDRAM, SDRAM and SGRAM) chips, and speakerphone
modem and fax/modem chipsets. Although the price and availability of many
semiconductor components improved during 1996 and 1997, these components are
periodically in short supply and on allocation by semiconductor manufacturers.
For example, it is expected that the Company may experience substantial
constraints in the supply of high-performance SGRAMs and high-performance 3D
graphics chips for the foreseeable future. There can be no assurances that the
Company can obtain adequate supplies of such components, or that such shortages
or the costs of these components will not adversely affect future operating
results. 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 over purchase certain components, or pay unnecessary expediting
or surcharges, resulting in excess inventory, or inventory at higher than normal
costs, 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. In the second quarter of 1998, such a condition
existed and the Company's perception of component shortages caused the Company
to over purchase components and pay surcharges for components that subsequently
declined in value. In addition, such inventory sell-offs by the Company or its
competitors could trigger channel price protection charges, further reducing the
Company's gross margins and profitability.
As noted above, supply and 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
force the Company to reduce its prices, thereby depressing the Company's net
sales and gross margins 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
that they hold since such inventory likely would bear a price deflation risk. As
a consequence, the Company may see its orders, unit shipments or average selling
prices depressed from time to time during such price-deflation and
inventory-reduction periods, this occurred during the second quarter of 1998,
which adversely affected net sales and gross margin during such period and this
may occur again in future periods.
When the PC or PC peripherals markets emerge from a period of oversupply,
such as that experienced in the second quarter of 1997, certain manufacturers,
distributors and resellers may be unprepared for a possible rapid increase in
market demand. Accordingly, the Company may not have sufficient inventory,
scheduled
20
<PAGE> 21
component purchase orders or available manufacturing capacity to meet any rapid
increase in market demand, thereby missing orders and revenue opportunities,
causing customer dissatisfaction and losing market share. The Company
experienced such a situation in the second half of 1997 and in the first quarter
of 1998 as the Company experienced a shortage of various components, restricting
the Company's ability to manufacture quantities of certain products in
sufficient quantities or in a linear fashion during the quarter to meet market
demand. For certain products, the Company continued to experience such
restrictions in the second quarter of 1998. In addition, the Company believes
that in the near term the Company will continue to be subjected to restricted
supply and increasing prices on certain semiconductor components including
certain graphics controllers and memories. The inability of the Company to
obtain product components at their historical or planned cost levels, resulting
in the Company being forced to pay higher prices to achieve timely delivery,
would directly affect the cost of the Company's products and could materially
and adversely affect the Company's gross margin. There can be no assurance that
the Company will be able to obtain adequate supplies of components or that such
shortages or the costs of these components will not adversely impact the
Company's future operating results. Conversely, there can be no assurance that
the Company will not see the value of its inventory depreciate if components in
a shortage condition emerge from that condition and experience a significant
oversupply condition. For example, this situation occurred during the second
quarter of 1998 with certain graphics chips that support only SGRAM memory.
DEPENDENCE ON SUBCONTRACTORS
The Company relies on independent surface mount technology ("SMT") and
printed circuit board ("PCB") subcontractors to manufacture, assemble or test
the Company's products. The Company typically procures its components, assembly
and test services and assembled products through purchase orders and does not
have specific volume purchase agreements with each of its subcontractors. Most
of the Company's subcontractors could cease supplying the services, products or
components at any time with limited or 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. The Company's emphasis on maintaining low inventory may
exacerbate the effects of any shortage that may result from the use of
sole-source subcontractors during periods of tight supply or rapid order growth.
The Company's ability to respond to greater than anticipated market demand may
be constrained by the 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 present heightened process
control, quality control, 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 82% and 56% of the Company's net sales in the second quarter of
1998 and 1997, respectively. Although the Company has introduced DVD and audio
subsystems, ISDN adapters and SCSI host bus adapters, and has entered the PC
modem and communications market through the acquisition of Supra Corporation,
and announced its intention to enter into the wireless home networking market,
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
21
<PAGE> 22
subsequently incorporated onto personal computer motherboards. The Company
expects that such migration will not occur in a substantial way with 3D graphics
or Intel's accelerated graphics port (AGP) in the near term, although the
Company recognizes that such migration could occur with respect to the
functionality provided by some of 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, 3D audio, MPEG-2 digital video, high-speed
I/O and modems, there can be no assurance that the incorporation of new
multimedia functions onto personal computer motherboards or into CPU
microprocessors, such as under Intel's MMX or AGP 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 3D graphics and digital video
MPEG-2 acceleration. This, in turn, may depend on the availability of compelling
3D 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 56Kbps and digital subscriber line (xDSL)
technologies in both client-side modems attached to the PC and server-side
modems provided by Internet Service Providers and telephone network central
offices. The timing of major technology introductions and the market acceptance
of these new technologies and standards are largely out of the control of the
Company.
The Company believes that a large portion of the growth in the sales of personal
computers will be in sealed systems which contain all functionality on the
motherboard and are not able to be upgraded in the manner most current personal
computers can be upgraded. These sealed computers would contain a systems board
that would include CPU, system memory, graphics, audio, and modem functionality
on a single board. The Company recently completed a tender offer and acquired
Micronics for the purpose of obtaining expertise in CPU motherboard design and
to develop system board products. There can be no assurance that a significant
market will exist for low cost fixed system boards or that the acquisition of
Micronics will enable the Company to successfully compete in such an emerging
market.
RISKS ASSOCIATED WITH INDUSTRY CONSOLIDATION
The Company pursues a strategy of "silicon agility" which entails
continuous evaluation of outside sources of graphics accelerators, modem
chipsets, SCSI chipsets, and audio chipsets. This strategy depends on a number
of competitive suppliers of each of these products in order to ensure that the
Company is offering leading edge technology in each product line at prices with
which the Company can compete with competitors who design their own chipsets. In
the recent past there have been some instances of chipset suppliers acquiring
their own add in card manufacturing and distribution (Evans & Sutherland Corp's
purchase of Accel Graphics or 3Dlabs Inc. acquiring Dynamic Pictures Inc.).
While these acquisitions in and of themselves are not material to the operations
of the Company, any increase in the number of vertical integration acquisitions
may restrict the choices of chipset suppliers available to the Company and
thereby reduce the likelihood that the Company will have access to leading edge
technology at prices which would allow the Company to compete with vertically
integrated competitors such as ATI Technologies Inc. and Matrox Graphics Inc.
COMPETITION
The market for the Company's products is highly competitive. The Company
competes directly against a large number of suppliers of graphics and multimedia
accelerator products for the PC such as Matrox Graphics Inc., STB Systems Inc.
and ATI Technologies Inc., 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 3Com (modems), Creative Technology (sound cards) and Adaptec (SCSI
host bus 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 today 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.
22
<PAGE> 23
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 (for example the acquisition of Accel Graphics but
Evans & Sutherland) , 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 or expense 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,
telephone sales by PC 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, increased use of mail-order catalogues, increased use
of consumer-electronics channels for personal computer sales, or increased use
of channel assembly to configure PC systems to fit customers' requirements 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 the 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
23
<PAGE> 24
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. In an environment of slower demand and abundant supply
of products, price declines are more likely to occur and, should they occur, are
more likely to be severe. Further, in such an event, high Channel Inventory
Levels may result in substantial price protection charges. Such price protection
charges have the effect of reducing net sales and gross profit. Consequently,
the Company, in taking steps to bring its Channel Inventory Levels down to a
more desirable level, may cause a shortfall in net sales during one or more
accounting periods. This situation may also result in price protection charges
as prices are decreased, having an adverse impact on operating results. While
the Company believes that its Channel Inventory Levels for many of its products
are appropriate at this time, there are certain products which have a Channel
Inventory Level that is higher than desirable. The Company accrues for potential
price protection charges on unsold channel inventory. However, there can be no
assurance that any estimates, reserves or accruals will be sufficient or that
any future price reductions will not have a material adverse effect on operating
results, including during the third quarter of 1998.
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 channel inventory. The Company
experienced significant price protection charges due to the transition from PCI
to AGP-based graphics accelerators and from SGRAM to SDRAM-based graphics
accelerators during the second quarter of 1998. The Company may be faced with
further significant price protection charges as the Company and its competitors
move to reduce channel inventory levels of current products as new product
introductions are made. However, there can be no assurance that any estimates,
reserves 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 effect
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. There can be no assurance that the Company will
be able to achieve gross margins in the PC installed-base upgrade market that
will be high enough to offset the expenses of end-user customer returns and
still generate an acceptable return on sales to the Company.
24
<PAGE> 25
OEM CUSTOMER RISKS
The Company currently has 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 processes, procedures and controls 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. Further,
to the extent that PC systems OEM's selection criteria are weighted toward
multimedia subsystem suppliers that have their own captive SMT manufacturing
operations, then the Company's sole reliance on outside SMT subcontract
manufacturers may be a negative factor in winning such PC systems suppliers' OEM
contracts.
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, many
large OEMs require that distribution hubs be established local to their
factories to supply such factories on very short notice. Such hubs represent a
cash drain on the Company to support the required inventory, and a product
obsolescence and inventory write-off risk as the price of such inventory may
decline or reach the end of its useful life or design-in life before such
inventory, which may be specific to a certain OEM, is completely consumed. The
Company's contractual relationship with Dell Computer Corporation may represent
such a product obsolescence and inventory write-off risk.
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 generated by
lower-selling-price or lower-gross-margin products, particularly with respect to
the Company's audio and modem products, which could adversely affect future
gross margins and operating results of the Company.
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, memory architectures and
speeds are changing rapidly, and DVD and MPEG-2 decryption techniques and
navigation technologies are still being refined. 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 the development
and market introduction of new products, it must still correctly forecast
customer demand for such new products so as to avoid either excessive unsold
inventory or excessive unfilled orders related to the products. The task of
forecasting such customer demand is unusually difficult for new products, for
which there is little sales history, and for indirect channels, where the
Company's customers are not the final end customers. Moreover, whenever the
Company launches new products, it must also successfully manage the corollary
obsolescence and price erosion of those of its older products that are impacted
by such new products, as well as any resulting price protection charges and
Stock Rotations from its distribution channels. During the second quarter of
1998, the Company experienced large price protection charges with respect to the
decline in average selling prices of graphics accelerators due to the SGRAM to
SDRAM transition of mainstream graphics accelerators and other competitive
pressures. Due to the much lower cost of SDRAM solutions SGRAM prices fell in
competition thereby lowering manufacturing costs of graphics accelerators. The
Company, forced to meet the pricing actions of its competitors was forced to
lower prices triggering larger than normal or expected price protection and
eroding the value of some of the Company's on hand inventory.
25
<PAGE> 26
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 it generally has less information with respect to the inventory
levels held by its international OEMs and distributors as compared to their
domestic counterparts, and that the supply chain to such international customers
is longer, and that therefore the Company generally has less visibility on how
this held inventory might affect future orders to and sales by the Company. In
the event that international OEMs or distributors change their desired inventory
levels, there can be no assurance that the Company's net sales to such customers
will not decline at such time or in future periods, or that the Company will not
incur price protection charges with respect to such customers.
Also during the first two quarters of 1998 sales in Asia and Southeast Asia
were below expected levels. The lack of sales in the Asian market were primarily
related to the lack of credit facilities available to customers in those markets
for the Company's products and other products necessary for those customers to
sell complete products. The Company expects continued sluggishness in sales in
Asia and Southeast Asia during the third quarter of 1998.
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, as well as a drain on management
resources, for the installation of information technology ("IT") and
telecommunications equipment and IT applications. As part of this program to
install IT systems throughout the Company, management has begun installation of
an enhanced enterprise-wide business management, resource planning and decision
support application. Further, in order to more effectively manage the Company's
business and avert Year 2000 issues, the Company is implementing this new ERP
application and the associated IT equipment in order for it to be fully
operational no later than by the beginning of 1999. Such an effort is expected
to comprise a further substantial investment of expenses and management
resources by the Company.
26
<PAGE> 27
YEAR 2000 COMPLIANCE
Many existing computer systems and applications, and other control devices,
use only two digits to identify a year in the date field, without considering
the impact of the upcoming change in the century. As a result, such systems and
applications could fail or create erroneous results unless corrected so that
they can process data related to the year 2000. The Company relies on its
systems, applications and devices in operating and monitoring all major aspects
of its business, including financial systems (such as general ledger, accounts
payable and payroll modules), customer services, infrastructure, embedded
computer chips, networks and telecommunications equipment and end products. The
Company also relies, directly and indirectly, on external systems of business
enterprises such as customers, suppliers, creditors, financial organizations,
and of governmental entities, both domestic and international, for accurate
exchange of data. The Company's current estimate is that the costs associated
with the year 2000 issue, and the consequences of incomplete or untimely
resolution of the year 2000 issue, will not have a material adverse effect on
the result of operations or financial position of the Company in any given year.
The Company is currently engaged in a project to upgrade the computer hardware
and software it uses to operate, monitor and manage its business on a day to day
basis. The vendors have indicated that their products accurately accommodate
dates beyond the year 1999. The Company is testing such capabilities as part of
its implementation process. However, despite the Company's efforts to address
the year 2000 impact on its internal systems, the Company has not fully
identified such impact or whether it can resolve it without disruption of its
business and without incurring significant expense. In addition, even if the
internal systems of the Company are not materially affected by the year 2000
issue, the Company could be affected through disruption in the operation of the
enterprises with which the Company interacts. See "-Information Technology and
Telecommunications Systems."
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.
PROPRIETARY RIGHTS
While the Company had 5 issued U.S. Patents and 22 pending U.S. Patent
Applications at June 30, 1998, 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 the
proprietary 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 proprietary rights of the Company or to defend the Company
against claimed infringement of the proprietary rights of others.
27
<PAGE> 28
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 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, California 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. The Company does not carry "key person" life
insurance on any of its employees.
LEGAL MATTERS
The Company has been named as a defendant in several putative class action
lawsuits which were filed in June and July, 1996 and June, 1997 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 trial date 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.
The Company is also party to other claims and pending legal proceedings
that generally involve employment and patent issues. These cases are, in the
opinion of management, ordinary and routine matters incidental to the normal
business conducted by the Company. In the opinion of management, the ultimate
disposition of such proceedings will not have a materially adverse effect on the
Company's consolidated financial position or future results of operations.
28
<PAGE> 29
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 and June 1997 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 trial date 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.
The Company is also party to other claims and pending legal proceedings
that generally involve employment and trademark issues. These cases are, in the
opinion of management, ordinary and routine matters incidental to the normal
business conducted by the Company. In the opinion of management, the ultimate
disposition of such proceedings will not have a materially adverse effect on the
Company's consolidated financial position or future results of operations.
29
<PAGE> 30
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
The following matters were approved at the Company's Annual Meeting of
Stockholders held on May 22, 1998:
a) The following Directors were elected:
<TABLE>
<CAPTION>
Votes
Directors Votes For Withheld
-------------------------------------------------------------
<S> <C> <C>
William Schroeder 31,306,970 640,542
Bruce C. Edwards 31,307,570 640,342
Carl W. Nuen 31,307,570 639,942
Gregorio Reyes 31,305,470 642,042
Jeffrey D. Saper 31,194,617 752,895
James T. Schraith 31,305,170 642,342
</TABLE>
b) The shareholders approved the following proposals:
<TABLE>
<CAPTION>
Number of Common Shares Voted
For Against Abstain Non-Vote
-----------------------------------------------------
<S> <C> <C> <C> <C>
To approve the 1998 Stock Plan 11,344,109 9,126,034 108,468 11,368,902
To approve an amendment to the 1995 19,388,373 1,105,282 84,955 11,368,902
Employee Stock Purchase Plan
To approve certain amendments to the 28,486,687 2,826,554 129,527 504,744
1995 Director Option Plan
To ratify the appointment of Coopers & 31,814,276 58,909 74,327 0
Lybrand LLP as independent accountants
</TABLE>
30
<PAGE> 31
ITEM 5. OTHER INFORMATION
Pursuant to Rule 14a-4(c)(1) under the Securities and Exchange Act of
1934, the proxies of management would be allowed to use their discretionary
voting authority with respect to any non-Rule 14a-8 stockholder proposal raised
at the Company's annual meeting of stockholders, without any discussion of the
matter in the proxy statement, unless the stockholder has notified the Company
of such proposal at least 45 days prior to the month and day on which the
Company mailed its prior year's proxy statement. Since the Company mailed its
proxy statement for the 1998 annual meeting of stockholders on April 17, 1998,
the deadline for receipt of any such stockholder proposal for the 1999 annual
meeting of stockholders is March 3, 1999.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
A. Exhibit
<TABLE>
<CAPTION>
Exhibit # Description of Document
--------- -----------------------
<S> <C>
27.1 Financial Data Schedule
</TABLE>
B. Reports on Form 8-K
In connection with the acquisition of Micronics the Company
filed a Schedule 14D1 on each of the following dates: May 15,
1998; May 18, 1998; June 5, 1998; June 15, 1998; June 19,
1998; June 24, 1998; and June 29, 1998.
31
<PAGE> 32
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: August 14, 1998 /s/ William J. Schroeder
-------------------------
William J. Schroeder
President and Chief Executive Officer
Date: August 14, 1998 /s/ James M. Walker
--------------------
James M. Walker
Senior Vice President and
Chief Financial Officer
32
<PAGE> 33
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ------ -----------
<S> <C>
27.1 Financial Data Schedule
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> JUN-30-1998
<CASH> 109,137
<SECURITIES> 6,073
<RECEIVABLES> 104,381
<ALLOWANCES> 2,232
<INVENTORY> 93,859
<CURRENT-ASSETS> 341,995
<PP&E> 43,070
<DEPRECIATION> 12,695
<TOTAL-ASSETS> 401,601
<CURRENT-LIABILITIES> 214,573
<BONDS> 1,718
0
0
<COMMON> 36
<OTHER-SE> 185,274
<TOTAL-LIABILITY-AND-EQUITY> 401,601
<SALES> 358,543
<TOTAL-REVENUES> 358,543
<CGS> 296,454
<TOTAL-COSTS> 296,454
<OTHER-EXPENSES> 64,594
<LOSS-PROVISION> (1,558)
<INTEREST-EXPENSE> (493)
<INCOME-PRETAX> (510)
<INCOME-TAX> (153)
<INCOME-CONTINUING> (357)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (357)
<EPS-PRIMARY> (0.01)
<EPS-DILUTED> (0.01)
</TABLE>
