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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 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 0-26660
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ESS TECHNOLOGY, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
CALIFORNIA 94-2928582
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
48401 FREMONT BLVD., FREMONT, CALIFORNIA 94538
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:
(510) 492-1088
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, NO PAR VALUE
(TITLE OF CLASS)
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 [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
State the aggregate market value of the voting and non-voting common equity
held by non-affiliates of the registrant, based upon the closing sale price of
the Common Stock on January 31, 1999 ($6.875) as reported on the Nasdaq National
Market, was approximately $160,508,000. Shares of Common Stock held by each
officer and director and by each person who owned 5% or more of the registrant's
outstanding Common Stock on that date have been excluded in that such persons
may be deemed to be affiliates. This determination of affiliate status is not
necessarily a conclusive determination for other purposes.
As of January 31, 1999, registrant had outstanding 40,863,083 shares of
Common Stock.
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DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for Registrant's 1999 Annual Meeting of
Shareholders are incorporated by reference in Part III.
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ESS TECHNOLOGY, INC.
1998 FORM 10-K
TABLE OF CONTENTS
PAGE
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PART I
Item 1. Business.................................................... 2
Item 2. Properties.................................................. 11
Item 3. Legal Proceedings........................................... 11
Item 4. Submission of Matters to a Vote of Security Holders......... 11
PART II
Item 5. Market for the Registrant's Common Equity and Related
Shareholder Matters......................................... 12
Item 6. Selected Financial Data..................................... 13
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 14
Item 7A. Quantitative and Qualitative Disclosures About Market
Risk........................................................ 24
Item 8. Financial Statements and Supplementary Data................. 24
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 43
PART III
Item 10. Directors and Executive Officers of the Registrant.......... 44
Item 11. Executive Compensation...................................... 45
Item 12. Security Ownership of Certain Beneficial Owners and
Management.................................................. 45
Item 13. Certain Relationships and Related Transactions.............. 45
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form
8-K......................................................... 46
Signatures............................................................. 48
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Statements contained in this filing that are not statements of historical
fact may be deemed to be forward-looking statements. A number of important
factors could cause actual events or the Company's actual results to differ
materially from those indicated by such forward-looking statements, including
dependence on continued growth in demand for Internet, PC audio, video and other
multimedia capabilities for notebook and desktop computers, as well as consumer
electronic and Internet products; the Company's ability to take advantage of new
markets; increased competition and pricing pressures, general economic
conditions and conditions specific to the semiconductor industry; the timing and
market acceptance of new product introductions; the timely development of new
products; continued availability of quality foundry capacity; and other risks
set forth in this filing and in the Company's filings from time to time with the
Securities and Exchange Commission.
PART I
ITEM 1. BUSINESS
ESS Technology, Inc. and its subsidiaries ("ESS" or the "Company") designs,
markets and supports highly integrated mixed signal semiconductor, hardware,
software and system solutions for multimedia applications in the Internet,
personal computer ("PC") and consumer marketplaces. The Company offers
comprehensive solutions for audio, video and modem applications. ESS has
established itself as a leading supplier in both mixed-signal PC audio solutions
that integrate all essential audio components on a single chip and Video CD
solutions ("VCD"). During 1998, ESS continued to strengthen its core family of
ISA and PCI audio solutions as well as its video and modem solutions. The
Company was incorporated in California in 1984.
AudioDrive Products
ESS' single chip AudioDrive products enable PC manufacturers to provide
audio capabilities on add-in sound cards and directly on the motherboards of
desktop and notebook computers. The Company has established itself as a leader
in integrated audio solutions and counts many of the leading manufacturers of
personal computers and sound cards among its customers.
During 1998, the manufacturers in the PC market began to shift from ISA
solutions to PCI solutions due to the higher performance which the PCI solutions
provide to meet the demands for advanced PC audio applications.
The Company's AudioDrive products are based on ESS' audio technologies,
design methodologies, and software and firmware expertise. ESS has developed a
proven set of ISA and PCI product solutions for the PC market.
The AudioDrive ISA and PCI product families integrate ESFM(TM), a
proprietary FM sound synthesis technology, that produces superior sound quality
by enhancing traditional FM synthesis techniques, with hardware, software and
music database technology. ESS also utilizes its proprietary advanced analog and
mixed signal design methodologies, together with its library of audio
semiconductor designs, to produce highly integrated mixed signal audio chips.
ESS software technology is bundled as part of its comprehensive solution and
consists of its AudioDrive device drivers for Microsoft(R) Windows(R)3.1,
Windows NT(R), Windows 95(R), Windows 98(R), IBM OS/2(R)Warp(R), DirectX(TM)PC
games, and audio applications, including ESS AudioRack(TM) controller, an
integrated graphical controller for the entire PC audio system.
ISA AudioDrive Products
ES692: a wavetable music synthesizer chip. The ES692 includes reverb
special effects without need for external RAM. With its embedded
microcontroller, the ES692 supports General MIDI, providing for 128 melodic
instruments with ability to play back 32 voices of 16-bit data at a sampling
rate of 44.1kHz. Music is produced in high fidelity with the realism of a live
symphony orchestra. The ES692 includes a 1MB wavetable ROM to provide a complete
wavetable solution. This internal ROM provides digitally recorded sound samples
of musical instruments.
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ES1869: a single mixed signal 16-bit stereo audio chip with integrated ESFM
synthesizer, plug-and-play, full-duplex operation, Zoom Video support, game
support and three-dimensional sound effect. The ES1869 integrates digital logic
and a microcontroller with audio CODEC and other analog functions onto one chip,
and includes ESFM synthesis. The ES1869 is PC games compatible in SB and SB Pro
modes and is compatible with Microsoft Windows and other operating systems. The
ES1869 provides full ISA plug-and-play support and includes hardware volume
control, 64 step volume control and dual game/joystick port for game support.
The ES1869 supports full-duplex operation with simultaneous record and playback
with two DMA channels and contains an I2S interface to support Zoom Video port
for MPEG audio. It also integrates circuitry to produce a three-dimensional
sound effect from two speakers.
ES1879: a single mixed signal 16-bit stereo audio chip with integrated ESFM
synthesizer, full-duplex operation, Zoom Video support, telegaming and game
support and three-dimensional sound effect. The ES1879 combines the features of
the ES1878 with I2S interface for Zoom Video support, as well as circuitry to
produce three-dimensional sound effect from two speakers. The ES1879 provides
full plug-and-play support and provides interface to a docking station unit.
PCI AudioDrive Products
ES1918: Maestro PCI audio CODEC. The ES1918 is a single mixed signal AC '97
CODEC and mixer for a digital audio controller. The ES1918 meets PC '98 and
Audio CODEC '97 Rev. 1.03 specifications.
ES1920: Maestro PCI audio CODEC. The ES1920 is a single mixed signal AC '97
CODEC and mixer for a digital audio controller. The ES1920 meets AC '98 and
Audio CODEC '97 Rev. 2.0 specifications.
ES1938: Solo-1: a PCI single mixed signal audio chip. The ES1938 provides a
single chip PCI audio solution providing high-quality audio processing while
maintaining full legacy DOS game compatibility. The ES1938 has 16-bit stereo
with 7 channel record and playback mixers and an integrated 3-D sound effects
processor. It supports ACPI, PPMI and PCI Mobile Design Guide specifications.
ES1946: Solo-1E: a PCI single mixed signal audio chip with I(2)S
interface. The ES1946 combines the features of the ES1938 with I(2)S interface
for ZOOMED Video Port audio and 3.3 Volt digital supply operation.
ES1948: Maestro-1: a PCI digital audio accelerator. The Maestro-1 provides
enhanced audio, utilizing the additional bandwidth provided by the PCI bus and
taking advantage of the Intel AC-97 architecture. The Maestro-1 implements
positional 3D and 64 channel hardware wavetable using system memory to
dramatically improve the multimedia gaming experience. The Maestro-1 uses ESS
proprietary technology called TDMA to provide legacy compatibility for DOS games
which is a requirement for multimedia PCs.
ES1968: Maestro-2: a PCI digital audio accelerator. The Maestro-2 provides
enhanced audio, utilizing the additional bandwidth provided by the PCI bus and
taking advantage of the Intel AC-97 architecture. The Maestro-2 implements
positional 3D using CRL's Digital Ear(TM) and Sensaura(TM) 3D audio technology
to dramatically improve the multimedia gaming experience. The Maestro-2
implements 64 channel hardware wavetable using system memory to reduce size,
cost and host utilization while increasing sound quality for MIDI. The Maestro-2
utilizes ACPI and small form factor to enable low power designs for notebooks
and motherboards. The Maestro-2 also uses ESS proprietary technology, TDMA to
provide legacy compatibility for DOS games, a requirement for multimedia PCs.
ES1968M: Maestro-2M: a PCI audio/modem combo solution. The Maestro-2M
provides the features of the Maestro-2 with a parallel modem interface to a
modem DSP processor.
ES1978: Maestro-2E: A PCI digital audio accelerator. The Maestro-2E
provides the features of the Maestro-2 with an EEPROM interface for system
configuration and S/PDIF output for interface to consumer stereo equipment.
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ES1978M: Maestro-2EM: a PCI audio/modem combo solution. The Maestro-2EM
provides the features of the Maestro-2E in a 144 pin TQFP package with a
parallel modem interface to a modem DSP processor.
TeleDrive Products
Internet-related applications, such as voice e-mail, Internet radio, audio
home pages, and news on demand, are increasing the demand for integrated audio
and computer fax/modem functions on the personal computer. ESS TeleDrive
products enable PC manufacturers to provide fax/modem capabilities to add-on
cards and directly onto the motherboards of desktop and notebook PCs.
ES336V: a V.34bis chipset data/fax/voice controller-less modem
solution. The ES336V provides base data, full duplex speaker phone, telephone
answer machine and V.80 support for H.324 video conferencing applications.
ES56V: a V.90 chipset data/fax/voice controller-less modem solution. The
ES56V is a superset of the ES336V and is compliant with the V.90 worldwide modem
standard via proprietary software.
ES56CVH: a ES56V modem solution with 16 or 32 bit full duplex stereo. The
ES56CVH combines the ES56V modem solution with a single mixed signal 16 or 32
bit stereo audio chip with integrated ESFM synthesizer, plug-and-play
full-duplex operation and game support.
VideoDrive Products
ESS VideoDrive products provide consumer original equipment manufacturers
("OEMs") of VCD, SuperVCD ("SVCD") and DVD players with total programmable
system solutions. The VideoDrive products provide OEMs of VCD players with a
programmable single-chip processor which includes MPEG-1 video, audio and system
decoder. It delivers full-screen, full-motion video at 30 frames per second with
selectable CD-quality audio and can be combined with memory and video/audio
DACs. The products also provide OEMs of SVCD and DVD players with a programmable
single chip processor which includes MPEG-2 audio/video/system and transport
layer decoder and video post-processing. In addition, the MPEG-2 decoder also
integrates Dolby AC-3 and Navigation Software for DVD players. These chips are
designed for a variety of applications in consumer electronics such as Internet
set-top boxes, SVCD and DVD players.
VCD Player Products
ES3207: Analog companion chip. The ES3207 provides echo, surround sound, 3D
audio, TV encoder with clock generation and audio DAC functions.
ES3209: Analog companion chip to VCD processor chip. The ES3209
incorporates the ES3207 features of echo, surround sound, 3D audio, TV encoder
with clock generation, audio DAC functions with HTML, hyperlink and a graphic
user interface.
ES3210: Single chip programmable VCD processor which includes MPEG-1
audio/video/system decoder for use in standalone and portable VCD players. The
ES3210 is a single chip that supports MPEG-1 video decoding and incorporates
on-screen display, Karaoke functions, programmable playback control, trick play
mode features, an integrated SRAM and remote control interface logic in a
smaller form factor allowing a more compact design.
ES3211: Arcade accelerator. The ES3211 enables direct interface with
external games controllers to allow CD-ROM games to be played on a VCD player.
ES3880: Single chip programmable VCD processor. The ES3880 incorporates the
ES3210 features and functions with improved video quality.
ES3883: Analog companion chip. The ES3883 replaces the ES3707 and ES3209
with the same features and functions.
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ES4108: Single chip programmable SVCD processor which include MPEG-2 video
and MPEG-1 audio. The ES4108 incorporates on-screen display, Karaoke functions,
programmable playback control, trick play mode features, integrated remote
control interface logic and a direct CD loader interface for small form factor
and cost effective design.
DVD Player Products
ES3301: Audio/video Transport Demultiplexer and Descrambler. The ES3301 is
a transport-layer demultiplexer, parser and descrambler designed for the set-top
box, DVD and Broadcast PC applications.
ES3308: Single chip programmable DVD processor that includes MPEG-2
audio/video/system decoder for use in DVD players and digital set-top boxes. The
ES3308 is a single chip solution that supports MPEG-2 video decoding and
provides on-screen display and transport layer compliance with DVD standard as
well as Digital Broadcast Signal standards.
ES4308: Single chip programmable DVD processor with integrated system
navagation software and direct DVD loader interface. ES4308 supports two
channels stereo down mix and incorporates the ES3308 features with the
integrated system navagation software and a direct DVD loader interface for a
smaller form factor and cost effective design. Currently sampling
ES4408: Single chip programmable DVD processor with 5.1 channel Dolby
AC-3. The ES4408 incorporates the features of the ES3308 with support of 5.1
channel Dolby AC-3. Currently sampling
Internet Set-Top Box Products
ES4228: Single chip programmable SVCD and Internet set-top box
processor. ES4228 incorporates the ES4108 features with a graphic function and
flicker filter algorithm to enhance viewing quality on the television.
ES4227: Analog companion chip. The ES4227 incorporates the ES3209 features
of echo, surround sound, 3D audio, TV encoder with clock generation, audio DAC
functions with HTML, hyperlink and a graphic user interface with a programmable
I/O interface to communicate with ES56V modem chip set.
Software and Support
ESS provides comprehensive support for its products including software that
can be bundled with its products. This software includes device drivers for
Microsoft(R) Windows(R) 3.1, Windows NT(R), Windows 95(R) and Windows 98(R), IBM
OS/2(R) Warp(R), Intel NSP and PC games, for PC products and systems support for
the Company's VCD and DVD products. Other support software that is available to
customers includes localization software and installation software that allows
customers to tailor their products for specific applications and needs.
Customer development support includes an Evaluation Kit that contains a
reference add-in card design with all the necessary information to incorporate
an ESS chip in the customer's product. To assist customers in further reducing
their time to market, ESS also provides a Manufacturing Kit that contains
manufacturing information, including a bill-of-materials, printed circuit board
layout and production test software.
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CUSTOMERS
ESS sells its products principally to OEMs of PCs, PC-related add-in boards
and consumer electronics systems. The Company sells its product through a direct
sales force, distributors and manufacturer representatives. The following table
shows representative customers worldwide:
HONG KONG UNITED STATES TAIWAN JAPAN(1) REST OF THE WORLD
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Dynax(2) Compaq Acer Fujitsu Hyundai
Weikeng(2) Dell BTC Hitachi Multiwave
Shinco Hewlett Packard FIC Matsushita Philips
IBM GVC NEC Pineview
Micron Inventec Sanyo Samsung
Labway Sony Trigem
Mitac Wearnes
Quanta
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(1) Sales in Japan are made through a distributor.
(2) Distributors of the Company.
A limited number of customers have historically accounted for a substantial
portion of the Company's net revenues. In 1996, 1997 and 1998, sales to the
Company's top five customers, including sales to its international distributors,
accounted for approximately 40%, 49% and 54%, respectively, of the Company's net
revenues. In 1996, Compaq and Universe Electron Corporation each accounted for
approximately 12% and 13%, respectively, of the Company's net revenues. In 1997,
Eastbase and Dynax, a Hong Kong distributor, each accounted for approximately
13% of the Company's net revenues. In 1998, Dynax and Shinco accounted for
approximately 16% and 15%, respectively, of the Company's net revenues. The
Company expects that a limited number of customers may continue to account for a
substantial portion of its net revenues for the foreseeable future. The Company
has experienced changes from year to year in the composition of its major
customer base and believes this will continue in the future.
SALES AND MARKETING
The Company sells and markets to leading PC and consumer OEM's worldwide.
The Company markets its products through its direct sales force, distributors
and manufacturer representatives.
In 1996, 1997 and 1998, international sales comprised approximately 92%,
89% and 92% of the Company's net revenues, respectively. The Company's
international revenues in 1996, 1997 and 1998 have been derived primarily from
Asian customers who manufacture PCs, PC-related add-in boards and consumer OEM's
of VCD players. A large percentage of the worldwide supply of these products is
manufactured by suppliers in Asia. ESS has direct sales personnel and technical
staff located in Taiwan. A significant portion of the Company's Asian sales have
been to customers located in Taiwan. See "Factors That May Affect Future
Results -- International Operations." The Company's products are also sold
internationally through distributors and manufacturer representatives located in
Hong Kong, Taiwan, Japan, India, Singapore, Korea and Germany. The Company's
manufacturer representatives and distributors are not subject to minimum
purchase requirements and can discontinue marketing any of the Company's
products at any time. In addition, certain of the Company's manufacturer
representatives, distributors and customers typically are authorized certain
rights of return for unsold product or pricing allowances to compensate for
rapid, unexpected prices changes. See "Factors That May Affect Future
Results -- Customer Concentration."
The Company believes that customer service and technical support are
important competitive factors in selling to major customers. The Company
provides technical support to its customers. Manufacturer representatives and
distributors supplement the Company's efforts by providing additional customer
service at the local level. The Company believes that close contact with its
customers not only improves the customers' level of satisfaction, but also
provides important insight into future market direction.
Sales of the Company's products are generally made pursuant to standard
purchase orders, which are frequently revised to reflect changes in the
customer's requirements. Product deliveries are scheduled upon the
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Company's receipt of purchase orders. Generally, these purchase orders allow
customers to reschedule delivery dates and cancel purchase orders without
significant penalties. For these reasons, the Company believes that its backlog,
while useful for scheduling production, is not necessarily a reliable indicator
of future revenues. See "Factors That May Affect Future Results -- Potential
Fluctuations in Operating Results."
RESEARCH AND DEVELOPMENT
In order to compete successfully, the Company believes that it must
continually design, develop and introduce new products that take advantage of
market opportunities and address emerging technical standards. The Company's
strategy is to leverage its base of design expertise, analog, digital and mixed
signal design capabilities and process technologies, and software and systems
expertise to develop audio, modem and video solutions for the Internet, PC and
consumer marketplace. ESS has in the past acquired and in the future will
consider acquiring technology and product lines to enhance its own product
offerings and to accelerate its time-to-market. The Company intends to continue
to provide comprehensive solutions for its customers by developing state of the
art semiconductor chips, device drivers, firmware and application software in
its chosen markets.
ESS utilizes a design environment based on workstations, dedicated product
simulators, system simulation with hardware and software modeling, and a high
level design description language. The Company invests regularly in new advanced
equipment and software tools and intends to maintain and enhance its library of
core cells.
At December 31, 1998, ESS had a staff of 185 research and development
personnel, 67 of which were involved in semiconductor design and process
development and 118 of which were involved in software development. In addition,
ESS has engaged outside developers to develop certain technologies to the
Company's specifications and intends to continue to utilize outside developers
in the future. During 1996, 1997 and 1998 the Company spent approximately $20.3
million, $29.5 million and $30.5 million, respectively, on research and
development activities, excluding a one-time pre and post-tax charge of $30.4
million related to acquired research and development in-process from the
acquisitions of VideoCore Technology, Inc. ("VideoCore") and OSEE Technology,
Inc. ("OSEE") in the first quarter of 1996 and a one-time pre and post-tax
charge of $22.2 million related to acquired research and development in-process
from the acquisition of Platform Technologies, Inc. ("Platform") in the second
quarter of 1997.
In June 1997, the Company completed its acquisition of Platform pursuant to
which the Company acquired all the outstanding capital stock of Platform in
exchange for approximately 2.54 million shares of the Company's Common Stock
including approximately 954,000 options with a value of $32.7 million. Platform
is a wholly-owned subsidiary of the Company. The acquisition of Platform
provided the Company with certain PCI audio expertise and designs in process,
along with significant engineering talent. In January 1996, the Company
completed its acquisition of VideoCore pursuant to which the Company acquired
all of the outstanding capital stock of VideoCore in exchange for approximately
525,000 shares of the Company's Common Stock and $5.7 million in cash.
VideoCore, a wholly owned subsidiary of the Company, is developing integrated
circuits which incorporates advanced compression technology for digital video
products. In March 1996, the Company completed its acquisition of OSEE pursuant
to which the Company acquired all of the outstanding capital stock of OSEE in
exchange for approximately 217,000 shares of the Company's Common Stock and $3.6
million in cash. Also outstanding stock options of OSEE were exchanged for
85,000 stock options of the Company. OSEE, a wholly owned subsidiary of the
Company, is developing algorithm technology which enables the Company to offer
modem applications to its customers. The Company may continue to utilize cash
and equity to acquire or invest in complementary businesses or products or to
obtain the right to use complementary technologies. From time to time, in the
ordinary course of business, the Company may evaluate potential acquisitions of
or investments in such businesses, products or technologies owned by third
parties.
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MANUFACTURING
The Company contracts with independent foundries and assembly and test
service providers to manufacture all of its products. This manufacturing
strategy enables the Company to focus on its design strengths, minimize fixed
costs and capital expenditures and gain access to advanced manufacturing
capabilities. Semiconductor manufacturing consists of foundry activity where
wafer fabrication takes place, and assembly and test activities. Wafer
fabrication is performed by two independent foundries, which utilize advanced
manufacturing technologies. A substantial majority of the Company's products are
manufactured by Taiwan Semiconductor Manufacturing Company Ltd. ("TSMC"), which
has manufactured certain of the Company's products since 1989. The Company also
has a foundry arrangement with United Microelectronics Corporation ("UMC") in
Taiwan. Most of the Company's devices are currently fabricated using a mixed
signal CMOS 0.35 micron process technology.
The Company is dependent on its foundries to allocate to the Company a
portion of their foundry capacity sufficient to meet the Company's needs and to
produce products of acceptable quality and with acceptable manufacturing yields
in a timely manner. These foundries fabricate products for other companies and
manufacture products of their own design. In November 1995, the Company entered
into long-term agreements with TSMC and UMC. Under the Company's long-term
agreement with TSMC, in exchange for TSMC's wafer capacity commitments for the
years 1996 through 1999, the Company made payments of approximately $32 million
in two installments in 1996 and 1997.
Under the Company's agreement with UMC, the Company entered into a joint
venture arrangement with UMC and other U.S. semiconductor companies to build a
separate semiconductor manufacturing facility to be located in Taiwan at an
estimated cost of $1 billion. The Company has invested approximately $24.6
million in this joint venture. Under the terms of the agreement, the Company
received approximately a 5% equity ownership in the joint venture company and
capacity rights. The facility was scheduled to open during 1998, but fires
during construction impeded progress. UMC has stated that it expects insurance
will cover its recent fire losses at the joint venture foundry. On October 17,
1998, the Company entered into an agreement with UMC to sell UMC approximately
63.8 million shares of the joint venture for a purchase price of $22.4 million
dollars. Following the sale, the Company continues to hold 6 million shares of
stock.
All of the Company's semiconductor products are assembled and tested by
third-party vendors, primarily OSE and Advanced Semiconductor Engineering in
Taiwan, ASAT in Hong Kong, and Astra Microtronics in Indonesia. The Company has
internally designed and developed its own test software and certain test
equipment, which are provided to the Company's test vendors. Shortages of raw
materials or disruptions in the provision of services by the Company's assembly
vendors could lead to supply constraints or delays in the delivery of the
Company's products. Such constraints or delays might result in the loss of
customers, limitations or reductions in the Company's revenues or other material
adverse effects on the Company's business, financial condition and results of
operations. The Company's reliance on third-party assembly and testing vendors
involves a number of other risks, including reduced control over delivery
schedules, quality assurance and costs. The inability of such third parties to
deliver products of acceptable quality and in a timely manner could have a
material adverse effect on the Company's business, financial condition and
results of operations. See "Factors That May Affect Future Results -- Dependence
on TSMC and Other Third Parties" and " -- International Operations."
COMPETITION
The markets in which the Company competes are intensely competitive and are
characterized by rapid technological change, price declines and rapid product
obsolescence. The Company currently competes with add-in card suppliers and
other semiconductor manufacturers. The Company expects competition to increase
in the future from existing competitors and from other companies that may enter
the Company's existing or future markets with products that may be at lower
costs or provide higher levels of integration, higher performance or additional
features. The Company is unable to predict the timing and nature of any such
competitive product offerings. The announcement and commercial shipment of
competitive products could adversely affect sales of the Company's products and
may result in increased price competition that would
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adversely affect the average selling prices ("ASPs") and margins of the
Company's products. In general, product prices in the semiconductor industry
have decreased over the life of a particular product. The markets for most of
the applications for the Company's products are characterized by intense price
competition. The willingness of prospective customers to design the Company's
products into their products depends to a significant extent upon the ability of
the Company to sell its products at a price that is cost-effective for such
customers. As the markets for the Company's products mature and competition
increases, the Company anticipates that prices for its products will continue to
decline. If the Company is unable to reduce its costs sufficiently to offset
declines in product prices or is unable to introduce more advanced products with
higher product prices, the Company's business, financial condition and results
of operations would be materially adversely affected. See "Factors That May
Affect Future Results -- Potential Fluctuations in Operating Results."
The Company's existing and potential competitors consist principally of
large domestic and international companies that have substantially greater
financial, manufacturing, technical, marketing, distribution and other
resources, greater intellectual property rights, broader product lines and
longer-standing relationships with customers than the Company. The Company's
competitors also include a number of smaller and emerging companies. The
Company's principal audio competitors include Cirrus Logic, Creative Technology
and Yamaha. The Company's principal video competitors include C-Cube, Windbond,
LSI Logic and SGS Thompson. The Company's principal modem competitors include
Cirrus Logic, Lucent, PC-TEL, Rockwell, 3Com and Texas Instruments. Certain of
the Company's current and potential competitors maintain their own semiconductor
foundries and may therefore benefit from certain capacity, cost and technical
advantages. The Company believes that its ability to compete successfully
depends on a number of factors, both within and outside of its control,
including the price, quality and performance of the Company's and its
competitors' products, the timing and success of new product introductions by
the Company, its customers and its competitors, the emergence of new multimedia
standards, the development of technical innovations, the ability to obtain
adequate foundry capacity and sources of raw materials, the efficiency of
production, the rate at which the Company's customers design the Company's
products into their products, the number and nature of the Company's competitors
in a given market, the assertion of intellectual property rights and general
market and economic conditions. There can be no assurance that the Company will
be able to compete successfully in the future.
Each successive generation of microprocessors has provided increased
performance, which could in the future result in a microprocessor capable of
performing multimedia functions. In this regard, Intel Corporation has developed
Native Signal Processing ("NSP") capability and an extended multimedia system
architecture ("MMX") for use in conjunction with its Pentium microprocessor, and
is promoting the processing power of the Pentium for data and signal intensive
functions such as graphics acceleration and other multimedia functions. There
can be no assurance that the increased capabilities of microprocessors will not
adversely affect demand for the Company's products. See "Factors That May Affect
Future Results -- Importance of New Products and Technological Changes."
PATENTS AND PROPRIETARY RIGHTS
The Company relies on a combination of patents, trademarks, copyrights,
trade secret laws and confidentiality procedures to protect its intellectual
property rights. As of December 31, 1998, the Company had 9 patents granted in
the United States, which expire over time, commencing in 1999 and ending in
2015, and 12 corresponding foreign patents. In addition, the Company intends to
seek further United States and international patents on its technology. There
can be no assurance that patents will be issued from any of the Company's
pending applications or applications in preparation or that any claims allowed
from pending applications or applications in preparation will be of sufficient
scope or strength, or be issued in all countries where the Company's products
can be sold, to provide meaningful protection or any commercial advantage to the
Company. Also, competitors of the Company may be able to design around the
Company's patents. The laws of certain foreign countries in which the Company's
products are or may be designed, manufactured or sold, including various
countries in Asia, may not protect the Company's products or intellectual
property rights to the same extent as do the laws of the United States and thus
make the possibility of piracy of the
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Company's technology and products more likely. Although the Company is not aware
of the development, distribution or sales of any illegal copies of the Company's
hardware or software, any infringements of its patents, copyrights or
trademarks, or any violation of its trade secrets, confidentiality procedures or
licensing agreements to date, there can be no assurance that the steps taken by
the Company to protect its proprietary information will be adequate to prevent
misappropriation of its technology or that the Company's competitors will not
independently develop technologies that are substantially equivalent or superior
to the Company's technology.
The semiconductor industry is characterized by vigorous protection and
pursuit of intellectual property rights or positions, which have resulted in
significant and often protracted and expensive litigation. Except for the
Lemelson Foundation complaint (See "Item 3. Legal Proceedings"), there was no
pending intellectual property litigation against the Company. However, the
Company or its foundries may from time to time receive notice of claims that the
Company has infringed patents or other intellectual property rights owned by
others. The Company may seek licenses under such patents or other intellectual
property rights. However, there can be no assurance that licenses will be
offered or that the terms of any offered licenses will be acceptable to the
Company. The failure to obtain a license from a third party for technology used
by the Company could cause the Company to incur substantial liabilities and to
suspend the manufacture of products or the use by the Company's foundries of
processes requiring the technology. Furthermore, the Company may initiate claims
or litigation against third parties for infringement of the Company's
proprietary rights or to establish the validity of the Company's proprietary
rights. Litigation by or against the Company could result in significant expense
to the Company and divert the efforts of the Company's technical and management
personnel, whether or not such litigation results in a favorable determination
for the Company. In the event of an adverse result in any such litigation, the
Company could be required to pay substantial damages, cease the manufacture, use
and sale of infringing products, expend significant resources to develop
non-infringing technology, discontinue the use of certain processes or obtain
licenses for the infringing technology. There can be no assurance that the
Company would be successful in such development or that such licenses would be
available on reasonable terms, or at all, and any such development or license
could require expenditures by the Company of substantial time and other
resources. Although patent disputes in the semiconductor industry have often
been settled through cross-licensing arrangements, there can be no assurance
that in the event that any third party makes a successful claim against the
Company or its customers, a cross-licensing arrangement could be reached. In
such a case, if a license is not made available to the Company on commercially
reasonable terms, the Company's business, financial condition and results of
operations could be materially adversely affected.
The Company currently licenses certain of the technology utilized by the
Company in its products, and expects to continue to do so in the future. The
Company has no current plans to grant licenses with respect to its products or
technology; however, it may become necessary for the Company to enter into
product licenses in the future in order, among other things, to secure foundry
capacity. Although the Company has in the past granted licenses to certain of
its technology, some of which have expired, such licenses have been limited and
the Company has not derived material revenues from such licenses in recent
periods. See "Factors That May Affect Future Results -- Uncertainty Regarding
Patents and Protection of Proprietary Rights."
EMPLOYEES
As of December 31, 1998, the Company had 426 full-time employees, including
185 in research and development, 118 in marketing, sales and support and 123 in
operations, finance and administration. The Company's future success will
depend, in part, on its ability to continue to attract, retain and motivate
highly qualified technical and management personnel, particularly highly skilled
semiconductor design personnel and software engineers involved in new product
development, for whom competition is intense. The Company's employees are not
represented by any collective bargaining unit, and the Company has never
experienced a work stoppage. See "Factors That May Affect Future
Results -- Dependence on Key Personnel."
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ITEM 2. PROPERTIES
Prior to October 1996, the Company leased two facilities in Fremont,
California. The leases for such facilities expired on June 30 and October 31,
1996. The facilities consisted of two buildings comprising approximately 62,000
square feet, which were used as the Company's headquarters. In October 1995, the
Company purchased approximately 16 acres of land near its previous Fremont
headquarters and constructed a new headquarters facility of 93,000 square feet.
The Company relocated its operations from the leased facility to the new
facility in September 1996. The Company completed construction of an additional
building of 77,000 square feet to support headcount growth in August of 1998.
The Company also completed construction of a dormitory of 11,000 square feet to
house visitors and guest workers in August 1998.
ITEM 3. LEGAL PROCEEDINGS
On March 11, 1998, Creative Technology Ltd. and its subsidiary E-mu
Systems, Inc. (together, "Creative") filed a lawsuit against the Company and one
of its customers, Diamond Multimedia Systems, Inc. ("Diamond"), alleging
infringement of U.S. Patent No. 5,698,803 (the "803 patent"), by the Company's
Maestro products, one of which is included in products sold by Diamond. The
complaint requests preliminary and permanent injunctions, and unspecified
damages. Creative also claims willful infringement and requests treble damages
and attorney's fees. The lawsuit, entitled Creative Technology Ltd. et al v. ESS
Technology, Inc. et al, was filed in the U.S. District Court for the Central
District of California.
On September 25, 1998, the lawsuit between Company and Creative was settled
to the parties' mutual satisfaction, and ESS is now under a license from
Creative regarding sales of its Maestro products. Further terms of the
settlement are confidential.
On February 26, 1999, the Company was named in a complaint, along with 87
other defendants, brought by the Lemelson Medical, Education & Research
Foundation (the "Lemelson Foundation") in the United States District Court for
the District of Arizona, no. Civ99-0377PHXRGS. The complaint alleges
infringement of unspecified claims in some or all of sixteen U.S. patents, and
seeks both injunctive relief and unspecified damages, with a request for damage
enhancement and attorneys' fees pursuant to 35 U.S.C. section 285. The Company
has not yet been formally served with the complaint, and has been approached by
representatives of the Lemelson Foundation suggesting that it agree to a
license. The Company is studying this proposal, and is also investigating
possible indemnification by its vendors and/or joint defense arrangements with
other defendants. Although the ultimate outcome of this matter is not currently
determinable, the Company believes, based in part on the licensing terms offered
by Lemelson Foundation that the resolution of the matter will not have a
material adverse effect on the Company's financial position or liquidity;
however, there can be no assurance that the ultimate resolution of this matter
will not have a material adverse effect on the Company's results of operation.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the quarter
ended December 31, 1998.
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PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER
MATTERS
The Company's Common Stock has been trading on the Nasdaq National Market
under the symbol "ESST" since October 6, 1995. The following table sets forth
the high and low last reported sales prices for the Common Stock as reported by
the Nasdaq National Market during the period indicated.
HIGH LOW
---------- --------
FISCAL 1997:
First Quarter ending March 31, 1997......................... 34 1/4 21 3/8
Second Quarter ending June 30, 1997......................... 29 1/2 11 7/8
Third Quarter ending September 30, 1997..................... 18 1/4 13 1/4
Fourth Quarter ending December 31, 1997..................... 14 3/8 7 9/16
FISCAL 1998:
First Quarter ending March 31, 1998......................... 8 7/16 6 1/4
Second Quarter ending June 30, 1998......................... 7 3/8 3 7/8
Third Quarter ending September 30, 1998..................... 4 15/32 2 1/32
Fourth Quarter ending December 31, 1998..................... 6 7/8 2 5/32
As of January 31, 1999, there were approximately 313 record holders of the
Company's Common Stock. Since shareholders are listed under their brokerage
firm's names, the actual number of shareholders is higher.
In connection with the Company's acquisition of VideoCore Technology, Inc.
in January 1996, the shareholders of VideoCore received an aggregate of
approximately 525,000 shares of the Company's Common Stock and $5.7 million in
cash.
In connection with the Company's acquisition of OSEE Technology, Inc. in
March 1996, the shareholders of OSEE received an aggregate of approximately
217,000 shares of the Company's Common Stock and $3.6 million in cash. Also
outstanding stock options at OSEE were exchanged for 85,000 stock options of the
Company.
In connection with the Company's acquisition of Platform Technologies, Inc.
in June, 1997, the shareholders of Platform Technologies received an aggregate
of approximately 2.54 million shares of the Company's Common Stock, including
approximately 954,000 options with a value of $32.7 million.
The issuance of securities in this Item 5 was deemed to be exempt from
registration under the Securities Act of 1933, as amended (the "Act"), in
reliance on Section 4(2) of the Act as a transaction by an issuer not involving
any public offering. The recipients of the securities in such transaction
represented their intention to acquire the securities for investment only and
not with a view to or for sale in connection with any distribution thereof and
appropriate legends were affixed to the securities issued in such transaction.
The recipients were given adequate access to information about the Company.
The Company has never declared or paid any cash dividends on its Common
Stock. The Company currently anticipates that it will retain all future earnings
for use in its business and does not anticipate paying any cash dividends in the
foreseeable future.
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ITEM 6. SELECTED FINANCIAL DATA
The following selected consolidated financial data should be read in
conjunction with the Consolidated Financial Statements and related notes thereto
and "Management's Discussion and Analysis of Financial Condition and Results of
Operations" appearing elsewhere in this Form 10-K.
YEAR ENDED DECEMBER 31,
-------------------------------------------------------
1994 1995 1996 1997 1998
------- -------- -------- -------- --------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
STATEMENT OF OPERATIONS DATA:
Net revenues......................... $33,435 $105,744 $226,455 $249,517 $218,252
Cost of revenues..................... 12,047 39,584 106,818 171,859 182,417
------- -------- -------- -------- --------
Gross profit....................... 21,388 66,160 119,637 77,658 35,835
Operating expenses:
Research and development........... 3,711 8,665 20,270 29,471 30,529
Research and development
in-process...................... -- -- 30,355 22,200 --
Selling, general and
administrative.................. 3,233 9,758 16,814 25,198 36,289
------- -------- -------- -------- --------
Operating income (loss).............. 14,444 47,737 52,198 789 (30,983)
Nonoperating income, net............. 283 2,694 3,241 2,183 1,478
------- -------- -------- -------- --------
Income before income taxes........... 14,727 50,431 55,439 2,972 (29,505)
Provision for (benefit from) income
taxes.............................. 6,346 20,545 33,813 13,838 (1,489)
------- -------- -------- -------- --------
Net income (loss).................... $ 8,381 $ 29,886 $ 21,626 $(10,866) $(28,016)
------- -------- -------- -------- --------
Net income (loss) per
share -- basic..................... $ 0.25 $ 0.96 $ 0.57 $ (0.27) $ (0.68)
======= ======== ======== ======== ========
Net income (loss) per
share -- diluted(1)................ $ 0.22 $ 0.79 $ 0.52 $ (0.27) $ (0.68)
======= ======== ======== ======== ========
Shares used in calculating net income
(loss) per share -- basic.......... 33,510 31,265 37,702 39,593 40,955
======= ======== ======== ======== ========
Shares used in calculating net income
(loss) per share -- diluted(1)..... 37,413 37,775 41,588 39,593 40,955
======= ======== ======== ======== ========
DECEMBER 31,
-------------------------------------------------------
1994 1995 1996 1997 1998
------- -------- -------- -------- --------
(IN THOUSANDS)
BALANCE SHEET DATA:
Cash, cash equivalents and short-term
investments........................ $10,860 $ 78,124 $ 69,204 $ 42,284 $ 82,471
Working capital...................... 11,135 70,602 65,207 74,238 81,124
Total assets......................... 24,014 162,703 211,985 231,654 214,645
Long-term debt, less current
portion............................ -- 15,960 -- -- --
Total shareholders' equity........... 14,458 105,208 143,176 171,107 142,072
- ---------------
(1) See Note 6 of Notes to Consolidated Financial Statements for an explanation
of shares used in calculating net income (loss) per share -- diluted.
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion should be read in conjunction with the Company's
Consolidated Financial Statements contained in Item 8 of this report. Except for
the historical information contained herein, the matters discussed in this
report are forward-looking statements that involve certain risks and
uncertainties that could cause actual results to differ materially from those in
the forward-looking statements. Potential risks and uncertainties include,
without limitation, those mentioned in this report and, in particular, the
factors described below under "Factors That May Affect Future Results."
OVERVIEW
ESS designs, develops and markets highly integrated mixed signal
semiconductor products for sale to the Internet, PC and consumer marketplace. In
1998, ESS had revenues totaling $218.3 million, a 13% decrease from the 1997
total of $249.5 million and 4% decrease from 1996 revenues of $226.5 million.
Net income decreased by 347% from $11.3 million in 1997, excluding a one-time
pre and post-tax charge of $22.2 million related to acquired research and
development in-process for the acquisition of Platform, to a net loss of $28.0
million in 1998. 1997 net income, excluding the one time pre and post- tax
charge for acquired research and development in-process, decreased by 78% from
1996 net income of $52.0 million, excluding a one-time pre and post-tax charge
of $30.4 million related to acquired research and development in-process for the
VideoCore and OSEE acquisitions. The gross margin for 1998 was 16%, reflecting
price competition offset in part by manufacturing cost reductions, compared to
gross margin in 1997 of 31%. 1997 margin declined from 53% in 1996 primarily due
to price competition in the audio segment offset in part by manufacturing cost
reductions.
The Company is a leader in semiconductor audio products for the PC
marketplace and semiconductor video products for the VCD player market. In 1996,
the Company entered the VCD player market after its January 1996 acquisition of
VideoCore pursuant to which the Company acquired all of the outstanding capital
stock of VideoCore in exchange for approximately 525,000 shares of the Company's
Common Stock and $5.7 million in cash. VideoCore develops integrated circuits
which incorporate advanced compression technology in digital video products
under the trade-name VideoDrive. In March 1996, the Company completed its
acquisition of OSEE pursuant to which the Company acquired all of the
outstanding capital stock of OSEE in exchange for approximately 217,000 shares
of the Company's Common Stock and $3.6 million in cash. Also outstanding stock
options of OSEE were exchanged for 85,000 stock options of the Company. OSEE
develops advanced modem algorithm technology that enables the Company to provide
modem products under the trade name TeleDrive. Both acquisitions were accounted
for as purchases and the portion of the purchase prices attributable to research
and development in-process was expensed in the first quarter of 1996. In 1996,
1997 and 1998, the Company's AudioDrive products served the market for the ISA
standard. In June 1997, the Company completed its acquisition of Platform
pursuant to which the Company acquired all the outstanding capital stock of
Platform in exchange for approximately 2.54 million shares of the Company's
Common Stock including approximately 954,000 options. The acquisition was
accounted for as a purchase and the portion of the purchase price attributable
to research and development in-process was expensed in the second quarter of
1997. The acquisition of Platform allowed the Company to develop and
subsequently introduce products for the PCI standard.
ESS' AudioDrive products enable PC manufacturers to provide audio
capabilities on add-in sound cards and directly on the motherboards of desktop
and notebook computers. The Company has established itself as a leader in
integrated audio solutions and counts many of the leading manufacturers of
personal computers and sound cards among its customers.
In 1996, the Company introduced its VideoDrive product, a single-chip
MPEG-1 decoder that provides full-screen, full-motion video and selectable
CD-quality audio for VCD players. Shipments of these chips to the VCD player
market began in the second quarter of 1996. In 1997, the Company introduced its
first MPEG-2 video chip solution, a fully programmable, single-chip processor
that incorporates the additional features needed for consumer electronics
applications such as DVD players, set-top boxes, multimedia personal computers
and home entertainment units.
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The TeleDrive products for the Internet and other modem markets were
developed following the Company's first quarter of 1996 acquisition of OSEE. In
1997, the Company began shipment of V.34bis modem solutions and introduced the
V.90 56K modem solutions. The Company is currently shipping both V.34bis and
V.90 56K modem solutions.
Prior to October 1996, the Company leased two facilities in Fremont,
California. The leases for such facilities expired on June 30 and October 31,
1996. The facilities consisted of two buildings comprising approximately 62,000
square feet, which were used as the Company's headquarters. At the end of 1995,
ESS purchased 16 acres of land in Fremont, California, near its previous
facilities. By the end of 1996, the Company completed and occupied a two-story,
93,000-square-foot headquarters. In 1998, the Company completed construction of
a 77,000 square foot building to support headcount growth. An 11,000 square foot
dormitory was also completed during 1998.
During the fourth quarter of 1997, the Company established a wholly-owned
foreign subsidiary in the Cayman Islands, British West Indies and transferred a
substantial portion of its business operations to it.
RESULTS OF OPERATIONS
The following table sets forth certain items from the Company's
consolidated statements of operations as a percentage of net revenues for the
periods indicated.
YEARS ENDED DECEMBER 31,
---------------------------
1996 1997 1998
----- ----- -----
Net revenues.................................... 100.0% 100.0% 100.0%
Cost of revenues................................ 47.2 68.9 83.6
----- ----- -----
Gross margin.................................. 52.8 31.1 16.4
Operating expenses:
Research and development...................... 9.0 11.8 14.0
Research and development in-process........... 13.4 8.9 --
Selling, general and administrative........... 7.4 10.1 16.6
----- ----- -----
Operating income (loss)......................... 23.0 0.3 (14.2)
Nonoperating income, net........................ 1.5 0.9 0.7
----- ----- -----
Income (loss) before income taxes............... 24.5 1.2 (13.5)
Provision for (benefit from) income taxes....... 14.9 5.5 (0.7)
----- ----- -----
Net income (loss)............................... 9.6%* (4.3)%** (12.8)%
===== ===== =====
- ---------------
* Includes a one-time pre and post-tax charge of 13.4% related to acquired
research and development in-process.
** Includes a one-time pre and post-tax charge of 8.9% related to acquired
research and development in-process.
Net Revenues. Net revenues were $226.5 million, $249.5 million and $218.3
million in 1996, 1997 and 1998, respectively. Net revenues decreased 13% between
1997 and 1998 primarily due to a decrease in ASP in both the audio and video
markets. Net revenues rose by 10% between 1996 and 1997 primarily from increased
sales of the Company's video products. The Company's PC audio products accounted
for substantially all of the Company's net revenues for 1996 and a majority in
1997 and 1998. International revenues accounted for approximately 92%, 89% and
92% of net revenues for 1996, 1997 and 1998, respectively. The Company's net
revenues are denominated in U.S. dollars. The Company expects that its
percentage of international sales will remain high in the future.
Gross Margin. Gross profit was $119.6 million, $77.7 million and $35.8
million in 1996, 1997 and 1998, respectively, representing corresponding gross
margins of 52.8%, 31.1% and 16.4% of net revenues for such years. The decrease
in gross margins from 1997 to 1998 was a result of lower ASPs on the Company's
products throughout the year. The decrease in gross margins from 1996 to 1997
was a result of lower ASPs on the
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Company's products throughout the year and an inventory charge to cost of goods
sold during the fourth quarter of $18.3 million for excess inventory positions.
During the third quarter of 1997, indication of strong demand led to a high
order rate. After non-cancelable production orders were placed, yields improved
dramatically and the marketplace demand was lower than expected. The Company was
under contractual agreement to pay a pre-established per-die price, and was
unable to realize the benefit of the enhanced yields and was committed to
purchase the increased volume. These factors led to the inventory charge and the
decrease in gross profit. The Company's overall gross profit and margin are
subject to change due to various factors, including among others, competitive
product pricing, unit volumes shipped, new product introductions, yields, wafer
costs, assembly costs and product mix. The Company has encountered increased
competition from other suppliers who are offering competitive products and new
features. In addition, the Company expects the overall ASPs for its existing
products to decline significantly over the life of the products. The Company
believes that in order to maintain or increase gross profit, it must achieve
higher unit volume shipments, reduce costs, add new features and introduce new
products. However, no assurance can be given that the Company will be able to
ship higher volumes, reduce costs, add new features or introduce new products
that gain market acceptance.
Research and Development Expenses. On-going research and development
expenses were $20.3 million, $29.5 million and $30.5 million, or 9.0%, 11.8% and
14.0% of net revenues, in 1996, 1997 and 1998, respectively. Research and
development in-process represents one-time pre and post-tax charges of $30.4
million from the acquisition of VideoCore and OSEE in the first quarter of 1996
and of $22.2 million from the acquisition of Platform in the second quarter of
1997. The growth in on-going research and development expenses between 1996 and
1997 was primarily due to the increase in the Company's engineering staff,
engineering test runs, masks, internal and external consulting expenses and
licensing fees associated with the research and development efforts to support
the introduction of new products. The growth in on-going research and
development expenses between 1997 and 1998 was primarily due to the increase in
amortization of technical infrastructure and covenants not to compete related to
the Company's acquisitions and a one-time charges for impaired assets related to
previous acquisitions offset by lower engineering test run and mask charges. The
Company expects that research and development expenses will remain relatively
constant as a percentage of net revenues. There can be no assurance, however,
that revenues will grow at the same rate as the anticipated research and
development expenses.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses were $16.8 million, $25.2 million and $36.3 million, or
7.4%, 10.1% and 16.6% of net revenues, in 1996, 1997 and 1998, respectively. The
increase in selling, general and administrative expenses from 1996 to 1997 was
primarily attributable to increased spending for additional sales and
administrative employees. The increase in expense was also due to commissions on
higher sales levels and, to a lesser extent, promotional expenses and costs
associated with the expansion of the Company's sales activities. The increase in
selling, general and administrative expense from 1997 to 1998 was primarily due
to the increase in reserves for accounts receivable, the amortization of
covenants not to compete related to the Company's acquisitions, one-time charge
for impaired assets related to a previous acquisition and the expenses
associated with the Company's conversion to a new management information system.
The Company expects to incur higher selling, general and administrative expenses
in the future due to the need to increase selling activities, although these
expenses are expected to remain relatively constant as a percentage of net
revenues. There can be no assurance, however, that revenues will grow at the
same rate as the anticipated selling, general and administrative expenses.
Non-Operating Income. Non-operating income was $3.2 million, $2.2 million
and $1.5 million in 1996, 1997 and 1998, respectively. In 1996, 1997 and 1998
non-operating income consisted primarily of interest income and gains on sale of
short-term investments.
Provision for Income Taxes. The Company's effective tax rate was 61%, 466%
and (5%) for 1996, 1997 and 1998, respectively. The tax rate for 1996 of 61%
reflects a non-deductible expense for the one-time pre and post-tax charge of
$30.4 million related to acquired research and development in-process from the
acquisition of VideoCore and OSEE in the first quarter 1996. The pro forma tax
rate excluding this charge of $30.4 million was 39%. The Company's pro forma tax
rate for 1996 was slightly lower than the combined
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federal and state statutory rate of 41% as a result of tax exempt interest
income and research and development credits. The reported tax rate for 1997 of
466% of pre-tax income significantly exceeds the combined federal and state
statutory tax rate of 41% due to two charges that are not deductible in the
federal and state tax returns. The first charge is the one-time pre- and
post-tax charge of $22.2 million for the acquisition of Platform in the second
quarter of 1997. The second is the charge to increase inventory reserves in the
fourth quarter of 1997. Because the majority of the inventories were held by a
foreign subsidiary, a majority of the charge was not deductible on the U.S.
federal and state income tax returns. The reported tax benefit for 1998 of 5% of
pre-tax losses is below the combined federal and state statutory rate of 41%. It
is because a majority of the losses were by a foreign subsidiary and are not
deductible on the U.S. federal and state income tax returns. See Note 4 of Notes
to Consolidated Financial Statements.
LIQUIDITY AND CAPITAL RESOURCES
Since its inception, the Company has financed its cash requirements from
cash generated by operations, the sale of equity securities, bank lines of
credit and short-term and long-term debt. At December 31, 1998, ESS had cash and
cash equivalents and short-term investments of $82.5 million and working capital
of $81.1 million. As of December 31, 1998, the Company had a $15.0 million line
of credit which expires on October 1, 2001 and was secured by land and buildings
with a net book value of $23.8 million. The line of credit requires the Company
to achieve certain financial ratios and operating results. At December 31, 1998,
the Company was in compliance with its borrowing criteria. There were no
borrowings under the line of credit as of December 31, 1998.
In 1998, the Company generated net cash from operating activities of $31.7
million. This resulted from a reduction in inventory of $24.4 million, a
decrease in prepaids and other assets of $13.3 million, an increase in accounts
payable and accrued liabilities of $7.1 million, an increase in income taxes
payable and deferred income taxes of $3.5 million, depreciation and amortization
of $12.5 million and a charge for compensation expense related to stock options
of $.5 million, partially offset by a net loss of $28.0 million and an increase
in accounts receivable of $1.6 million. The Company received $22.4 million from
sale of its UICC investment, $1.2 million from the issuance of common stock and
the income tax credit from disqualifying disposition of common stock options.
The Company invested $12.3 million in property and equipment, $2.8 million in
the repurchase of stock and $2.2 million in the net purchase of short-term
investments. For the year, cash and cash equivalents increased by $38.0 million.
In 1997, the Company used net cash of $2.6 million in operating activities.
This resulted from a net loss of $10.9 million, a gain on sale of short-term
investments of $0.1 million, an increase in accounts receivable of $14.2
million, an increase in inventories of $14.0 million, a decrease in accounts
payable and accrued expenses of $8.4 million and a decrease in income taxes
payable and deferred income taxes of $7.5 million offset in part by reductions
in prepaid expenses and other assets of $22.4 million, a one-time non-cash
charge for research and development in-process of $22.2 million and depreciation
and amortization of $7.9 million. The company received net proceeds of $5.6
million from sale of short term investments, $3.1 million from the issuance of
common stock from exercise of stock options and employee stock purchase plan,
$3.0 million in income tax credits from disqualifying disposition of common
stock options and $2.5 million from the acquisition of Platform. The Company
invested $17.7 million in UICC joint venture and $15.2 million in property and
equipment. For the year, cash and cash equivalents declined $21.3 million.
In 1996, the Company generated net cash from operating activities of $43.3
million. This resulted from net income of $21.6 million, a one-time non-cash
charge for research and development in-process of $30.4 million, an increase in
accounts payable and accrued expenses of $24.1 million, depreciation and
amortization of $3.2 million and a charge for compensation expense related to
stock options of $0.1 million, less a gain on sale of short-term investments of
$1.0 million an increase in inventories of $14.0 million, an increase in
accounts receivable of $11.8 million, an increase in prepaid expenses and other
assets at $9.1 million and a decrease in income taxes and deferred income taxes
of $0.2 million. The Company received net proceeds of $7.1 million from sale of
short term investments, $3.8 million from the issuance of common stock from
exercise of stock options and employee stock purchase plan, and $8.9 million in
income tax credits from disqualifying disposition of common stock options. The
Company invested $14.0 million in property and
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equipment, repurchased stock for $19.7 million, paid $16.0 million on capacity
commitments, $9.3 million for acquisition of VideoCore and OSEE and $6.9 million
in UICC joint venture. For the year, cash and cash equivalents declined $2.8
million.
The Company believes that its existing cash and cash equivalents as of
December 31, 1998 together with the cash generated from operations, available
borrowings under its line of credit and other financing options, will be
sufficient to fund acquisitions of property and equipment and provide adequate
working capital through at least the next twelve months. Capital expenditures
for the next twelve months are anticipated to be approximately $14.1 million
which will be primarily used to acquire capital equipment. The Company may also
utilize cash to acquire or invest in complementary businesses or products or to
obtain the right to use complementary technologies. From time to time, in the
ordinary course of business, the Company may evaluate potential acquisitions of
or investment in such businesses, products or technologies owned by third
parties.
NEW ACCOUNTING STANDARDS
In June 1997, the Financial Accounting Standards Board issued Statement No.
130, "Reporting Comprehensive Income" which was adopted by the Company in the
first quarter of fiscal 1998. This Statement establishes standards for reporting
and displaying comprehensive income and its components (revenues, expenses,
gains and losses) in a full set of general-purpose financial statements.
Comprehensive income as defined includes all changes in equity (net assets)
during a period from non-owner sources. Such items may include foreign currency
translation adjustments, unrealized gains/losses from investing and hedging
activities, and other transactions. This Statement requires that all items that
are required to be recognized under accounting standards as components of
comprehensive income be reported in a financial statement that is displayed with
the same prominence as other financial statements. As the Company has no
components of other comprehensive income, there are no disclosure requirements
involved in the Company's adoption of this Statement.
In June 1997, the Financial Accounting Standards Board issued Statement No.
131, "Disclosures about Segments of an Enterprise and Related Information" which
was adopted by the Company in the first quarter of fiscal 1998. This Statement
establishes standards for the way that public business enterprises report
information about operating segments in annual financial statements and requires
that those enterprises report selected information about operating segments in
interim financial reports issued to stockholders. It also establishes standards
for related disclosures about products and services, geographic areas and major
customers. The Company expanded its disclosure of geographical areas in
accordance with the new standard. As the Company operates and tracks its results
in only one segment, there are no additional disclosure requirements involved
with the Company's adoption of this Statement.
YEAR 2000 ISSUES
General. The Company is currently conducting a company-wide Year 2000
readiness program ("Y2K Program"). The Y2K Program is addressing the issue of
computer programs and embedded computer chips being unable to distinguish
between the year 1900 and the year 2000. Therefore, some computer hardware and
software will need to be modified prior to the Year 2000 in order to remain
functional. The Company anticipates that Year 2000 compliance will be
substantially complete by June 1999.
Year 2000 Program. The Company's Year 2000 Program is divided into four
major sections -- ESS manufactured products, internal information ("IT")
systems, non-IT systems (e.g., testing equipment), and third-party suppliers and
customers. The general phases common to all sections are: (1) inventorying Year
2000 items; (2) assessing the Year 2000 compliance of items determined to be
material to the company; and (3) repairing or replacing material items that are
determined not to be Year 2000 compliant.
The Company has completed its review of substantially all ESS manufactured
products for Year 2000 compliance purposes. The Company believes that
substantially all of the Company's products are Year 2000 compliant and that
those that are not Year 2000 compliant can be upgraded to be Year 2000 compliant
by June 1999.
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With respect to its internal IT computer systems, the Company has completed
the inventory and review phases of the Y2K program and has been in the repair or
replacement phase. In February 1998, the Company began to install Year 2000
compliant programs from Oracle Corporation for approximately 80 percent of its
business systems. This installation was fully implemented by the end of 1998.
With respect to the remaining internal IT computer systems that are not yet Year
2000 compliant, the Company plans to either replace or upgrade them by the end
of September 1999.
The Company has completed the inventory phase and Year 2000 compatibility
of its non-IT systems. To date, about 80 percent of its non-IT systems are Year
2000 compliant. The Company plans to repair or replace those that are not yet
Year 2000 compliant by the end of June 1999.
The Company has been working with its key suppliers and contract
manufacturers to assess the possible effects of their Year 2000 readiness on the
Company's operations. Although these suppliers and contract manufacturers have
notified the Company that they have been addressing the problem, they have not
provided specific assurance regarding the Year 2000 compliance of their systems
and software. The Company's reliance on suppliers and contract manufacturers
and, therefore, on the proper functioning of their information systems and
software, means that failure of such key suppliers and contract manufacturers to
address Year 2000 issues could have a material adverse impact on the Company's
operations and financial results; however, the potential impact and related
costs are not known at this time.
Costs of the Assessment and Modification. The total cost associated with
required modifications to become Year 2000 compliant is not expected to be
material to the Company's financial position. Through December 31, 1998, the
Company has spent $2.6 million to implement Year 2000 compliant programs from
Oracle Corporation. The Company estimates that it may spend up to an additional
$250,000 for other replacements or upgrades and for communicating with key
suppliers and customers.
Risks. The failure to correct a material Year 2000 problem could result in
an interruption in, or a failure of, certain normal business activities or
operations. Such failures could materially and adversely affect the Company's
results of operations, liquidity and financial condition. Due to the general
uncertainty inherent in the Year 2000 problem resulting in part from the
uncertainty of the Year 2000 readiness of third-party suppliers and customers,
the Company is unable to determine at this time whether the consequences of Year
2000 failures will have a material impact on the Company's results of
operations, liquidity or financial condition. The Company believes that its Year
2000 Program will help to significantly reduce the Company's level of
uncertainty about the Year 2000 problem and, in particular, about the Year 2000
compliance and readiness of its material key suppliers and customers. The
Company believes that, with the implementation of new business systems and
completion of the Year 2000 Program as scheduled, the possibility of significant
interruptions of normal operations should be reduced.
We are at work on the development of various types of contingency plans to
address potential problems with critical internal systems and third party
interactions. Our contingency plans include procedures for dealing with a major
disruption of internal business systems, plans for factory shutdown and
identification of alternative vendors of critical materials in the event of Year
2000 related disruption in supply. Contingency planning will continue through at
least 1999, and will depend heavily on the results of the remediation and
testing of critical systems. The potential ramifications of a Year 2000 type
failure are potentially far-reaching and largely unknown. We cannot assure you
that a contingency plan in effect at the time of a system failure will
adequately address the immediate or long term effects of a failure, or that such
a failure will not have a material adverse affect on the Company.
FACTORS THAT MAY AFFECT FUTURE RESULTS
This report contains certain forward-looking statements that are subject to
risk and uncertainties. For such statements, the Company desires to take
advantage of the "Safe Harbor" provisions of the Private Securities Litigation
Reform Act of 1995 and of Section 21E of and Rule 3b-6 under the Securities
Exchange Act of 1934. Such forward-looking statements include, without
limitation, statements regarding the Company's expectations, intentions of
future strategies and involve known and unknown risks, uncertainties and
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other factors. All forward looking statements included in this document are
based on information available to the Company on the date hereof, and the
Company assumes no obligation to update such forward-looking statements.
Potential Fluctuations in Operating Results. The Company's operating
results are subject to quarterly and other fluctuations due to a variety of
factors, including the gain or loss of significant customers, increased
competitive pressures, changes in pricing policies by the Company, its
competitors or its suppliers, including decreases in unit average selling prices
("ASPs") of the Company's products, the timing of new product announcements and
introductions by the Company or its competitors and market acceptance of new or
enhanced versions of the Company's and its customers' products. Other factors
include the availability of foundry capacity, fluctuations in manufacturing
yields, availability and cost of raw materials, changes in the mix of products
sold, the cyclical nature of both the semiconductor industry and the market for
PCs, seasonal customer demand, the timing of significant orders and significant
increases in expenses associated with the expansion of operations. The Company's
operating results could also be adversely affected by economic conditions in
various geographic areas where the Company or its customers do business, or
order cancellations or rescheduling. These factors are difficult to forecast,
and these or other factors could materially affect the Company's quarterly or
annual operating results. There can be no assurance as to the level of sales or
earnings that may be attained by the Company in any given period in the future.
The Company currently places noncancelable orders to purchase its products from
independent foundries on an approximately three month rolling basis, while its
customers generally place purchase orders with the Company less than four weeks
prior to delivery that may be canceled without significant penalty.
Consequently, if anticipated sales and shipments in any quarter are canceled or
do not occur as quickly as expected or forecasted sales levels are not realized,
expense and inventory levels could be disproportionately high and the Company's
business, financial condition and results of operations could be materially
adversely affected. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
Competition; Pricing Pressures. The markets in which the Company competes
are intensely competitive and are characterized by rapid technological change,
price declines and rapid product obsolescence. See "Item 1.
Business -- Competition."
Dependence on the PC and Consumer Markets. In 1996, 1997 and 1998, sales of
PC audio semiconductor chips accounted for a majority of the Company's net
revenues, and the Company expects that sales of audio semiconductors will
continue to account for a significant portion of its net revenues for the
foreseeable future. In 1998, sales of video semiconductor chips to the video
compact disk ("VCD") player market accounted for a significant portion of the
Company's revenues. Any reduction in ASPs or demand for the Company's
semiconductor chips, whether because of a reduction in demand for PCs or VCD
players in general, increased competition or otherwise, would have a material
adverse effect on the Company's business, financial condition and results of
operations.
The Company is currently engaged in the development and introduction of new
PC audio, video and modem semiconductor devices for the Internet, PC and
consumer markets. There can be no assurance that the Company will be able to
identify market trends or new product opportunities, develop and market new
products, achieve design wins or respond effectively to new technological
changes or product announcements by others. A failure in any of these areas
would have a material adverse effect on the Company's business, financial
condition and results of operations. See "Item 1. Business -- Audio Drive
Products," "-- Video Drive Products" and "TeleDrive Products."
The Company's products are sold for incorporation into desktop and notebook
computers and VCD players. Therefore, the Company is heavily dependent on the
growth of the markets and the cost requirements for desktop and notebook
computers and VCD players. There can be no assurance that these markets will be
able to grow. A slowing in unit volume and a decrease in ASPs could result in a
decline in revenues which would have a material adverse effect on the Company's
business, financial condition and results of operations.
Importance of New Products and Technological Changes. The markets for the
Company's products are characterized by evolving industry standards, rapid
technological change and product obsolescence. The Company's success is highly
dependent upon the successful development and timely introduction of new
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products at competitive price and performance levels. The success of new
products depends on a number of factors, including timely completion of product
development, market acceptance of the Company's and its customers' new products,
securing sufficient foundry capacity for volume manufacturing of wafers,
achievement of acceptable wafer fabrication yields by the Company's independent
foundries and the Company's ability to offer new products at competitive prices.
In order to succeed in having the Company's products incorporated into new
products being designed by its customers, the Company must anticipate market
trends and meet performance, quality and functionality requirements of such OEMs
and must successfully develop and manufacture products that adhere to these
requirements. In addition, the Company must meet the timing and price
requirements of such manufacturers and must make such products available in
sufficient quantities. Accordingly, in selling to OEMs, the Company can often
incur significant expenditures prior to volume sales of new products, if any. In
order to help accomplish these goals, the Company has in the past and will
continue to consider in the future the acquisition of other companies or the
products and technologies of other companies. Such acquisitions carry additional
risks such as a lack of integration with existing products and corporate
culture, the potential for large write-offs and the diversion of management
attention. There can be no assurance that the Company will be able to identify
market trends or new product opportunities, develop and market new products,
achieve design wins or respond effectively to new technological changes or
product announcements by others. A failure in any of these areas would have a
material adverse effect on the Company's business, financial condition and
results of operations. See "Item 1. Business -- Research and Development."
Dependence on TSMC and Other Third Parties. The Company relies on
independent foundries to manufacture all of its products. A substantial majority
of the Company's products are currently manufactured by TSMC, which has
manufactured certain of the Company's products since 1989. The Company also has
foundry arrangements with UMC, which has manufactured certain of the Company's
products since 1995. These relationships provide the Company with access to
advanced process technology necessary for the manufacture of the Company's
products. These foundries fabricate products for other companies and, in certain
cases, manufacture products of their own design. In November 1995, the Company
entered into long-term agreements with TSMC and UMC in which the Company has
secured access to additional capacity and to leading edge technology. See "Item
1. Business -- Manufacturing."
While the Company has entered into long-term agreements with its two
foundries, the Company's reliance on these independent foundries involves a
number of risks, including the absence of adequate capacity, the unavailability
of, or interruption in access to, certain process technologies and reduced
control over delivery schedules, manufacturing yields and costs, and the
international risks more fully described below. In addition, the Company has
pre-negotiated certain of its purchase orders and could be unable to benefit
from enhanced yields realized by its vendors. The Company expects to rely upon
TSMC and UMC to manufacture substantially all of the Company's products for the
foreseeable future. In the event that TSMC and UMC are unable to continue to
manufacture the Company's key products in required volumes, the Company will
have to identify and secure additional foundry capacity. In such an event, the
Company may be unable to identify or secure additional foundry capacity from
another manufacturer. Even if such capacity is available from another
manufacturer, the qualification process could take six months or longer. The
loss of any of its foundries as a supplier, the inability of the Company to
acquire additional capacity at its current suppliers or qualify other wafer
manufacturers for additional foundry capacity should additional capacity be
necessary, or any other circumstances causing a significant interruption in the
supply of semiconductors to the Company would have a material adverse effect on
the Company's business, financial condition and results of operations.
To address potential foundry capacity constraints in the future, ESS will
continue to consider and may be required to enter into additional arrangements,
including equity investments in or loans to independent wafer manufacturers in
exchange for guaranteed production capacity, joint ventures to own and operate
foundries, or "take or pay" contracts that commit the Company to purchase
specified quantities of wafers over extended periods. Any such arrangements
could require the Company to commit substantial capital and grant licenses to
its technology. The need to commit substantial capital may require the Company
to obtain additional debt or equity financing, which could result in dilution to
the Company's shareholders. There can be no assurance that such additional
financing, if required, will be available when needed or, if available, will be
obtained on terms acceptable to the Company.
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Customer Concentration. A limited number of customers have accounted for a
substantial portion of the Company's net revenues. In 1996, 1997 and 1998, sales
to the Company's top five customers, including sales to distributors, accounted
for approximately 40%, 49% and 54% respectively, of the Company's net revenues.
In 1996, Compaq and Universe Electron Corporation each accounted for
approximately 12% and 13%, respectively, of the Company's net revenues. In 1997,
Eastbase and Dynax, a Hong Kong distributor, each accounted for approximately
13% of the Company's net revenues. In 1998, Dynax and Shinco accounted for
approximately 16% and 15% of the Company's net revenues. Sales to distributors
are generally subject to agreements allowing limited rights of return and price
protection with respect to unsold products. Returns and allowances in excess of
reserves could have a material adverse impact on the Company's business,
financial condition and results of operation. During 1997, the Company adopted a
policy of deferring revenue recognition on sales of devices to distributors in
Hong Kong and Taiwan until devices are sold to the end customers. This has led
to increased operational visibility on product moving through the channel. The
Company expects that a limited number of customers may account for a substantial
portion of its net revenues for the foreseeable future. The Company has
experienced changes from year to year in the composition of its major customer
base and believes this pattern may continue. The Company does not have long-term
purchase agreements with any of its customers. The reduction, delay or
cancellation of orders from one or more major customers for any reason or the
loss of one or more of such major customers could materially and adversely
affect the Company's business, financial condition and results of operations. In
addition, since the Company's products are often sole sourced to its customers,
the Company's operating results could be materially and adversely affected if
one or more of its major customers were to develop other sources of supply.
There can be no assurance that the Company's current customers will continue to
place orders with the Company, that orders by existing customers will not be
canceled or will continue at the levels of previous periods or that the Company
will be able to obtain orders from new customers.
Management of Growth. The Company has experienced significant growth in
unit shipments and the addition of multiple product lines that require
additional management systems and processes. To manage its future operations and
growth effectively, the Company will need to hire and retain management, hire,
train, motivate, manage and retain its employees, continue to improve its
operational, financial and management information systems and implement
additional systems and controls. There can be no assurance that the Company will
be able to manage such growth effectively, and the failure to do so could have a
material adverse effect on the Company's business, financial condition and
results of operations. In addition, the Company has implemented an
enterprise-wide software package that integrates its core business functions.
Should the implementation be incomplete or otherwise problematic, substantial
disruption to the business operations of the Company could result. There can be
no assurance that the software implementation will not cause business
disruptions to the Company.
International Operations. During 1996, 1997 and 1998, international sales
accounted for a substantial majority of the Company's net revenues.
Substantially all of the Company's international sales were to customers in Hong
Kong, Taiwan, Singapore, Japan and Korea. The Company expects that international
sales will continue to represent a significant portion of its net revenues for
the foreseeable future. In addition, substantially all of the Company's products
are manufactured, assembled and tested by independent third parties in Asia. Due
to its reliance on international sales and foreign third-party manufacturing,
assembly and testing operations, the Company is subject to the risks of
conducting business outside of the United States. These risks include unexpected
changes in, or impositions of legislative or regulatory requirements, delays
resulting from difficulty in obtaining export licenses for certain technology,
tariffs, quotas and other trade barriers and restrictions, longer payment
cycles, greater difficulty in accounts receivable collection, potentially
adverse taxes, the burdens of complying with a variety of foreign laws and other
factors beyond the Company's control. The Company is also subject to general
geopolitical risks in connection with its international trade relationships.
Although the Company has not to date experienced any material adverse effect on
its business, financial condition or results of operations as a result of such
regulatory, geopolitical and other factors, there can be no assurance that such
factors will not have a material adverse effect on the Company's business,
financial condition and results of operations in the future or require the
Company to modify its current business practices.
In addition, the laws of certain foreign countries in which the Company's
products are or may be manufactured or sold, including various countries in
Asia, may not protect the Company's products or
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intellectual property rights to the same extent as do the laws of the United
States and thus make the possibility of piracy of the Company's technology and
products more likely. Currently, all of the Company's product sales and all of
its arrangements with foundries and assembly and test vendors provide for
pricing and payment in U.S. dollars. In 1998, the effect of significant currency
fluctuations in Asia had no material impact on the Company. There can be no
assurance that future fluctuations in currency exchange rates will not have a
material adverse effect on the Company's business, financial condition and
results of operations. To date, the Company has not engaged in any currency
hedging activities, although the Company may do so in the future. Further, there
can be no assurance that one or more of the foregoing factors will not have a
material adverse effect on the Company's business, financial condition and
results of operations or require the Company to modify its current business
practices.
Semiconductor Industry. The semiconductor industry has historically been
characterized by rapid technological change, cyclical market patterns,
significant price erosion, periods of over-capacity and production shortages,
variations in manufacturing costs and yields and significant expenditures for
capital equipment and product development. In addition, the industry has
experienced significant economic downturns at various times, characterized by
diminished product demand and accelerated erosion of product prices. The Company
may experience substantial period-to-period fluctuations in operating results
due to general semiconductor industry conditions.
Uncertainty Regarding Patents and Protection of Proprietary Rights. The
Company relies on a combination of patents, trademarks, copyrights, trade secret
laws and confidentiality procedures to protect its intellectual property rights.
See "Item 1. Business -- Patents and Proprietary Rights," "Item 3. Legal
Proceedings."
Dependence on Key Personnel. The Company's success depends to a significant
degree upon the continued contributions of Fred S.L. Chan, the Company's Chief
Executive Officer, President and Chairman of the Board of Directors. The present
and future success of the Company depends on its ability to continue to attract,
retain and motivate qualified senior management, sales and technical personnel,
particularly highly skilled semiconductor design personnel and software
engineers, for whom competition is intense. The loss of Mr. Chan, other key
executive officers, key design personnel or software engineers or the inability
to hire and retain sufficient qualified personnel could have a material adverse
effect on the Company's business, financial condition and results of operations.
There can be no assurance that the Company will be able to retain these
employees. The Company currently does not maintain any key man life insurance on
the life of any of its key employees.
Control by Existing Shareholders. As of December 31, 1998, Fred S.L. Chan,
the Company's Chief Executive Officer, President and Chairman of the Board of
Directors, together with his spouse, Annie M.H. Chan, a director of the Company,
and certain trusts for the benefit of the Chan's children beneficially owned, in
the aggregate, 37% of the Company's outstanding Common Stock. As a result, these
shareholders, acting together, possess significant voting power over the
Company, giving them the ability among other things to influence significantly
the election of the Company's Board of Directors and approve significant
corporate transactions. Such control could delay, defer or prevent a change in
control of the Company, impede a merger, consolidation, takeover or other
business combination involving the Company, or discourage a potential acquirer
from making a tender offer or otherwise attempting to obtain control of the
Company. Additionally, Fred S.L. Chan and Annie M.H. Chan announced on April 28,
1998, that they would be purchasing between $5 and $10 million of the Company's
common stock on the open market. As of December 31, 1998, such purchases had
totaled $1.4 million representing 241,000 shares at prices ranging from $5.15 to
$6.56.
Possible Volatility of Stock Price. The price of the Company's Common Stock
has in the past and may continue in the future to fluctuate widely. Future
announcements concerning the Company, its competitors or its principal
customers, including quarterly operating results, changes in earnings estimates
by analysts, technological innovations, new product introductions, governmental
regulations or litigation may cause the market price of the Company's Common
Stock to continue to fluctuate substantially. Further, in recent years the stock
market has experienced extreme price and volume fluctuations that have
particularly affected the market prices of equity securities of many high
technology companies and that often have been unrelated or disproportionate to
the operating performance of such companies. These fluctuations, as well as
general
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economic, political and market conditions such as recessions or international
currency fluctuations, may materially adversely affect the market price of the
Common Stock.
Year 2000 Compliance. The dates on which the Company believes the Year 2000
Program (the "Y2K Program") will be completed are based on Management's best
estimates, which were derived utilizing numerous assumptions of future events,
including the continued availability of certain resources, third-party
modification plans and other factors. However, there can be no guarantee that
these estimates will be achieved, or that there will not be a delay in, or
increased costs associated with, the implementation of the Y2K Program. Specific
factors that might cause differences between the estimates and actual results
include, but are not limited to, the availability and cost of personnel trained
in these areas, the ability to locate and correct all relevant computer code,
timely responses to and corrections by third-parties and suppliers, the ability
to implement interfaces between the new systems and the systems not being
replaced, and similar uncertainties. Due to the general uncertainty inherent in
the Year 2000 problem, resulting in part from the uncertainty of the Year 2000
readiness of third-parties and the interconnection of global businesses, the
Company cannot ensure its ability to timely and cost-effectively resolve
problems associated with the Year 2000 issue that may affect its operations and
business, or expose it to third-party liability.
Euro Conversion. The Company is in the process of addressing the issues
raised by the introduction of the Single European Currency ("Euro") for initial
implementation as of January 1, 1999, and through the transition period to
January 1, 2002. The Company does not expect the cost of any system
modifications to be material or result in any material increase in transaction
costs. The Company will continue to evaluate the impact over time of the
introduction of the Euro; however, based on currently available information
management does not believe that the introduction of the Euro will have a
material adverse impact on the Company's financial condition or the overall
trends in results of operations.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Foreign Exchange Risks: The Company funds its operations from cash
generated from its operations, the sale of marketable securities and short and
long-term debt. As the Company operates primarily in Asia, the Company is
exposed to market risk from changes in foreign exchange rates, which could
affect its results of operations and financial condition. In order to reduce the
risk from fluctuation in foreign exchange rates, the Company's product sales and
all of its arrangements with its foundry and test and assembly vendors are
denominated in U.S. dollars. The Company has not entered into any currency
hedging activities.
Interest Rate Risks: The Company also invests in short-term investments.
Consequently, the Company is exposed to fluctuation in rates on these
investments. Increases or decreases in interest rates generally translate into
decreases and increases in the fair value of these investments. In addition, the
credit worthiness of the issuer, relative values of alternative investments, the
liquidity of the instrument and other general market conditions may affect the
fair values of interest rate sensitive investments. In order to reduce the risk
from fluctuation in rates, the Company invests in highly liquid governmental
notes and bonds with contractual maturities of less than two years. All of the
investments have been classified as available for sales and at December 31,
1998, the fair market value of the Company's investments approximated their
costs.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
(a) The following documents are filed as part of this Report.
(1) Financial Statements:
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Report of Independent Accountants
Consolidated Balance Sheets as of December 31, 1997 and 1998
Consolidated Statements of Operations for the years ended
December 31, 1996, 1997 and 1998
Consolidated Statements of Shareholders' Equity for the
years ended December 31, 1996, 1997 and 1998
Consolidated Statements of Cash Flows for the years ended
December 31, 1996, 1997 and 1998
Notes to Consolidated Financial Statements
(2) Financial Statement Schedules:
Financial Statement Schedules have been omitted because they are not
required or applicable, or the information required to be set forth
therein is included in the Financial Statements or notes thereto.
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REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders of
ESS Technology, Inc.
In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of operations, shareholders' equity and of cash
flows present fairly, in all material respects, the financial position of ESS
Technology, Inc. and its subsidiaries at December 31, 1997 and 1998, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1998, in conformity with generally accepted
accounting principles. These financial statements are the responsibility of the
Company's management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits of these
statements in accordance with generally accepted auditing standards which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.
/s/ PRICEWATERHOUSECOOPERS LLP
San Jose, California
January 21, 1999
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ESS TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1997 AND 1998
(AMOUNTS IN THOUSANDS)
ASSETS
DECEMBER 31,
--------------------
1997 1998
-------- --------
Current assets:
Cash and cash equivalents................................. $ 27,760 $ 65,752
Short-term investments.................................... 14,524 16,719
Accounts receivable, net.................................. 36,265 37,830
Inventories............................................... 47,285 22,882
Deferred income taxes..................................... 4,898 6,372
Prepaid expenses and other assets......................... 4,053 4,142
-------- --------
Total current assets.............................. 134,785 153,697
Property and equipment, net................................. 32,922 38,000
Other assets................................................ 63,947 22,948
-------- --------
$231,654 $214,645
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses..................... $ 50,858 $ 57,930
Income taxes payable and deferred income taxes............ 9,689 14,643
-------- --------
Total current liabilities......................... 60,547 72,573
-------- --------
Commitments and Contingencies (Note 9)
Shareholders' equity:
Preferred stock, no par value, 10,000 shares authorized;
none issued and outstanding............................ -- --
Common stock, no par value, 100,000 shares authorized;
40,674 and 40,849 shares issued and outstanding at
December 31, 1997 and 1998, respectively............... 137,452 137,312
Retained earnings......................................... 33,655 4,760
-------- --------
Total shareholders' equity........................ 171,107 142,072
-------- --------
Total liabilities and shareholders' equity........ $231,654 $214,645
======== ========
The accompanying notes are an integral part of these financial statements.
27
29
ESS TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
YEAR ENDED DECEMBER 31,
--------------------------------
1996 1997 1998
-------- -------- --------
Net revenues............................................... $226,455 $249,517 $218,252
Cost of revenues........................................... 106,818 171,859 182,417
-------- -------- --------
Gross profit............................................. 119,637 77,658 35,835
Operating expenses:
Research and development................................. 20,270 29,471 30,529
Research and development in-process...................... 30,355 22,200 --
Selling, general and administrative...................... 16,814 25,198 36,289
-------- -------- --------
Operating income (loss).................................... 52,198 789 (30,983)
Interest income, net....................................... 2,276 2,117 1,478
Gain on sale of short-term investments..................... 965 66 --
-------- -------- --------
Income (loss) before provision for (benefit from) income
taxes.................................................... 55,439 2,972 (29,505)
Provision for (benefit from) income taxes.................. 33,813 13,838 (1,489)
-------- -------- --------
Net income (loss).......................................... $ 21,626 $(10,866) $(28,016)
======== ======== ========
Net income (loss) per share -- basic....................... $ 0.57 $ (0.27) $ (0.68)
======== ======== ========
Net income (loss) per share -- diluted..................... $ 0.52 $ (0.27) $ (0.68)
======== ======== ========
Shares used in calculating net income (loss) per
share -- basic........................................... 37,702 39,593 40,955
======== ======== ========
Shares used in calculating net income (loss) per
share -- diluted......................................... 41,588 39,593 40,955
======== ======== ========
The accompanying notes are an integral part of these financial statements.
28
30
ESS TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998
(AMOUNTS IN THOUSANDS)
COMMON STOCK
----------------- DEFERRED RETAINED
SHARES AMOUNT COMPENSATION EARNINGS TOTAL
------ -------- ------------ --------- --------
Balance at December 31, 1995............ 35,473 $ 66,891 $(60) $ 38,377 $105,208
Issuance of common stock upon exercise
of options......................... 3,667 3,152 -- -- 3,152
Issuance of common stock for
acquisitions....................... 743 23,352 -- -- 23,352
Issuance of common stock for employee
stock purchase plan................ 47 621 -- -- 621
Amor