ITEM 1. BUSINESS
ESS Technology, Inc. ("ESS" or the "Company"), a California corporation, designs, markets and supports highly integrated mixed signal semiconductor and software solutions for multimedia applications in the personal computer ("PC") and consumer marketplaces. The Company offers comprehensive solutions for audio, video, and fax/modem applications. ESS has established itself as a leading supplier of mixed signal PC audio solutions that integrate all essential audio components on a single chip. During 1996, ESS introduced a family of integrated circuits that incorporate advanced decompression technology for digital video products and began marketing a line of highly integrated V.34bis modem solutions.
PRODUCTS
ESS leverages a leadership position in PC audio, its video and fax/modem technology, a diverse customer base, recognized quality, and dependable on-time delivery to provide high quality, cost effective, and highly integrated multimedia solutions for the personal computer and consumer markets. The Company has three major families of products: the AudioDRIVE(TM) family addressing the PC digital audio device market; the VideoDRIVE(TM) family targeting MPEG-1 and MPEG-2 decompression-based consumer products, such as Video Compact Disk ("VCD") player, Digital Versatile Disk ("DVD") player and set-top box; and the Tele(TM)DRIVE family, focusing on the integrated audio-fax/modem applications, including full duplex speakerphone, digital simultaneous voice and data (DSVD) and videoconferencing.
Audio Products
ESS' single chip AudioDRIVE products enable PC manufacturers to provide audio capabilities on 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.
ESS' single chip AudioDRIVE products provide comprehensive PC audio solutions that offer higher performance and functionality, consume less power and board space, and cost less than other commercially available PC audio solutions.
Recently, demand for multimedia desktop and notebook computers with high quality sound, graphics and video capabilities has increased due to three dynamic factors: (1) advances in semiconductor technology; (2) growth in interactive PC entertainment, educational and business software applications; and (3) increases in use of on-line services. These factors have created market opportunities for highly integrated multimedia semiconductor solutions that can be placed on the PC motherboard and on multi-function sound cards.
The Company's AudioDRIVE products are based on ESS' proprietary audio technologies, design methodologies, and software and firmware expertise. ESS has developed a set of product solutions for desktop and notebook PCs and other consumer electronics applications.
The AudioDRIVE product family integrates 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), 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.
AudioDRIVE Products
ES688: a single mixed signal 16-bit stereo audio chip. The ES688 integrates digital logic and a microcontroller with audio CODEC and other analog functions onto one chip and, when coupled with the Yamaha OPL3 FM synthesizer chip, provides a low cost solution for high performance multimedia PC audio. The ES688 is PC games compatible in SB Pro mode with the Yamaha OPL3 and is compatible with Microsoft Windows and other operating systems. The ES688 provides power management capability and is packaged in a 100 pin PQFP package.
ES1488: a single mixed signal 16-bit mono audio chip with integrated ESFM synthesizer. The ES1488 integrates digital logic and a microcontroller with audio CODEC and other analog functions onto one chip, and includes ESFM synthesis. The ES1488 is PC games compatible in SB mode and is compatible with Microsoft Windows and other operating systems. The ES1488 is socket compatible with the ES488 and provides a single chip alternative for the combined solution offered by the ES488 and the Yamaha OPL2 FM synthesis chip.
ES1688: a single mixed signal 16-bit stereo audio chip with integrated ESFM synthesizer. The ES1688 integrates digital logic and a microcontroller with audio CODEC and other analog functions onto one chip, and includes ESFM synthesis. The ES1688 is PC games compatible in SB and SB Pro modes and is compatible with Microsoft Windows and other operating systems. The ES1688 is socket compatible with the ES688 and provides a single chip alternative for the combined solution offered by the ES688 and the Yamaha stereo OPL3 FM synthesis chip.
ES1788: a single mixed signal 16-bit stereo audio chip with integrated ESFM synthesizer and game support. The ES1788 integrates digital logic and a microcontroller with audio CODEC and other analog functions onto one chip, and includes ESFM synthesis. The ES1788 is PC games compatible in SB and SB Pro modes and is compatible with Microsoft Windows and other operating systems. The ES1788 includes hardware volume control, 64 step volume control and dual game/joystick port for game support.
ES1868: a single mixed signal 16-bit stereo audio chip with integrated ESFM synthesizer, plug-and-play, full-duplex operation and game support. The ES1868 integrates digital logic and a microcontroller with audio CODEC and other analog functions onto one chip, and includes ESFM synthesis. The ES1868 is PC games compatible in SB and SB Pro modes and is compatible with Microsoft Windows and other operating systems. The ES1868 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 ES1868 also supports full-duplex operation with simultaneous record and playback with two DMA channels.
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 I(2)S interface to support Zoom Video port for MPEG audio. It also integrates circuitry to produce a three-dimensional sound effect from two speakers. Currently sampling.
ES1878: a single mixed signal 16-bit stereo audio chip with integrated ESFM synthesizer, full-duplex operation, Zoom Video support, and game support. The ES1878 integrates digital logic and a microcontrol-
ler with audio CODEC and other analog functions onto one chip, and includes ESFM synthesis. The ES1878 is PC games compatible in SB and SB Pro modes and is compatible with Microsoft Windows and other operating systems. The ES1878 includes hardware volume control, 64 step volume control and dual game/joystick port for game support. The ES1878 provides full plug-and-play support. The ES1878 also includes support for full-duplex operation with simultaneous record and playback, and it contains an I(2)S interface to support the PCMCIA Zoom Video port specification for MPEG input to PCs. The ES1878 provides full plug-and-play support and provides interface to a docking station unit.
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 also integrates hardware volume control, 64 steps volume control, dual game port for game, I(2)S 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. Sampling in Q2 1997.
ES1887: a single mixed signal 16-bit stereo audio chip with integrated ESFM synthesizer, full-duplex operation, game support and plug-and-play through the PC's BIOS. The ES1887 integrates digital logic and a microcontroller with audio CODEC and other analog functions onto one chip, and includes ESFM synthesis. The ES1887 is PC games compatible in SB and SB Pro modes and is compatible with Microsoft Windows and other operating systems. The ES1887 includes hardware volume control, 64 step volume control and dual game/joystick port for game support. The ES1887 also includes support for full-duplex operation with simultaneous stereo record and playback with two DMA channels. The ES1887 supports plug-and-play through the PC's BIOS.
ES1888: a single mixed signal 16-bit stereo audio chip with integrated ESFM synthesizer which supports full-duplex operation. The ES1888 integrates digital logic and a microcontroller with audio CODEC and other analog functions onto one chip, and includes ESFM synthesis. The ES1888 is PC games compatible in SB and SB Pro modes and is compatible with Microsoft Windows and other operating systems. The ES1888 includes hardware volume control, 64 step volume control and dual game/joystick port for game support. The ES1888 also includes support for full-duplex operation with simultaneous stereo record and playback with two DMA channels.
Wavetable Synthesizer Products
ES689: a wavetable music synthesizer chip. The ES689 is a high performance wavetable music synthesizer chip that is General MIDI compatible and offers 32 note polyphony. It provides a serial interface to the ES1688 internal digital-to-analog converter ("DAC") to provide an audio implementation that includes both wavetable and ESFM synthesis, or external DAC for wavetable synthesis. The ES689 interfaces to the ES981 or ES982 for one or two megabyte sound sample sets, respectively.
ES690: a wavetable music synthesizer chip with chorus and reverb sound effects. The ES690 is a high performance wavetable music synthesizer chip with chorus and reverb sound effects for enriched sound. The ES690 is General MIDI compatible and offers 32 note polyphony. It provides a serial interface to the ES1688 internal DAC to provide an audio implementation that includes both wavetable and ESFM synthesis, or external DAC for wavetable synthesis. The ES690 interfaces to the ES981 or ES982 for one or two megabyte sound sample sets, respectively.
ES981: a 512K x 16 wavetable ROM. The ES981 is a 512K x 16 read only memory ("ROM") with a General MIDI sound sample set for use with the ES689 and ES690.
ES982: a 1M x 16 wavetable ROM. The ES982 is a 1M x 16 ROM with a General MIDI sound sample set for use with the ES689 and ES690.
Multimedia System Chipsets
ES938: a sound effects processor. The ES938 provides enhanced sound effects by expanding monophonic and stereo sound to 3-D spatial soundfields. The ES938 also integrates bass and treble control.
ES968: a multi-function chip for multimedia add-in cards. The ES968 integrates plug-and-play support, MPU401 interface, dual game/joystick port and CD-ROM interface for Sony, Panasonic, Mitsumi and IDE drives in one chip.
ES978: a mixer expansion chip to support the ES1878 and ES1879 when building a PC Notebook and Docking Station PC system. The ES978 is an analog mixer chip which is placed in a docking station and interfaces directly with the ES1878 and ES1879 located inside the notebook. This interface provides an efficient structure for notebook and docking stations systems, requiring only six pins of the notebook to connect with all communications paths to the docking station.
Fax/modem 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 is using its highly efficient fax/modem technology, in combination with its leadership in audio technology, to provide high speed modem products integrated with audio capabilities. The ESS V.34 TeleDRIVE modem solutions for PC and add-in card manufacturers take advantage of this unique combination of technologies to deliver a cost-effective, upgradable communications solution.
TeleDRIVE Products
ES336V: a V.34bis chipset data/fax/voice controller-less modem solution. The ES336V provides base data, full duplex speaker phone, telephone answer machine ("TAM") and V.80 support for H.324 video conferencing applications. Currently sampling.
ES336D: a V.34bis chipset data/fax/voice controller-less modem solution with ITU-T computable V.70 Digital Simultaneous Voice and Data ("DSVD"). The ES336D is a superset of the ES336V and contains a programmable bus interface for support of both ISA and PCI busses. Currently sampling.
ES336CV/ES336DV: a ES336V/ES336D modem solution with 16-bit full duplex stereo. The ES336CV/ ES336CD combines a single mixed signal 16-bit stereo audio chip with integrated ESFM synthesizer, plug-and-play full-duplex operation and game support. Currently sampling.
Video Products
Multimedia applications are evolving at a rapid pace, primarily in response to increasing acceptance and use of the Internet and the introduction of new applications such as VCD, DVD, Digital set-top boxes and video conferencing. In its VideoDRIVE(TM)video chips, ESS offers integrated solutions to consumer electronics and PC manufacturers for use in a wide variety of next-generation multimedia applications utilizing MPEG-1 and MPEG-2 technology.
ESS provides OEM manufactures 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.
ESS also provides a programmable single chip processor which includes MPEG-2 audio/video/system and transport layer decoder, AC3 and video post-processing. These chips are designed for a variety of applications in consumer electronics such as set-top boxes and DVD player.
VideoDRIVE Products
ES3204: Single chip processor which includes MPEG-1 audio/video/system decoder for use in VCD players. The ES3204 incorporates video standards (NTSC/PAL) conversion, on-screen display, Karaoke functions, programmable playback control for VCD 2.0 and trick play mode features.
ES3207: Analog companion chip to MPEG decoder chips. The ES3207 provides echo, surround sound, 3D audio, TV encoder with clock generation and audio DAC functions. Sampling in Q2 1997.
ES3208: Single chip processor which includes MPEG-1 audio/video/system decoder for use in VCD players with an integrated SRAM and remote control interface logic. The ES3208 incorporates video standards (NTSC/PAL) conversion, on-screen display, Karaoke functions, programmable playback control for VCD 2.0, trick play mode features, an integrated SRAM and remote control interface logic. Currently sampling.
ES3210: Single chip processor which includes MPEG-1 audio/video/system decoder for use in portable VCD players. The ES3210 incorporates the ES3208 features of video standards (NTSC/PAL) conversion, on-screen display, Karaoke functions, programmable playback control for VCD 2.0, trick play mode features, an integrated SRAM and remote control interface logic in a smaller form factor allowing a more compact portable designs. Currently sampling.
ES3308: Single chip processor which includes MPEG-2 audio/video/system decoder for use in digital set-top boxes. The ES3308 incorporates video standards (NTSC/PAL) conversion, on-screen display and transport layer compliant with Digital Broadcast Signal standards. Currently sampling.
ES3309: Single chip processor which includes MPEG-2 audio/video/system decoder for use in DVD players. The ES3309 incorporates Dolby AC-3 decoder, video standards (NTSC/PAL) conversion, sub-picture unit, letter box conversion, on-screen display, navigation 1.0 and is compliant with DVD specifications. Sampling in Q2 1997.
Software and Support
ESS provides comprehensive support for its multimedia products including software that can be bundled with products that incorporate ESS AudioDRIVE chips. This software includes device drivers for Microsoft Windows 3.1, Windows NT and Windows 95, IBM OS/2 Warp, Intel NSP and PC games. 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.
CUSTOMERS
ESS sells its product principally to manufacturers of PCs and add-in boards. The following table shows representative customers worldwide:
- --------------- (1) Sales in Japan are made through a distributor.
A limited number of customers have historically accounted for a substantial portion of the Company's net revenues. In 1994, 1995 and 1996, sales to the Company's top five customers, including sales to the Company's international distributor, accounted for approximately 51%, 48% and 40%, respectively, of the Company's net revenues. In 1994, two customers, Compaq and Western Publishing, accounted for approxi-
mately 20% and 14%, respectively, of the Company's net revenues. In 1995, Compaq and Universe Electron Corporation, the Company's Japanese distributor, each accounted for approximately 17% of the Company's net revenues. The decline in the percentage of net revenues attributable to Western Publishing was a result of the Company's shift in product mix from toy and other consumer products to PC audio products. In 1996, Compaq and Universe Electron Corporation each accounted for approximately 12% and 13%, 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. For example, Compaq has been a significant customer of the Company since 1994. 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 manufacturers worldwide. In the United States, the Company markets its products through its direct sales force and manufacturer representatives.
In 1994, 1995 and 1996, international sales comprised approximately 72%, 73% and 92% of the Company's net revenues, respectively. The majority of the Company's international revenues in 1994, 1995 and 1996 have been derived from Asian customers who manufacturer PCs and PC-related add-in boards. 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 Taipei, Taiwan. To date, 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 is continuing to expand its Taiwan sales force and opened new customer and technical support centers in Beijing and Tokyo in order to support its broadening customer base. The Company's products are also sold internationally through a distributor located in Japan and manufacturer representatives located in China, Taiwan, Singapore, Korea, Hong Kong and Germany. To date, the Company has not had substantial sales to customers located in Europe, and the Company is seeking to expand its sales and distribution activities in Europe. The Company's manufacturer representatives and distributor are not subject to minimum purchase requirements and can discontinue marketing any of the Company's products at any time. In addition, the Company's manufacturers' 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 "Factor That May Effect 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 worldwide. Manufacturers' 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 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.
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 standards. The Company's strategy is to leverage its substantial base of audio technology and design expertise, analog, digital and mixed signal design and process technologies, and software and systems expertise to develop new PC audio solutions as well as other new products targeting opportunities in the multimedia PC and consumer market. The Company is currently engaged in the development of new PC audio products that provide
advanced sound effects. ESS has also developed new multimedia products for video, and fax/modem/voice applications. 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.
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. In addition, the Company opened a new design center in Austin, Texas in order to gain access to additional talented design engineers.
At December 31, 1996, ESS had a staff of 114 research and development personnel, 76 of which were involved in semiconductor design and process development and 38 of which were involved in software development. In addition, ESS has, on occasion, engaged outside developers to develop certain technologies to the Company's specifications and intends to increase its reliance on outside developers in the future. During 1994, 1995 and 1996, the Company spent approximately $3.7 million, $8.7 million and $20.3 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 acquisition of VideoCore Technology, Inc. ("VideoCore") and OSEE Technology, Inc. ("OSEE") in the first quarter of 1996.
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. 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, now a wholly owned subsidiary of the Company, is developing integrated circuits which will incorporate 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. OSEE, now a wholly owned subsidiary of the Company, is developing an advanced fax/modem V.34 and V.34bis algorithm technology which will enable the Company to offer fax/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.
MANUFACTURING
The Company contracts with independent foundries 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. The Company's products are currently manufactured by four independent foundries, all of 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 foundry arrangements with United Microelectronics Corporation ("UMC") in Taiwan, Sharp Corporation ("Sharp") in Japan and IC Works ("ICW") in California. Most of the Company's devices are currently fabricated using a mixed signal CMOS 0.6 and 0.5 micron process technology. The Company is currently developing new products and converting some existing products which will be manufactured utilizing a 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, with the exception of TSMC, manufacture products of their own design. In November 1995, the Company entered into long-term agreements with two of its foundries, TSMC and UMC. The Company intends to continue to work with its other foundries and to qualify new foundries to obtain additional
manufacturing capacity. There can be no assurance, however, that the Company will be able to obtain additional capacity when necessary.
Under the Company's agreement with TSMC, in exchange for TSMC's wafer capacity commitments for the years 1996 through 1999, the Company is obligated to pay approximately $32 million in two installments in 1996 and 1997. The Company also obtained an option to expand the TSMC wafer capacity commitments further for years 1997 through 2000. If the Company exercises its option, it would be obligated to pay an additional $31 million in two installments in 1997 and 1998. The Company is obligated to make payments whether or not it takes the wafers.
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 will invest approximately $26.4 million in three installments over the projected eighteen month period required to build the facility. Under the terms of the agreement, the Company will receive a 5% equity ownership in the joint venture company and capacity rights. The new fabrication facility is currently projected to commence production of 8-inch wafers in 1997.
All of the Company's semiconductor products are assembled and tested by third-party vendors, primarily Amkor ANAM in Korea, Advanced Semiconductor Engineering in Taiwan, ASAT in Hong Kong, Astra Microtronics in Indonesia and OSE in Taiwan. The Company has internally designed and developed its own test software and certain test equipment, which is 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.
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 semiconductor manufacturers. The Company expects competition to increase in the future from existing competitors and from other companies that may enter the Company's existing or future markets with products that may be at lower costs or provide higher levels of integration, higher performance or additional features. The Company is unable to predict the timing and nature of any such competitive product offerings. The announcement and commercial shipment of competitive products could adversely affect sales of the Company's products and may result in increased price competition that would adversely affect the average selling price ("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, particularly the PC market, are characterized by intense price competition. The willingness of prospective customers to design the Company's products into their products depends to a significant extent upon the ability of the Company to sell its products at a price that is cost-effective for such customers. As the markets for the Company's products mature and competition increases, the Company anticipates that prices for its products will continue to decline. If the Company is unable to reduce its costs sufficiently to offset declines in product prices or is unable to introduce more advanced products with higher product prices, the Company's business, financial condition and results of operations would be materially adversely affected.
The Company's existing and potential competitors consist principally of large domestic and international companies that have substantially greater financial, manufacturing, technical, marketing, distribution and other resources, greater intellectual property rights, broader product lines and longer-standing relationships with customers than the Company. The Company's competitors also include a number of smaller and
emerging companies. The Company's principal audio competitors include Cirrus Logic, Creative Technology, OPTi and Yamaha. The Company's principal video competitors include C-Cube, Hyundai, LSI Logic and SGS Thompson. The Company's principal fax/modem competitors include Cirrus Logic, Lucent, Rockwell 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.
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, 1996, the Company had 10 patents granted in the United States, which expire over time, commencing in 1997 and ending in 2011, and 9 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 manufactured or sold, including various countries in Asia, may not protect the Company's products or intellectual property rights to the same extent as do the laws of the United States and thus make the possibility of piracy of the Company's technology and products more likely. Although the Company is not aware of the development, distribution or sales of any illegal copies of the Company's hardware or software, any infringements of its patents, copyrights or trademarks, or any violation of its trade secrets, confidentiality procedures or 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. There is no pending intellectual property litigation against the Company. However, the Company or its foundries may from time to time receive notice of claims that the Company has infringed patents or other intellectual property rights owned by others. The Company may seek licenses under such patents or other intellectual property rights. However, there can be no assurance that licenses will be offered or that the terms of any offered licenses will be acceptable to the Company. The failure to obtain a license from a third party for technology used by the Company could cause the Company to incur substantial liabilities and to suspend the manufacture of products or the use by the Company's foundries of processes requiring the technology. Furthermore, the Company may initiate claims or litigation against third parties for infringement of the
Company's proprietary rights or to establish the validity of the Company's proprietary rights. Litigation by or against the Company could result in significant expense to the Company and divert the efforts of the Company's technical and management personnel, whether or not such litigation results in a favorable determination for the Company. In the event of an adverse result in any such litigation, the Company could be required to pay substantial damages, cease the manufacture, use and sale of infringing products, expend significant resources to develop non-infringing technology, discontinue the use of certain processes or obtain licenses for the infringing technology. There can be no assurance that the Company would be successful in such development or that such licenses would be available on reasonable terms, or at all, and any such development or license could require expenditures by the Company of substantial time and other resources. Although patent disputes in the semiconductor industry have often been settled through cross-licensing arrangements, there can be no assurance that, in the event that any third party makes a successful claim against the Company or its customers, a cross-licensing arrangement could be reached. In such a case, if a license is not made available to the Company on commercially reasonable terms, the Company's business, financial condition and results of operations could be materially adversely affected.
The Company currently licenses certain of the technology utilized by the Company in its products, and expects to continue to do so in the future. The Company has no current plans to grant licenses with respect to its products or technology; however, it may become necessary for the Company to enter into product licenses in the future in order, among other things, to secure foundry capacity. Although the Company has in the past granted licenses to certain of its technology, some of which have expired, such licenses have been limited and the Company has not derived material revenues from such licenses in recent periods.
EMPLOYEES
As of December 31, 1996, the Company had 253 full-time employees, including 114 in research and development, 60 in marketing, sales and support and 79 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.
ITEM 2.
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 anticipates that it will begin construction of additional buildings on the existing land in the spring of 1997.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
In March 1995, Yamaha filed a lawsuit against the Company alleging that the Company's FM synthesis products infringe two of Yamaha's patents, U.S. Patent No. 4,249,447 and U.S. Patent No. 4,813,326 (the "Yamaha Patents"). Yamaha initiated suit with a motion for a temporary restraining order and a request for a preliminary injunction. In addition, in its complaint, Yamaha sought a permanent injunction against future infringement, damages for past infringement, attorneys' fees and costs. Yamaha's lawsuit alleged infringement by all of the Company's FM synthesis chips, consisting at that time of the ES1488, ES1688, ES1788, ES1868 and ES1888. For 1995, the Company had revenues of approximately $52.9 million attributable to sales of these products, constituting approximately 50% of net revenues. Further, a substantial majority of the Company's revenues for the foreseeable future was, and still is expected to be dependent upon sales of these and future products incorporating FM synthesis. The lawsuit, entitled Yamaha Corporation vs. ESS
Technology, Inc., was filed in the U.S. District Court for the Central District of California in Los Angeles, California.
Yamaha's requests for a temporary restraining order and preliminary injunction were denied on March 17, 1995 and May 1, 1995, respectively. In its order denying the request for preliminary injunction, the District Court stated that its decision was based on an assessment of the likelihood of Yamaha's success on the merits, as well as a balance of the relative hardships that would be suffered by ESS or Yamaha as a result of the granting or denial of the preliminary injunction. Yamaha appealed the District Court's denial of the request for preliminary injunction to the U.S. Court of Appeals for the Federal Circuit. The hearing at the Federal Circuit took place on January 8, 1996, and on March 29, 1996 that Court confirmed the denial of the request for preliminary injunction.
On August 18, 1995 the District Court granted in part and denied in part a motion for summary judgment which had been filed by the Company. The District Court held that the Company's FM synthesis products did not literally infringe Yamaha's U.S. Patent No. 4,249,447, but held that there was a triable issue of fact as to the infringement of such patent on another basis. The Court also found triable issues of fact and, therefore, denied the Company's motion for summary judgment with regard to U.S. Patent No. 4,813,326.
On May 17, 1996, the Company and Yamaha settled all patent infringement litigation between the two companies. The settlement agreement did not have a material adverse affect on the Company's financial position or results of operations or on the Company's ability to sell its products or conduct its operations.
ITEM 4.
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, 1996.
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information regarding the Company's current executive officers:
Mr. Chan joined the Company in November 1985 as President and has been a director since January 1986. He was appointed Chairman of the Board of Directors in October 1992 and Chief Executive Officer in June 1994. Mr. Chan has been serving as President since February 1997. Mr. Chan served as Secretary from October 1992 to August 1995 and Chief Financial Officer from October 1992 to May 1995. From 1984 to 1985, Mr. Chan was founder, President and Chief Executive Officer of AC Design Inc., a VLSI chip design center providing CAD, engineering and design services. From 1982 to 1984, he was co-founder, President and Chief Executive Officer of CADCAM Technology, Inc., a company in the business of CAE systems development. Mr. Chan holds B.S.E.E. and M.S.C. degrees from the University of Hawaii. Mr. Chan is the husband of Annie M. H. Chan, a director of the Company.
Mr. Barnet joined the Company in September 1996 as Vice President, Finance, Chief Financial Officer and Secretary. Prior to joining the Company, he was Executive Vice President, Finance and Chief Financial Officer of Trimble Navigation Limited from 1993. From mid 1992 to mid 1993 he served as Senior Vice President, Finance and Chief Financial Officer of Centex Telemanagement, Inc., a telecommunications management company. From 1988 to 1992, he was Vice President, Finance and Chief Financial Officer of Acurex Corporation, a conglomerate engaged in military and commercial aerospace, environmental systems,
and industrial process controls. Previously he held executive positions at BankAmerica Corporation, Signetic Corporation and Teledyne, Inc. Mr. Barnet received a BS degree in Industrial Engineering from Stanford University in 1957 and an MBA degree from Columbia University Graduate Business School in 1961.
Dr. Wang has been Chief Technical Officer of the Company since December 1995. Prior to joining the Company he was a co-founder of Integrated Information Technology, a semiconductor company, and served as President and Chief Executive Officer from 1987 to December 1995. From 1981 to 1986, he was a co-founder of Weitek Corporation and served as Vice President of Engineering. Dr. Wang was a member of the technical staff of Hughes Aircraft Company from 1973 to 1976 and a project manager of Hewlett Packard from 1976 to 1981. He holds a M.S. degree in Physics from the California Institute of Technology and a Ph.D.E.E. from Stanford University.
Mr. Blair has been Executive Vice President, Operations of the Company since February 1997. From December 1994 to January 1997, he was Vice President of Operations of the Company. From December 1991 to November 1994, he was Senior Vice President Operations (Software Packaging & Printing Division) of Logistix Corporation, a software turnkey company, and, from 1989 to November 1991, he was Vice President and co-owner of Rock Canyon Investments, a real estate development planning firm in California. From 1986 to 1989, he held various positions at Xidex Corporation, a computer diskette manufacturer, including President/General Manager, at XEMAG, a division of Xidex Corporation. From 1973 to 1986 he was Vice President, High Reliability Operations at Precision Monolithics, Inc.
Mr. Ericsson joined the Company in November 1996 as Vice President of Marketing. Prior to joining the Company, he held various engineering and management positions with Cirrus Logic between 1990 and 1996. Mr. Ericsson's most recent position at Cirrus Logic was Vice President, Desktop PC Marketing, Planning and Business Development. From May 1995 to March 1996, Mr. Ericsson was Director of Strategic Marketing, Visual and Systems Interface Division. Mr. Ericsson held the position of Director of Marketing, Personal Systems Division between 1993 and 1995. From 1992 to 1993, Mr. Ericsson was Director of Multimedia, Strategic Planning. In 1990, Mr. Ericsson joined Cirrus Logic as Director of Software and Systems Architecture. Prior to joining Cirrus Logic, Mr. Ericsson was Software Engineering Manager at Chips and Technologies, a company he joined in 1987 as Senior Software Engineer. In 1984, Mr. Ericsson founded Micro Systemation AB, a communications software company in Stockholm, Sweden. From 1977 to 1981, Mr. Ericsson attended the Stockholm School of Economics. Between 1989 and 1994, Mr. Ericsson served in various functions within the Video Electronics Standards Association, including the position of Vice Chairman in 1991-92.
Mr. Aretakis has been Vice President, Sales of the Company since August 1994. Prior to joining the Company, he held sales positions in various semiconductor companies, including Director of OEM Sales at Media Vision, a computer peripherals manufacturer, from March 1993 to July 1994 and Director of Sales at SEEQ from 1988 to January 1993. From 1984 through 1988, Mr. Aretakis held various marketing positions at Microchip Technology Inc. Mr. Aretakis holds a B.S.E.E. degree from Columbia University and a B.A. degree in Mathematics from Hobart College.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER 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.
As of January 31, 1997, there were approximately 126 record holders of the Company's Common Stock.
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.
ITEM 6.
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.
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(1) See Note 1 of Notes to Consolidated Financial Statements for an explanation of weighted average common and common equivalent shares used to compute net income per share.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
ESS designs, develops and markets highly integrated mixed signal semiconductor multimedia solutions for sale to desktop and notebook personal computer manufacturers and consumer product companies. In 1996, ESS experienced four quarters of strong sequential growth, with revenues totaling a record $226.5 million, a 114% increase from the 1995 total of $105.7 million and seven-times revenues in 1994 of $33.4 million. Similarly, net income rose to $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, a 74% increase over 1995 net income of $29.9 million and six-times 1994 net income of $8.4 million. The gross margin for 1996 was 53%, declining from 63% in 1995 primarily due to price competition in the audio segment offset in part by manufacturing cost reductions.
The Company is a leader in single-chip audio solutions for both personal computers and consumer electronics products. Having established itself as a leading supplier of mixed signal PC audio components on a single chip, ESS entered both the video and fax/modem markets. 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 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. OSEE develops advanced fax/modem V.34 and V.34bis algorithm technology which will enable the Company to provide modem and computer fax/modem products under the trade-name TeleDRIVE. Both acquisitions were accounted for as a purchase, and the portion of the purchase prices attributable to research and development in-process was expensed in the first quarter of 1996.
After completing development of its first video product, the Company introduced its first VideoDRIVE product, a single-chip MPEG-1 video/audio/system decorder that provides full-screen, full-motion video and selectable CD-quality audio for a variety of digital video playback applications, such as karaoke players, VCD players, PC MPEG playback cards, and CD-XA video playback systems. Shipments of these chips to the VCD player market began in the second quarter of 1996. The Company also announced 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 set-top boxes, multimedia personal computers and home entertainment units. By year-end 1996, ESS had sold approximately 800,000 chips in the VideoDRIVE product line, comprising 7% of the Company's revenues for 1996.
The TeleDRIVE products for the Internet and other modem markets followed the Company's first quarter acquisition of OSEE. The Company introduced its integrated V.34bis modem solutions, the Company's first modem digital signal processor which is scheduled for production volumes in the first half of 1997.
As the Company expanded during 1996, the number of employees increased to 253 from 158, and it became increasingly important to invest in the Company's infrastructure to broaden and deepen the Company's management team. New senior executives have been hired whose skills and experience will help to continue ESS' growth.
1996 also marked significant physical expansion for the Company. At the end of 1995, ESS purchased 16 acres of land in Fremont, California, near ESS' previous facilities. By the end of 1996, the Company completed and occupied a two-story, 93,000-square-foot, world headquarters. The site has expansion capacity for three additional buildings, and the Company plans to begin construction of two of these buildings in the spring of 1997 to house additional engineering capacity and other needs.
With the Company's growth focused on the rapidly expanding Asia/Pacific region, ESS supplemented its existing sales and technical support centers with new centers in Beijing and Tokyo. The new centers are supporting the Company's new MPEG video products for VCD player, DVD player and set-top box products.
In addition, the Company opened a new design center in Austin, Texas, in order to gain access to additional talented design engineers.
RESULTS OF OPERATIONS
The following table sets forth certain items from the Company's consolidated statement of operations as a percentage of net revenues for the periods indicated.
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* Includes a one-time pre and post-tax charge of 13.4% related to acquired research and development in-process.
Net Revenues. Net revenues were $33.4 million, $105.7 million and $226.5 million in 1994, 1995 and 1996, respectively. Net revenues for 1996 increased 114% from 1995 primarily as a result of the increased sales growth of the Company's existing PC audio products as well as from the introduction of new PC audio and video semiconductor products. The Company's PC audio semiconductor products accounted for 92% of the Company's net revenues for 1996. Net revenues for 1995 increased 216% from 1994 primarily as a result of the sales growth of the Company's PC audio semiconductor products. The increase in PC audio semiconductor product sales was partially offset by a continued decrease in sales of the Company's consumer speech/sound semiconductors. International revenues accounted for approximately 72%, 73% and 92% of net revenues for 1994, 1995 and 1996, respectively. The increase in international sales as a percentage of net revenues between 1995 and 1996 primarily reflects the transfer of production by U.S. based PC customers from U.S. to Asia and growth in the sales of video products which are sold in Asian markets.
Gross Margin. Gross profit was $21.4 million, $66.2 million and $119.6 million in 1994, 1995 and 1996, respectively, representing 64.0%, 62.6% and 52.8% of net revenues for such years. Gross margin declined from 1995 to 1996 as a result of lower ASPs on existing products arising from highly competitive market conditions and manufacturing startup costs associated with the Company's new PC audio, video, and fax/modem products. Lower ASPs were partially offset by manufacturing cost reductions on existing products and higher ASPs associated with the introduction of new PC audio and video products. Gross margins declined from 1994 to 1995 as a result of a decrease in ASPs of the Company's PC audio products and manufacturing startup costs associated with the Company's new PC audio products. 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 single chip products and new features. In addition, the Company expects the overall average selling prices 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, cost reductions, new features and
product introductions. 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. Research and development expenses were $3.7 million, $8.7 million and $20.3 million, or 11.1%, 8.2% and 9.0% of net revenues, in 1994, 1995 and 1996, respectively, excluding a 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 of 1996. The increase in absolute dollars was primarily due to the increase in the Company's engineering staff, engineering test runs, masks, internal and external consulting expenses and one-time licensing fees associated with the research and development efforts to support the introduction of new multimedia products. The increase in absolute dollars in research and development expenses from 1994 to 1995 primarily reflected increases in the Company's engineering staff and internal and outside consulting expenses associated with increased research and development efforts to support the introduction of new PC audio products and multimedia products. The Company expects to incur higher absolute research and development expenses in 1997, 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 research and development expenses.
Selling, General and Administration Expenses. Selling, general and administrative expenses were $3.2 million, $9.8 million and $16.8 million, or 9.7%, 9.2% and 7.4% of net revenues, in 1994, 1995 and 1996, respectively. The increase in absolute dollars in selling, general and administration expenses from 1995 to 1996 was primarily due to increase in commissions and bonuses on higher sales volumes, increased personnel and related expenses resulting from Company's status as a public company. The increase in absolute dollars in selling, general and administrative expenses from 1994 to 1995 was primarily due to legal expenses associated with the Company's litigation with Yamaha. See "Item 3. Legal Proceedings" and Note 8 of Notes to Consolidated Financial Statements. The increase in these expenses was also due to commissions on higher sales levels, added personnel and related expenses and, to a lesser extent, promotional expenses and costs associated with the expansion of the Company's sales activities. The Company expects to incur higher selling, general and administrative expenses due to increased selling activities and reporting and other requirements of a public company, 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 (Expense), Net. Non-operating income, net was $283,000, $2,694,000 and $3,241,000 in 1994, 1995 and 1996, respectively. In 1994, 1995 and 1996 non-operating income (expense), net consisted of interest income net of interest expense and gains on sale of securities.
Provision for Income Taxes. The Company's effective tax rate was 43%, 41% and 61% for 1994, 1995 and 1996. The Company's tax rate for 1994 was higher than the combined federal and state statutory rate of 41% as a result of federal taxes provided on foreign earnings. The Company's tax rate for 1995 was at the combined federal and state statutory rate of 41%. The tax rate for 1996 of 61% includes 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. Pro forma tax rate excluding this one-time pre and post-tax charge of $30.4 million was 39%. The Company's pro forma tax rate for 1996 was lower than the combined federal and state statutory rate of 41% as a result of tax exempt interest income and research and development credits. 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, 1996, ESS had cash and cash equivalents and short-term investments of $69.2 million and working capital of $65.2 million. As of December 31, 1996, the Company had two $10.0 million bank lines of credit expiring on March 31, 1997 and May 1, 1997. These lines of credit require the Company to achieve certain financial ratios and operating results. There were no borrowing under these lines of credit as of December 31, 1996.
In 1996, the Company generated net cash from operating activities of $36.4 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 and depreciation and amortization of $3.2 million, less a gain on sale of short-term investments of $1.0 million and investment in working capital of $17.8 million. The Company received net proceeds of $7.1 million from sale of marketable equity securities, $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 equipment, repurchased stock for $19.7 million, paid $16.0 million on capacity commitments and $9.3 million for acquisition of VideoCore and OSEE. For the year, cash and cash equivalents declined $2.8 million.
In 1995, the Company generated net cash from operating activities of $13.5 million. This resulted from net income of $29.9 million, depreciation and amortization of $0.9 million less a gain on sale of marketable equity securities of $1.3 million and investments in working capital of $16.0 million. The Company received net proceeds of $60.8 million from the issuance of common stock related to its initial public offering. The Company purchased $24.9 million in short-term investments and invested $8.4 million in property and equipment. For the year, cash and cash equivalents increased $41.0 million.
In 1994, the Company generated net cash from operating activities of $5.1 million. This resulted from net income of $8.4 million, depreciation or amortization of $0.6 million less investments in working capital of $3.8 million. The Company received $1.3 million from the sale of marketable equity securities. The Company paid $2.7 million in short-term debt and invested $1.1 million in property and equipment. For the year, cash and cash equivalents increased $2.7 million.
The Company believes that its existing cash and cash equivalents as of December 31, 1996, together with the cash generated from operations and available borrowings under its line of credit, 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 $17 million of which approximately $7 million will be used to fund construction of additional facilities and approximately $10 million will be used to acquire capital equipment. In addition, the Company is obligated to pay approximately $16 million over the next 6 months to TSMC in exchange for certain wafer capacity commitments and will invest approximately $20 million in 2 installments over the next 6 months in exchange for equity ownership in a joint venture with UMC. 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. The Company also has bank lines of credit which may be utilized to provide additional cash.
FACTORS THAT MAY AFFECT FUTURE RESULTS
Except for the historical information contained in this Annual Report on Form 10-K, the matters discussed in this report are forward looking statements which involve risks and uncertainties that could cause actual results to differ from those indicated by such forward looking statements. Such risks and uncertainties include but are not limited to those set forth below. In any event, the matters set forth below should be carefully considered when evaluating the Company's business and prospects.
Potential Fluctuations in Operating Results. The Company's operating results are subject to quarterly and other fluctuations due to a variety of factors, including the gain or loss of significant customers, increased competitive pressures, changes in pricing policies by the Company, its competitors or its suppliers, including decreases in unit ASPs of the Company's products, the timing of new product announcements and introductions by the Company or its competitors and market acceptance of new or enhanced versions of the Company's and its customers' products. Other factors include the availability of foundry capacity, fluctuations in manufacturing yields, availability and cost of raw materials, changes in the mix of products sold, the cyclical nature of both the semiconductor industry and the market for PCs, seasonal customer demand, the timing of significant orders and significant increases in expenses associated with the expansion of operations. The Company's operating results could also be adversely affected by economic conditions generally in various
geographic areas where the Company or its customers do business, or order cancellations or rescheduling. These factors are difficult to forecast, and these or other factors could materially affect the Company's quarterly or annual operating results. There can be no assurance as to the level of sales or earnings that may be attained by the Company in any given period in the future. See "Management 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 Single Product Line and PC Industry. In 1995 and 1996, sales of PC audio semiconductors accounted for approximately 98% and 92%, respectively, of the Company's net revenues, and the Company expects that sales of audio semiconductors will continue to account for a majority of its net revenues for the foreseeable future. Any reduction in ASPs for audio products or demand for the Company's audio semiconductors, whether because of a reduction in demand for PCs in general or PC audio, 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 products as well as new multimedia products for the PC and consumer markets that provide capabilities such as video and fax/ modem/voice applications. There can be no assurance that the Company will be able to identify market trends or new product opportunities, develop and market new products, achieve design wins or respond effectively to new technological changes or product announcements by others. A failure in any of these areas would have a material adverse effect on the Company's business, financial condition and results of operations.
The Company's audio products are sold for incorporation into multimedia desktop and notebook computers. ESS audio semiconductors are incorporated into motherboards by multimedia PC original equipment manufacturers ("OEMs") or in add-in sound cards. Therefore, the Company is heavily dependent on the continued growth of the markets for multimedia desktop and notebook computers and multimedia applications utilizing high quality audio. There can be no assurance that these markets will be able to sustain continued growth. A slowing in unit volume and a decrease in ASPs could result in a decline in market revenues in the PC industry which could result in a corresponding decline in demand for the Company's products, which would have a material adverse effect on the Company's business, financial condition and results of operations. See "Item 1. Business -- Products."
Importance of New Products and Technological Change. The markets for the Company's products are characterized by evolving industry standards, rapid technological change and product obsolescence. The Company's success is highly dependent upon the successful development and timely introduction of new products at competitive price and performance levels. The success of new products depends on a number of factors, including timely completion of product development, market acceptance of the Company's and its customers' new products, securing sufficient foundry capacity for volume manufacturing of wafers, achievement of acceptable wafer fabrication yields by the Company's independent foundries and the Company's ability to offer new products at competitive prices. In order to succeed in having the Company's products incorporated into new products being designed by desktop and notebook computer manufacturers, the Company must anticipate market trends and performance and functionality requirements of such manufacturers and must successfully develop and manufacture products that meet 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. The Company is currently engaged in the development of new PC audio products as well as new multimedia products that provide telephony capabilities such as fax/modem/voice and video applications. 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 I. 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 Sharp, ICW, and UMC, which have been manufacturing certain of the Company's products since 1986, 1991 and 1995, respectively. TSMC, in particular, provides 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, with the exception of TSMC, 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 I. Business -- Manufacturing."
While the Company has entered into long-term agreements with two of its foundries, the Company's reliance on these and other 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. The Company expects to rely upon TSMC and UMC to manufacture a substantial majority 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, particularly at the levels that the Company currently expects TSMC and UMC to provide. Even if such capacity is available from another manufacturer, the qualification process could take six months or longer. The loss of any of its foundries as a supplier, the inability of the Company to acquire additional capacity at its current suppliers or qualify other wafer manufacturers for additional foundry capacity should additional capacity be necessary, or any other circumstances causing a significant interruption in the supply of semiconductors to the Company would have a material adverse effect on the Company's business, financial condition and results of operations.
To address potential foundry capacity constraints in the future, ESS will continue to consider and may be required to enter into additional arrangements, including equity investments in or loans to independent wafer manufacturers in exchange for guaranteed production capacity, joint ventures to own and operate foundries, or "take or pay" contracts that commit the Company to purchase specified quantities of wafers over extended periods. Any such arrangements could require the Company to commit substantial capital and grant licenses to its technology. The need to commit substantial capital may require the Company to obtain additional debt or equity financing, which could result in dilution to the Company's shareholders. There can be no assurance that such additional financing, if required, will be available when needed or, if available, will be obtained on terms acceptable to the Company.
Customer Concentration. A limited number of customers have accounted for a substantial portion of the Company's net revenues. In 1994, 1995 and 1996, sales to the Company's top five customers, including sales to the Company's international distributor, accounted for approximately 51%, 48% and 40% respectively, of the Company's net revenues. In 1994, two customers, Compaq and Western Publishing, accounted for approximately 20% and 14%, respectively, of the Company's net revenues. In 1995, Compaq and Universe Electron Corporation, the Company's Japanese distributor, each accounted for approximately 17% of the Company's net revenues. The decline in the percentage of sales attributable to Western Publishing reflects the Company's shift in product mix from toy and other consumer products to PC audio products. In 1996, Compaq and Universe Electron Corporation each accounted for approximately 12% and 13%, respectively, of the Company's net revenues. Sales to distributors are generally subject to agreements allowing limited rights of return and price protection with respect to unsold products. While the Company has not experienced returns and allowances in excess of the Company's reserves, returns and allowances in excess of reserves could have a material adverse impact on the Company's business, financial condition and results of operation. 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. For example, Compaq has been a significant customer of the Company since 1994. 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. 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, expense and inventory levels could be disproportionately high and the Company's business, financial condition and results of operations could be materially adversely affected.
Management of Growth. The Company has recently experienced significant growth in revenues 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 continue to improve its operational, financial and management information systems, implement additional systems and controls, and hire, train, motivate, manage and retain its employees. There can be no assurance that the Company will be able to manage such growth effectively, and the failure to do so could have a material adverse effect on the Company's business, financial condition and results of operations.
International Operations. During 1994, 1995 and 1996, international sales, accounted for approximately 72%, 73% and 92% of the Company's net revenues, respectively. Substantially all of the Company's international sales were to customers in Taiwan, Japan, Hong Kong and Singapore. The Company expects that international sales will continue to represent a significant portion of its net revenues for the foreseeable future. In addition, substantially all of the Company's products are manufactured, assembled and tested by independent third parties in Asia. Due to its reliance on international sales and foreign third-party manufacturing, assembly and testing operations, the Company is subject to the risks of conducting business outside of the United States. These risks include unexpected changes in, or impositions of legislative or regulatory requirements, delays resulting from difficulty in obtaining export licenses for certain technology, tariffs, quotas and other trade barriers and restrictions, longer payment cycles, greater difficulty in accounts receivable collection, potentially adverse taxes, the burdens of complying with a variety of foreign laws and other factors beyond the Company's control. The Company is also subject to general geopolitical risks in connection with its international trade relationships. In particular, mainland China, which represents a large potential market for the Company's products, has recently experienced the death of its leader Deng Xiaoping. Should the death of Deng Xiaoping result in instability in the government, it is possible that sales to mainland China will be impeded. Such instability could also lead to disruption in the Company's ability to trade with Taiwan, which represents a majority of the Company's sales and is the location of its major foundries and two test facilities. Should such disruption occur, it is possible that purchases by Taiwanese customers will decline and semiconductor manufacturing in Taiwan will be impeded, cutting off the Company's main supply of guaranteed wafer production. This could also lead to capacity constraints at non-Taiwanese foundries. Although the Company has not to date experienced any material adverse effect on its business, financial condition or results of operations as a result of such regulatory, geopolitical and other factors, there can be no assurance that such factors will not have a material adverse effect on the Company's business, financial condition and results of operations in the future or require the Company to modify its current business practices.
In addition, the laws of certain foreign countries in which the Company's products are or may be manufactured or sold, including various countries in Asia, may not protect the Company's products or
intellectual property rights to the same extent as do the laws of the United States and thus make the possibility of piracy of the Company's technology and products more likely. Currently, all of the Company's product sales and all of its arrangements with foundries and assembly and test vendors, other than its foundry arrangement with Sharp Corporation, provide for pricing and payment in U.S. dollars. To date, although the effect of currency fluctuations have been insignificant, there can be no assurance that fluctuations in currency exchange rates will not have a material adverse effect on the Company's business, financial condition and results of operations. In addition, 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. Although the semiconductor industry in recent periods has experienced increased demand, it is uncertain how long these conditions will continue. The Company may experience substantial period-to-period fluctuations in operating results due to general semiconductor industry conditions.
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. See "Item 1. Business -- Patents and Proprietary Rights."
Dependence on Key Personnel. The Company's success depends to a significant degree upon the continued contributions of Fred S.L. Chan, the Company's Chief Executive Officer and Chairman of the Board of Directors. As of January 31, 1997, Mr. Chan, together with his spouse, Annie M.H. Chan, a director of the Company and certain trusts for the benefit of the Chan's children and certain charities beneficially own, in the aggregate, approximately 41% of the Company's Common Stock. The 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. Recently, the Company has hired a number of key executives and management personnel. 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 January 31, 1997, Fred S.L. Chan, the Company's Chief Executive Officer and Chairman of the Board of Directors, together with his spouse, Annie M. H. Chan, a director of the Company, and certain other shareholders related to Mr. and Mrs. Chan owned, in the aggregate, 41% 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 acquiror from making a tender offer or otherwise attempting to obtain control of the Company.
Shares Eligible for Future Sale. As of January 31, 1997, the Company had approximately 38,307,036 shares of Common Stock outstanding. Of such shares, 22,406,639 shares are freely tradable and the remaining 15,900,397 shares are restricted shares ("Restricted Shares") under the Securities Act of 1933, as amended (the "Securities Act") and are eligible for sale in the public market, subject to certain volume and resale restrictions pursuant to Rule 144.
Possible Volatility of Stock Price. The price of the Company's Common Stock has in the past and may continue in the future to fluctuate widely. Future announcements concerning the Company, its competitors or
its principal customers, including quarterly operating results, changes in earnings estimates by analysts, technological innovations, new product introductions, governmental regulations or litigation may cause the market price of the Common Stock to continue to fluctuate substantially. Further, in recent years the stock market has experienced extreme price and volume fluctuations that have particularly affected the market prices of equity securities of many high technology companies and that often have been unrelated or disproportionate to the operating performance of such companies. These fluctuations, as well as general economic, political and market conditions such as recessions or international currency fluctuations, may materially adversely affect the market price of the Common Stock.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Accountants
Consolidated Balance Sheets as of December 31, 1996 and 1995
Consolidated Statements of Operations for the years ended December 31, 1996, 1995 and 1994
Consolidated Statements of Shareholders' Equity for the years ended December 31, 1996, 1995 and 1994
Consolidated Statements of Cash Flows for the years ended December 31, 1996, 1995 and 1994
Notes to Consolidated Financial Statements
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 cash flows present fairly, in all material respects, the financial position of ESS Technology, Inc. and its subsidiaries at December 31, 1995 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, 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.
Price Waterhouse LLP San Jose, California January 17, 1997
ESS TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1995 AND 1996 (AMOUNTS IN THOUSANDS)
The accompanying notes are an integral part of these financial statements.
ESS TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996 (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The accompanying notes are an integral part of these financial statements.
ESS TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996 (AMOUNTS IN THOUSANDS)
The accompanying notes are an integral part of these financial statements.
ESS TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996 (AMOUNTS IN THOUSANDS)
The accompanying notes are an integral part of these financial statements.
ESS TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. THE COMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES
ESS Technology, Inc. (the "Company") was incorporated in California in February 1984. The Company and its wholly-owned subsidiaries design, develop and market highly integrated mixed signal semiconductors and software solutions for multimedia applications in the PC and consumer marketplaces.
In October 1995, the Company completed its initial public offering of 8,050,000 shares of common stock including the shares from an over-allotment option. Of the total shares offered, 4,427,500 were sold by the Company and 3,622,500 shares were sold by shareholders. Net proceeds to the Company were $61,763,000 before deducting offering expenses of $1,081,000.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.
Use of Estimates and Assumptions
The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.
Cash and Cash Equivalents and Short-Term Investments
The Company considers all highly liquid investments with an initial maturity of 90 days or less to be cash equivalents and investments with original maturity dates of greater than 90 days to be short-term investments. The Company accounts for its short-term investments under Financial Accounting Standard No. 115, "Accounting for Certain Investments in Debt or Equity Securities" (SFAS 115), which requires investment securities to be classified as either held to maturity, trading or available for sale.
All of the Company's short-term investments, comprising primarily debt instruments with contractual maturities of less than two years have been classified as available for sale. Management determines the appropriate classification of securities at the time of purchase and reevaluates the classification at each reporting date. Interest income is accrued as earned. At December 31, 1996, the fair value of the Company's investments approximated cost.
Inventories
Inventories are stated at the lower of cost or market, with cost being determined by the first-in, first-out (FIFO) method.
Property and Equipment
Property and equipment are stated at cost. Depreciation of property and equipment is provided using the straight-line method over estimated useful lives that range from 3 to 5 years for machinery and equipment and furniture and fixtures and 4 to 30 years for buildings and building improvements.
Revenue Recognition
Revenue from product sales is recognized at the time of shipment. Sales to distributors are generally subject to agreements allowing limited rights of return and price protection with respect to unsold products held by the distributor. Reserves for estimated returns and price adjustments are provided at the time revenue
ESS TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
is recognized. Such reserves are calculated based on historical rates of returns and allowances, distributor inventory levels and other factors.
Research and Development
Research and development costs are expensed as incurred.
Income Taxes
The Company accounts for income taxes under an asset and liability approach that requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. U.S. deferred income taxes are provided on unremitted earnings of the Company's foreign subsidiary to the extent that such earnings are not considered permanently invested.
Stock Based Compensation
The Company accounts for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued to Employees" and related Interpretations. The Company's policy is to grant stock options with an exercise price equal to the quoted market price of the Company's stock on the day prior to the grant date. In 1996, the Company adopted SFAS 123, "Accounting for Stock Based Compensation" for disclosure purpose.
Net Income per Share
Net income per share is computed using the weighted average number of common and common equivalent shares ("weighted average shares") outstanding during the period. Common equivalent shares consist of the Company's common stock issuable upon exercise of stock options (using the treasury stock method), except when antidilutive. Common stock issued and stock options granted subsequent to July 31, 1994 through October 5, 1995 (the date of the initial public offering) have been included in the calculation of weighted average shares outstanding as if they were outstanding for reporting periods occurring between these dates. The Company used the treasury stock method and the initial public offering price of $15.00 per share for these calculations.
ESS TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
2. BALANCE SHEET COMPONENTS (IN THOUSANDS)
ESS TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
3. DEBT
On November 16, 1995, the Company entered into an unsecured short-term line of credit agreement with a foreign bank totaling $10 million which expires on March 31, 1997. Under the terms of the agreement, the Company may borrow at a fixed rate of LIBOR plus 1% or a variable rate at the foreign bank's reference rate minus 1%. On May 15, 1996, the Company entered into a second unsecured short-term line of credit agreement totaling $10 million which expires on May 1, 1997. Under the terms of the agreement, the Company may borrow at a variable rate of either LIBOR plus 1% or at the bank's reference rate minus 1%. Both lines of credit require the Company to achieve certain financial ratios and operating results, and the Company was in compliance with the financial covenants at December 31, 1996. There were no borrowings under the lines of credit as of December 31, 1996.
4. INCOME TAXES
Income before provision for income taxes consisted of the following:
Provision for income taxes consisted of the following:
ESS TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
A reconciliation between the provision for income taxes computed at the federal statutory rate of 35% for the year ended December 31, 1994, 1995 and 1996 and the provision for income taxes is as follows:
Deferred tax assets (liabilities) are comprised of the following:
The Internal Revenue Service completed its examination of the Company's federal income tax returns for 1991 to 1993. The outcome of these examinations had no material adverse impact on the Company's financial position or results of operations.
5. SHAREHOLDERS' EQUITY
Common Stock
On July 15, 1996, the Company's Board of Directors authorized repurchase at management's discretion of up to 2.0 million of the Company's shares of common stock over the subsequent 12 months at market prices and as the market and business conditions warrant. At December 31, 1996, the Company had repurchased 1,802,500 shares at market prices ranging from $9.41 to $16.75 per share.
1986 Stock Option Plan
In February 1986, the Company adopted the 1986 Stock Option Plan (the "1986 Plan"). Under the 1986 Plan, 3,600,000 shares of common stock were reserved for issuance to employees, consultants and investors as approved by the Board of Directors. The 1986 Plan provides for incentive stock options and the Board may terminate the 1986 Plan at any time. Options under the Plan are granted, subject to certain conditions, at estimated fair value as determined by the Board of Directors. Options granted under the 1986 Plan generally
ESS TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
vest 25% each year after the date of grant. Options are adjusted on a pro rata basis for certain changes in the capitalization of the Company, such as stock splits and stock dividends. In addition, the outstanding options issued under the 1986 Plan terminate within 90 days after termination of an option holder's employment with the Company.
1992 Stock Option Plan
In January 1992, the Company adopted the 1992 Stock Option Plan (the "1992 Plan"). The 1992 Plan authorized 6,966,000 shares to be reserved for issuance. The terms of the 1992 Plan are generally similar to those of the 1986 Plan outlined above.
Executive Plan
In January 1990 and March 1991, the Company granted 5,400,000 and 1,080,000 options, respectively, outside of the 1986 Plan to officers of the Company under the Executive Plan. The options were granted at the then fair value of $0.083 per share, as determined by the Board of Directors. The options generally vested over periods of one to four years.
Equity Incentive Plan
In August 1995, the Company adopted the 1995 Equity Incentive Plan (the "Incentive Plan"), which provides for the grant of stock options and stock bonuses and the issuance of restricted stock by the Company to its employees, directors and others. The Company has reserved 3,000,000 shares of the Company's Common Stock for issuance under the Incentive Plan.
In September of 1996, the Company canceled 326,000 shares under the Incentive Plan with exercise prices greater than $14.75 and reissued the options with an exercise price of $14.75.
Employee Stock Purchase Plan
In August 1995, the Company adopted the 1995 Employee Stock Purchase Plan (the "Purchase Plan") and reserved a total of 225,000 shares of the Company's Common Stock for issuance thereunder. The Purchase Plan permits eligible employees to acquire shares of the Company's Common Stock through payroll deductions.
Directors Plan
In August 1995, the Company adopted the Directors Plan and reserved a total of 300,000 shares of the Company's Common Stock for issuance thereunder. The Directors Plan allows for granting of stock options to members of the Board of Directors of the Company.
ESS TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Stock Based Compensation:
Transactions under the Company's various Stock Option Plans are summarized as follows (in thousands except per share amounts):
The options exercisable at December 31, 1996 was 786,000. The weighted average grant date fair value of options granted during the years ended December 31, 1995 and 1996 were $2.16 and $8.68, respectively.
The following table summarizes information about stock options outstanding at December 31, 1996:
ESS TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Fair Value Disclosures
The Company's net income (loss) and pro forma net income per share would have been as follows had compensation costs for options granted in 1995 and 1996 under the Company's option plans been determined based on the fair value at the grant dates, as prescribed in FAS 123, (in thousands except per share amounts):
The fair value of each option grant is estimated on the date of grant using the Black-Scholes model with the following assumptions used for grants during the applicable period: dividend yield of 0.0% for both periods; expected volatility of 0% for the period between January 1, 1995 through October 5, 1995 (the date of the initial public offering), expected volatility of 65% to 69% for the period between October 6, 1995 and December 31, 1995 and 63% to 65% for the year ended December 31, 1996; risk-free interest rates of 5.51% to 7.05% during the year ended December 31, 1995 and 5.97% to 6.69% for options granted during the year ended December 31, 1996; and a weighted average expected option term of 5 years for both periods.
Sales under the Purchase Plan in 1996 were approximately 47,000 shares at average price of $13.19 per share. Compensation cost (included in pro forma net income and net income per share amounts) for the grant date fair value, as defined by SFAS 123, of the purchase rights granted under the Purchase Plan was calculated using the Black-Scholes model with the following assumptions for 1995 and 1996, respectively: an expected life of six months for both periods; expected volatility of 63% and 69%; expected dividend yield of 0% for both periods and risk-free interest rate of 5.81% and 5.31%. The weighted average estimated grant date fair value, as defined by SFAS 123, of rights to purchase stock under the Purchase Plan in 1995 and 1996 were $7.50 and $5.34 per share, respectively.
Because additional option grants are expected to be made each year, the above pro forma disclosures are not representative of pro forma effects of reported net income for future years.
6. INDUSTRY SEGMENT AND FOREIGN OPERATIONS
The Company and its wholly-owned subsidiaries are engaged in the design, manufacture and marketing of semiconductors and software solutions for multimedia applications in the PC and consumer marketplaces. Sales and purchase transactions are generally denominated in U.S. dollars.
ESS TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following is a summary of the Company's geographic operations:
Sales by ESS (Far East) and foreign sales by ESS (U.S.) are primarily to customers in the Pacific Rim, and to a lesser extent to customers in Europe.
7. SIGNIFICANT CUSTOMERS AND CONCENTRATION OF RISK
Financial instruments that potentially subject the Company to concentration of credit risk consist primarily of cash equivalents, short-term investments and trade accounts receivable. Cash equivalents and short-term investments which primarily comprised of investments in money market funds and municipal debt instruments, are maintained with high quality institutions and the composition and maturities are regularly monitored by management.
The following table summarizes the percentage of net revenues accounted for by the Company's significant customers.
A majority of the Company's trade receivables are derived from sales to manufacturers of computer systems. The Company generally extends 30-day credit terms to its customers, which is consistent with industry business practices. The Company performs ongoing credit evaluations of its customers' financial condition and generally, requires letters of credit from international customers. The Company maintains an allowance for doubtful accounts on its receivables based upon the expected collectibility of all accounts receivable. To date, the Company has not incurred any significant losses due to uncollectible accounts receivable. At December 31, 1996 and 1995, approximately 30% and 35%, respectively, of trade accounts receivable represent amounts due from two customers.
8. LITIGATION
In March 1995, the Company was served with a patent infringement claim in which Yamaha Corporation ("Yamaha") claimed that the Company's ESFM products infringe upon patents held by Yamaha. The complaint sought an injunction against future infringement, damages for past infringement, fees and costs. If
ESS TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
the Company had been found to be infringing a valid Yamaha patent, then the Company might have been required to cease the sale of ESFM products, which represent a significant portion of the Company's revenues.
Management had investigated Yamaha's claims and discussed them with its patent counsel, who was consulted early during the design and development of the allegedly infringing ESFM products. On May 1, 1995, the U.S. District Court in Los Angeles denied the plaintiff's request for a preliminary injunction. Yamaha appealed the District Court's denial of the request for preliminary injunction to the U.S. Court of Appeals for the Federal Circuit. The hearing at the Federal Circuit took place on January 8, 1996, and on March 29, 1996 that Court confirmed the denial of the request for preliminary injunction.
On August 18, 1995 the District Court granted in part and denied in part a motion for summary judgment which had been filed by the Company. The District Court held that the Company's FM synthesis products did not literally infringe Yamaha's U.S. Patent No. 4,249,447, but held that there was a triable issue of fact as to the infringement of such patent on another basis. The Court also found triable issues of fact and, therefore, denied the Company's motion for summary judgment with regard to U.S. Patent No. 4,813,326.
On May 17, 1996, the Company and Yamaha settled all patent infringement litigation between the two companies. The settlement agreement did not have a material adverse effect on the Company's financial position or results of operations.
9. WAFER CAPACITY COMMITMENTS
In November 1995, the Company entered into agreements with two wafer foundries, TSMC and UMC, in which the Company secured access to additional manufacturing capacity and to certain technology.
Under the TSMC agreement, in exchange for TSMC's increased wafer capacity commitments, the Company committed to pay approximately $32 million over two years as deposits for wafers through 1999. The cash requirements associated with this agreement are two $16 million payments due on June 30, 1996 and 1997. The Company issued two promissory notes in the sum of $32 million securing these payments. The Company made the first $16 million installment payment by making payments of $12.6 million and $3.4 million on June 28 and July 1, 1996, respectively. The Company also obtained an option to expand the TSMC wafer capacity commitments further for years 1997 through 2000. If the Company exercises its option to commit TSMC to additional wafer capacity, the Company would be committed to an additional $30.8 million in deposits to be paid in two $15.4 million payments due on June 30, 1997 and 1998. If the Company is not able to use, assign, or sell the additional wafer quantities, a portion of the deposits may be forfeited.
Under the UMC agreement, the Company entered into a joint venture arrangement with UMC, together with other US semiconductor companies, to build a separate semiconductor manufacturing facility located in Taiwan at an estimated cost of $1 billion. The Company will invest approximately $26.4 million in three installments over the projected eighteen-month period required to build the facility. The Company made the first installment payment of $6.9 million and accrued for the second installment payment of $13.0 million in 1996. The Company will invest the remaining installment of $6.5 million during the next six months. Under the terms of the agreement, the Company will receive a 5% equity ownership in the joint venture company and certain capacity rights.
10. ACQUISITIONS AND RELATED CHARGES
On January 3, 1996, the Company completed its acquisition of VideoCore Technology, Inc. ("VideoCore"), a California based company, 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, now a wholly owned subsidiary of the Company, is developing integrated circuits which will incorporate advanced compression technology for digital video products. On March 29, 1996, the Company completed its acquisition of OSEE Technology, Inc. ("OSEE"), a California based company,
ESS TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
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, now a wholly owned subsidiary of the Company, is a developer of advanced fax/modem V.34 and V.34bis algorithm technology which will enable the Company to provide modem and computer fax/modem applications on the Company's multimedia processor.
The purchase price of these companies was allocated to assets acquired and facilities assumed based upon the book value of VideoCore's and OSEE's current assets, equipment and facilities, which management believes approximates their fair value, and independent appraisal for all other identifiable assets as follows:
These acquisitions were recorded using the purchase method of accounting and accordingly, the results of operations and cash flows of such acquisitions have been included from the applicable dates of acquisition. The acquired research and development in-process aggregating $30.4 million was charged to expense in the first quarter of 1996. Additionally, the pro forma effect of these acquisitions was not significant on the Company's reported operating results for 1996 or 1995.
SELECTED QUARTERLY OPERATING RESULTS (UNAUDITED)
The following table presents unaudited quarterly financial information for each of the Company's last eight quarters. This information has been derived from the Company's unaudited financial statements and has been prepared on the same basis as the audited Consolidated Financial Statements appearing elsewhere in this Form 10-K. In the opinion of management, all necessary adjustments, consisting only of normal recurring adjustments, have been included to present fairly the quarterly results.
The following table sets forth the above quarterly financial information as a percentage of net revenues:
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
Not applicable.
PART III
Certain information required by Part III is omitted from this Report since the Company plans to file with the Securities and Exchange Commission the definitive proxy statement for its 1997 Annual Meeting of Shareholders (the "Proxy Statement") not later than 120 days after the end of the fiscal year covered by this Report, and certain information included therein is incorporated herein by reference.
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information concerning the Company's directors required by this Item is incorporated by reference to the section in the Company's Proxy Statement entitled "Proposal No. 1 -- Election of Directors -- Directors/Nominees."
The information concerning the Company's executive officers required by this Item is incorporated by reference herein to Part I, Item 4A, entitled "Executive Officers of the Registrant" on page 12 of this Report.
The information concerning compliance with Section 16 of the Securities Exchange Act of 1934 is incorporated by reference to the section in the Company's proxy statement entitled "Compliance under Section 16(a) of the Securities Exchange Act of 1934."
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item is incorporated by reference to the sections in the Company's Proxy Statement entitled "Executive Compensation," "Compensation of Directors and "Compensation Committee Interlocks and Insider Participation."
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item is incorporated by reference to the section in the Company's Proxy Statement entitled "Security Ownership of Certain Beneficial Owners and Management."
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item is incorporated by reference to the section in the Company's Proxy Statement entitled "Certain Transactions."
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this Report:
1. FINANCIAL STATEMENTS. The following Consolidated Financial Statements of ESS Technology, Inc. are included in Item 8.
Report of Independent Accountants Consolidated Balance Sheets as of December 31, 1996 and 1995 Consolidated Statements of Operations for the years ended December 31, 1996, 1995 and 1994 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1996, 1995 and 1994 Consolidated Statements of Cash Flows for the years ended December 31, 1996, 1995 and 1994
Notes to Consolidated Financial Statements
2. FINANCIAL STATEMENT SCHEDULES. Financial statement schedules have been omitted because the information called for is not required or is shown either in the Consolidated Financial Statements or Notes thereto.
3. EXHIBITS
- --------------- * Represents a management contract or compensatory plan of arrangement.
** Confidential treatment has been granted with respect to certain portions of this agreement.
*** Confidential treatment has been requested with respect to certain portions of this agreement.
(b) Reports on Form 8-K: The Company did not file a report on Form 8-K during the quarter ended December 31, 1996.
With the exception of the information incorporated by reference to the Company's Proxy Statement for the 1997 Annual Meeting of Shareholders in Items 10, 11, 12 and 13 of Part III, the Proxy Statement is not deemed to be filed as part of this Report.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Amendment to Report to be signed on its behalf by the undersigned, thereunto duly authorized.
ESS TECHNOLOGY, INC.
Dated: March 18, 1997 By: /s/ JOHN H. BARNET ------------------------------------ John H. Barnet Vice President, Chief Financial Officer and Secretary
INDEX TO EXHIBITS
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* Represents a management contract or compensatory plan of arrangement.
** Confidential treatment has been granted with respect to certain portions of this agreement.
*** Confidential treatment has been requested with respect to certain portions of this agreement.
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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
EXHIBITS TO
FORM 10-K
REGISTRATION STATEMENT
Under
THE SECURITIES ACT OF 1933
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ESS TECHNOLOGY, INC. ------------------------
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