Item 1.
Business
Proposed Merger
On February 21, 2008, ESS Technology, Inc., a California corporation (“ESS California”), Echo Technology (Delaware), Inc., a Delaware corporation and a wholly owned subsidiary of ESS California (“Delaware Merger Subsidiary”), Semiconductor Holding Corporation, a Delaware corporation and wholly owned subsidiary of Imperium Master Fund, Ltd. (“Parent”), and Echo Mergerco, Inc., a Delaware corporation and a wholly owned subsidiary of Parent (“Merger Subsidiary”) entered into an Agreement and Plan of Merger (the “Merger Agreement”) pursuant to which (i) ESS California will, subject to the satisfaction or waiver of the conditions set forth in the Merger Agreement, merge with and into Delaware Merger Subsidiary (the “Reincorporation Merger”), the separate corporate existence of ESS California shall cease and Delaware Merger Subsidiary shall be the successor or surviving corporation of the merger (“ESS Delaware”), and (ii) following the Reincorporation Merger, Merger Subsidiary will, subject to the satisfaction or waiver of the conditions set forth in the Merger Agreement, including the consummation of the Reincorporation Merger, merge with and into ESS Delaware (the “Merger”), the separate corporate existence of Merger Subsidiary shall cease and ESS Delaware shall be the successor or surviving corporation of the merger and wholly owned subsidiary of the Parent.
Upon the consummation of the Reincorporation Merger, ESS California will become a Delaware corporation, each share of ESS California common stock will be converted into one share of ESS Delaware common stock and each option to acquire ESS California common stock granted pursuant to ESS California’s stock plans and outstanding immediately prior to the consummation of the Reincorporation Merger, whether vested or unvested, exercisable or unexercisable, will be automatically converted into the right to receive an option to acquire one share of ESS Delaware common stock for each share of ESS California common stock subject to such option, on the same terms and conditions applicable to the option to purchase ESS California common stock (each, an “ESS Delaware Option”).
Upon the consummation of the Merger, (i) ESS Delaware will become a wholly owned subsidiary of Parent and (ii) each share of ESS Delaware common stock will be converted into the right to receive $1.64 in cash, unless the stockholder properly exercises appraisal rights. In addition, each ESS Delaware Option, whether vested or unvested, exercisable or unexercisable, will be converted into the right to receive an amount in cash equal to the product obtained by multiplying (x) the aggregate number of shares of ESS Delaware common stock subject to such ESS Delaware Option and (y) the excess, if any, of the Merger Consideration less the exercise price per share of ESS Delaware common stock subject to such ESS Delaware Option, after which it shall be cancelled and extinguished.
The parties to the Merger Agreement intend to consummate the Merger as soon as practicable after the Reincorporation Merger and ESS California will not consummate the Reincorporation Merger unless the parties are in a position to consummate the Merger. ESS California and Delaware Merger Subsidiary have made customary representations and warranties in the Merger Agreement and agreed to certain customary covenants, including covenants regarding operation of the business of ESS California and its subsidiaries, including Delaware Merger
Subsidiary, prior to the closing and covenants prohibiting ESS California from soliciting, or providing information or entering into discussions regarding, proposals relating to alternative business combination transactions, except in limited circumstances to permit the board of directors of ESS California to comply with its fiduciary duties under applicable law.
The transactions contemplated by the Merger Agreement are subject to ESS California shareholder approval, delivery of ESS California’s audited financial statements for the year ended December 31, 2007 and other customary closing conditions. The Merger Agreement contains certain termination rights for both ESS California and Parent and further provides that, upon termination of the Merger Agreement under certain circumstances, ESS California may be obligated to pay Parent a termination fee of $1,981,000 plus reimbursement of Parent’s and its affiliates’ reasonable expenses incurred in connection with the transactions contemplated by the Merger Agreement up to, but not in excess of, $500,000.
The Merger Agreement contains representations and warranties by ESS California and Delaware Merger Subsidiary, on the one hand, and by Parent and Merger Subsidiary, on the other hand, made solely for the benefit of the other. The assertions embodied in those representations and warranties are qualified by information in confidential disclosure schedules that the parties have exchanged in connection with signing the Merger Agreement. The disclosure schedules contain information that modifies, qualifies and creates exceptions to the representations and warranties set forth in the Merger Agreement. Moreover, certain representations and warranties in the Merger Agreement were made as of a specified date, may be subject to a contractual standard of materiality different from what might be viewed as material to shareholders, or may have been used for the purpose of allocating risk between ESS California and Delaware Merger Subsidiary, on the one hand, and Parent and Merger Subsidiary, on the other hand. Accordingly, the representations and warranties and other disclosures in the Merger Agreement should not be relied on by any persons as characterizations of the actual state of facts about ESS California, Delaware Merger Subsidiary, Parent or Merger Subsidiary at the time they were made or otherwise.
The Company
ESS Technology, Inc. was incorporated in California in 1984 and became a public company in 1995. We have historically operated in two primary business segments, Video and Digital Imaging, both in the semiconductor industry serving the consumer electronics and digital media marketplace.
In our Video business, we design, develop and market highly integrated analog and digital processor chips and digital amplifiers. Our digital processor chips drive digital video and audio devices, including DVD players, Video CD (“VCD”) players, consumer digital audio players and digital media players. We continue to sell certain legacy products we have in inventory including chips for use in recordable DVD players, modems, other communication devices and PC audio products. On September 18, 2006 we announced an ongoing strategic review of our operations and business plan. In connection with this strategic review, on November 3, 2006, we licensed to Hangzhou Silan Microelectronics Co., Ltd. (“Silan”) the development, manufacture and sale of our next generation standard definition DVD chips, the Phoenix II and LMX II, and also granted Silan a non-exclusive license for our standard definition DVD technology. Silan has recently notified us, however, that it does not intend to proceed with the development, manufacture and sale of any of the chips or technology we licensed to Silan and we have sent Silan a notice to cure this breach of our agreements. On February 16, 2007, we sold to Silicon Integrated Systems Corporation and its affiliates (“SiS”) our tangible and intangible assets relating to the development of high definition DVD chips based on next generation blue laser technology. Also, in connection with this restructuring strategy, during the first quarter of 2007 we substantially terminated the production and sale of our camera phone image sensors, which were the only remaining products of our Digital Imaging segment. We plan to license our image sensor patents in exchange for royalties, but we will no longer sell imaging sensor semiconductor chips. We continue to design, develop and market highly integrated analog and digital processor chips and digital amplifiers, including chips for standard definition DVD players primarily for the Korean market, and chips for digital audio players and digital media players for all markets. We are now concentrating on our standard definition DVD chip business and evaluating opportunities to develop profitable operations.
Our strategy is to focus on the design and development of our chip products while outsourcing all of our chip fabrication, assembly, and test operations. All of our products are manufactured, assembled and tested by
independent third parties primarily in Asia. We market our products worldwide through our direct sales force, distributors and sales representatives. Substantially all of our sales are to distributors, direct customers and end-customers in China, Hong Kong, Taiwan, Japan, Korea, Indonesia and Singapore. We employ sales and support personnel located outside of the United States in China, Hong Kong, Taiwan and Korea to support these international sales efforts. We expect that international sales will continue to represent a significant portion of our net revenues. We also have a number of employees engaged in research and development efforts outside of the United States. There are special risks associated with conducting business outside of the United States.
Industry Background
The conversion of analog to digital technology and the emergence of Asia as a manufacturing hub for consumer electronic devices created a growth opportunity for U.S. and foreign companies in consumer entertainment products during the past decade. However, in recent years that opportunity has matured, the technology has become integrated with other complementary technologies from other industries and competitors have consolidated into large entities with significant financial and human resources. The growing complexity of these new technologies, the commoditization of ASIC semiconductor products, the emergence of hundreds of design houses in Asia, the increased regulatory requirements of public companies in the United States and the emergence of highly educated but lower cost labor centers in China and other foreign locations has created a challenging business environment for ESS and for all fabless semiconductor design houses in the United States.
Today technology advancements are enhancing consumer electronic product offerings allowing consumers to choose from a virtually endless variety of features, brands and price points. In particular, the transition from analog to digital formats has allowed audio and video data to be compressed with little or no perceptible audio and image degradation, improving storage and transmission efficiency and enhancing the consumer experience. Digital formats provide users with several benefits, including greatly expanded content selection, accelerated transmission of video and audio content, random access to data, superior editing capabilities, and enhanced security features such as protection against unauthorized copying. The technology that has been developed in recent years to provide these enhancement has been staggering as has been the amount of resources devoted by companies that are in these industries.
The television, the telephone and the personal computer (“PC”) have emerged as the three principal systems that manage digital entertainment and information. Of those systems, the television and the PC are the principal devices for viewing and manipulating digital content. Digital set-top-boxes (“STBs”), DVD players and game consoles connected to televisions are emerging as the principal platforms for viewing and listening to entertainment, while PCs remain the principle platform for storing, and manipulating data and accessing the internet. The cellular phone is emerging as the principal mobile device for viewing and transmitting digital content. However, because of size limitations for screens and keypads other mobile devices such as PDAs, MPEG Audio Players (“MP3s”), and portable DVD players also enjoy sizable end markets.
Increasing advances in semiconductor technology are allowing these digital products to converge, resulting in cost savings and added convenience for consumers. At the same time, advances in communication allow better distribution of information and entertainment content and provide opportunities for further development of multimedia products.
This changing consumer market place and this merging of technologies has caused a consolidation of industries and companies that had in the past appeared to be unrelated. At the same time the increasing commoditization of ASIC products has made economies of scale in purchasing power for raw materials and economies of scale in technical human resources critical to survival. Of course, this environment means that suppliers and vendors like ESS must aggressively compete for business dominated by large purchasers with the market power to demand price cuts. This has caused suppliers and vendors like ESS to cut margins to unsustainable levels with the goals of increasing market share and maintaining quarterly revenue targets. This rapid rate of technology change puts even more pressure on companies that are not first to market as prices erode quickly with respect to older generation products. It is critical for companies like ESS to identify and pursue those areas where it can keep up with these rapid changes in technology.
Our Current Businesses
Through our Video business segment, we offer video processor chips that drive multi-featured video and audio products, and incorporate video standards including MPEG1, MPEG2 and MPEG4. Our chips use multiple processors and a programmable architecture that enable us to offer a broad array of features and functionality. Our decoder chips play DVD, VCD, MPEG4, DivX, CD, MP3, WMA (Windows media audio) and other video formats and support high quality audio formats, including full-featured karaoke, Dolby Digital, DTS Surround, DVD audio and Sony’s Super Audio CD (“SACD”) audio. Our decoder chips also allow consumers to view digital photo CDs with the music slideshow feature on their televisions.
Through our Digital Imaging business segment, we historically offered chips that contain image sensors used to manufacture camera enabled cellular phones. Our CMOS image sensor technology integrated several functions including image capture, image processing, color processing and the conversion and output of a fully processed image or video stream. We have discontinued the sale of our image sensor products and therefore expect zero revenues from our Digital Imaging business in 2008.
Our Future Businesses
We plan to continue to offer standard definition DVD products including MPEG1, MPEG2, and MPEG4 video standards; however, the MPEG1 revenue has continued to decline to insignificant levels and we do not expect significant revenues from our MPEG1 products in 2008. MPEG2 and MPEG4 products are planned to continue to sell mainly to the non-China market, but we expect DVD revenues to continue to decline. We have substantially terminated the production and sale of our image sensor products and therefore expect zero revenues from our Digital Imaging business in 2008. Although we plan to pursue licensing of our Digital Imaging patents, we are not forecasting any revenue from this area in 2008.
We are currently evaluating, designing and developing a new product line of standard CMOS process digital semiconductor products for the consumer electronics market that will perform functions that have traditionally been addressed using analog technology. An example of these products is a new digital-to-analog-converter for Blu-ray players; however, these products have not been proven, and we are not forecasting any significant revenues from these products in 2008.
Our Strategy
We significantly reorganized our operations and our business strategy in the third and fourth quarter of 2006, and throughout 2007. We continue to evaluate our remaining businesses as well as explore new opportunities to maximize shareholder value. Digital technology in consumer electronics has matured and consolidated with other technologies. In this environment, we believe it will be increasingly difficult for ESS to compete with competitors based in Asia that have significantly greater technical and financial resources and have lower human resource costs. Therefore, we will continue to evaluate our existing businesses and explore new opportunities to maximize shareholder value outside of our historical industries and technologies.
We currently plan to stay in certain niche markets or sub-segments of our existing DVD markets that have higher ASPs and thus higher margins. These niche markets are usually characterized by customized or specialty software necessary to address the consumers’ requirements such as digital media players, digital audio players and automotive applications. Our plan is to run this smaller DVD business at a profit and have those sales contribute to the cost of addressing our new businesses, however, if the revenue or margin prospects in these niche markets change, our plan may change. With regard to those new businesses, we are researching, defining and developing new products for new markets where our digital knowledge can be combined with our analog expertise to design digital semiconductor solutions built on a standard CMOS process and designed to address traditional analog functions. However, these concepts are under evaluation and in the design process. It is not certain that any product will be developed from these efforts. To achieve our plan, we are pursuing the following strategies in operating our business:
Leverage Expertise Across Market Applications. We believe additional markets and applications will emerge as digital technologies and analog technologies converge. We plan to share and leverage our expertise
in these two historically different areas of technology to introduce new product offerings into existing markets and to expand into other markets where traditional analog is either too expensive, too big or where a digital counterpart can achieve higher price/performance offering.
Offer a Low-Cost Solution. Our engineers have significant system design expertise at the device level. We design our chips to either work with lower-cost components or to decrease the number of components in our customers’ products to lower their total bill-of-material cost. We work in close collaboration with our customers in their own product development processes, and with other vendors that are in our customers’ bill-of-material supply chain, to reduce the cost of our semiconductor products to lower our customers’ total bill-of-material. We believe this approach enables us to provide our customers with a lower-cost total solution and drive total demand by reducing the cost to consumer.
Leverage Our Existing Relationships with OEMs and ODMs Worldwide. We believe we have a good reputation and working relationship with many large consumer electronics branded companies and that we can utilize that reputation to introduce new products in existing markets or new products in markets that are new to ESS. ESS has good channels to market and an ability to access OEMs and ODMs at the decision making level in those organizations.
Employ Our Software and Hardware Expertise to Develop New Technologies. The products and markets we serve require significant expertise in software and hardware design, many companies cannot do both with a very high level of quality and in a very timely manner. That expertise and timeliness is critical for a successful fabless semiconductor company in today’s global, highly competitive and fast paced marketplace. We have a diversified base of technologies and a strong track record for developing new technologies in-house. We intend to leverage our software and hardware expertise to continue to develop new technologies and add features to our products and to enter new markets.
Leverage Our Relationships with Large Suppliers to Be One of the Low-Cost Providers. We believe consumer electronics markets are so competitive and rapidly changing that a manufacturer of fabless semiconductor products must focus on being one of the low-cost providers of semiconductor chips in the world. To do so, our products must have a relatively small die size and achieve high yields throughout the manufacturing process. We have extensive third party manufacturing expertise and utilize long-standing and close relationships with some of the largest third party fabrication companies and assemblers in the world.
Pursue Acquisitions of Complementary and Advanced Technologies. We have in the past acquired and will continue to consider acquiring complementary technologies or product lines to enhance our own product offerings and to accelerate our time to market.
Explore Opportunities To Maximize Shareholder Value. We have in the past and will continue to consider opportunities outside complementary technologies and product lines and even outside our historical businesses of the fabless semiconductor industry.
Pursue Licenses of Complementary Technologies. We have in the past licensed and will continue to consider licensing complementary technologies or product lines to enhance our own product offerings and to accelerate our time to market.
Leverage Our Proprietary Technology. Our chips utilize a combination of licensed and proprietary software.
Products
Historically, we have offered the products described below. As we continue to evaluate our businesses in 2008 we could decide to discontinue any and/or all of these products, indeed several are not actively being sold at this time but we continue efforts to reduce current on-hand inventory.
Through our Video business, we offer DVD decoder chips and Video CD chips. Through our Digital Imaging business, we historically offered image sensor chips and image processor chips. In 2007, we announced we were stopping sales of our image chips. Additionally, we continue to offer certain legacy products such as communication chips and PC audio chips, although we no longer manufacture those chips.
DVD Decoder Chips. Our DVD chips enable consumers to play DVD, CD, VCD, DivX, MP3, JPEG, WMA, DVD audio, full-featured karaoke and other audio and video formats. Our DVD chips support high quality video formats such as Progressive Scan, and high quality audio formats, including Dolby Digital, DTS Surround, and DVD audio. These chips can also be used as the primary processor in digital media players. We offer both MPEG2 and MPEG4 decoding products and various levels of integrated products incorporating such capabilities as TV encoder, radio frequency, and servo controller.
Video CD Chips. We offer VCD chip products with various feature combinations and price points. Our VCD chips include an MPEG1 video and audio system decoder. They deliver full-screen, full-motion video at 30 frames per second with selectable CD-quality audio. These chips are used in relatively low-cost VCD players that are sold primarily in China, South East Asia, India and other emerging countries. VCD chips are being replaced by cheaper priced DVD players in certain foreign markets. We have experienced decline in this business and expect this trend to continue. In 2005 we entered into a license and collaboration arrangement with a third party pursuant to which our VCD products are distributed in China and India.
Image Sensor Chips. Our SOC image sensor chips performed the image processing, color processing and the conversion and output of a fully processed image or video stream in camera enabled cellular phones. In 2007, we announced we were terminating production and sales of our image sensor chips.
Consumer Digital Audio Chips. Our Audio chips handle high quality audio formats such as Dolby Digital, Dolby ProLogic, Dolby ProLogic II, Dolby Ex, Dolby Virtual Speaker, DTS Surround, DTS ES, MP3, WMA, DVD audio and Sony’s SACD audio, enabling consumer electronics manufacturers to build high quality, low cost 5.1 channel audio video receivers (“AVR”) that compliment the existing installed base of DVD players. Our class-D multi-channel digital audio amplifier chip further enables us to deliver a total single chip solution for home theater system applications.
Communication Chips. We are not actively manufacturing these chips but sell a modest amount out of inventory each year. The volumes are declining and are insignificant.
PC Audio Chips. We are not actively manufacturing these chips but sell a modest amount out of inventory each year. The volumes are declining and are insignificant.
Sales of these products accounted for the following percentages of our net revenues in the past three years:
Information on revenues and margins attributable to our business segments is included in Note 13, “Business Segment Information and Concentration of Certain Risks,” to the consolidated financial statements in Item 8 of this Report.
Technology and Research and Development
In the digital semiconductor marketplace we design and develop products utilizing our base of analog, digital and mixed-signal design expertise and process technologies, as well as our software and systems expertise. Our
design environment is based on workstations, dedicated product simulators, system simulation with hardware and software modeling, and a high-level, design-description language.
On research and development activities for both business segments, we spent approximately $12.6 million during 2007, $36.0 million during 2006 and $34.0 million during 2005.
In our Video business, our DVD technology includes DVD decoder chips that incorporate a digital signal processor (“DSP”) and a reduced instruction set computer processor (“RISC”). The two processors work in parallel on separate tasks. In 2001, we integrated a TV encoder into our DVD decoder engine (labeled the Vibratto family of products) to cut down the number of components required to build a DVD player. In 2003, we enhanced the decoder engine to handle MPEG4 technology. Our Vibratto II chip integrated the front-end with the back-end into a single decoder chip and our Phoenix chip added our own servo IP and our own RF encoder technology.
In our Digital Imaging business, our chips were historically manufactured using a proprietary CMOS process and utilizing a unique chip architecture designed for low light sensitivity at comparative lens sizes.
Customers
We have historically sold our chips to distributors and OEMs of DVD, VCD, MP3, digital camcorders, consumer digital audio players, digital media players, cellular phones, modem and PC products. Our customers manufacture and sell these products both as contract manufacturers for well-known brand labels and under their own brands.
Samsung Electronics Company (“Samsung”), one of our direct customers, accounted for approximately 31% and 13% of our net revenues for 2007 and 2006, respectively. LG Electronics, Inc. (“LG”), one of our direct customers, accounted for approximately 16% and 15% of our net revenues for 2007 and 2006, respectively. Xing Qiu, an end customer of one of our distributors, accounted for approximately 10% and 8% of our net revenues for 2007 and 2006, respectively.
No other end-customers or direct customers accounted for more than 10% of our net revenues during 2007 and 2006. Information on net sales from external customers and long-lived assets attributable to our geographic regions is included in Note 13, “Business Segment Information and Concentration of Certain Risks,” to the consolidated financial statements in Item 8 of this Report.
Sales and Distribution
We market our products worldwide through our direct sales force, distributors and sales representatives. We have sales and support offices in the United States, China, Hong Kong, Taiwan, and Korea.
We believe customer service and technical support are important competitive factors in selling to major customers. Sales representatives and distributors supplement our efforts by providing additional customer service at the local level. We believe close contact with our customers not only improves the customer’s level of satisfaction, but also provides important insight into future market direction.
International sales comprised almost 100% of our revenue in 2007, 2006 and 2005. International sales are based upon destination of the shipment. Our international sales in 2007, 2006 and 2005 were derived primarily from Asian customers who manufacture DVD products, VCD products, cameras, cell phones, communications and PC audio products. Companies in Asia manufacture a large percentage of the worldwide supply of these products. We believe a significant portion of our chip products are incorporated into consumer electronic devices that are ultimately sold into the United States. We currently have direct sales personnel and technical staff located in Hong Kong, Taiwan, China, and Korea where significant portions of our sales have historically been derived. Sales and technical staff in these locations are being reviewed along with our efforts to restructure our company, therefore the location and number of our employees could change significantly. Our products are also sold internationally through distributors and sales representatives located in Hong Kong, Taiwan, Korea, Japan and Indonesia. For fiscal year 2007, net sales to customers (including distributors) in each region as a percentage of our total net revenue were: Hong Kong 31%, Taiwan 29%, and Korea 12%. Due to our current restructuring efforts, our geographic mix could change significantly in the future and is expected to change significantly in 2008 as we focus more on business lines that have greater sales
to customers headquartered in Korea. All of our international sales are denominated in U.S. dollars. Our business is usually seasonal due to the Christmas holiday season in America and Europe, and the Chinese New Year season in China and Asia. Our sales representatives and distributors are not subject to minimum purchase requirements and can discontinue marketing any of our products at any time. In addition, certain of our distributors have rights of return for unsold product and rights to pricing adjustments to compensate for rapid, unexpected price changes.
We historically relied on our largest distributor, FE Global (China) Limited (“FE Global”), for a significant portion of our revenues in the Video business. Sales through FE Global were approximately 18%, 32%, and 37% of our net revenues in 2007, 2006, and 2005, respectively. In addition to FE Global, Weikeng Industrial Company Ltd (“Weikeng”), our other distributor, accounted for approximately 11% of our net revenues in 2007 and less than 10% in 2006 and 2005. On August 31, 2007, our distribution agreement with FE Global was terminated, and we signed a new distribution agreement with CKD (Hong Kong) High Tech Company Limited (“CKD”) who will perform similar functions as those previously provided by FE Global.
As mentioned above, the geographic and product mix in our revenues is expected to change significantly from what it has been historically and we would expect CKD’s portion of our revenues to also change significantly from what it has been historically but believe it is impossible to predict those changes with any degree of certainty. CKD is not subject to any minimum purchase requirements and can discontinue marketing any of our products at any time. In addition, CKD has rights of return for unsold product and rights to pricing allowances to compensate for rapid, unexpected price changes, therefore we do not recognize revenue until CKD sells through to our end-customers.
Information on revenues and long-lived assets attributable to our geographic regions is included in Note 13, “Business Segment Information and Concentration of Certain Risks,” to the consolidated financial statements in Item 8 of this Report.
Manufacturing
To manufacture products, we contract with third parties for all of our fabrication and assembly as well as the majority of our test operations. This manufacturing strategy enables us to focus on our design and development strengths, minimize fixed costs and capital expenditures and gain access to advanced manufacturing capabilities. Semiconductor manufacturing consists of foundry activity where wafer fabrication takes place, as well as chip assembly and testing activities. We use several independent foundries that use advanced manufacturing technologies to fabricate our chips. Substantially all of our products are manufactured by a variety of foundries including: Taiwan Semiconductor Manufacturing Company (“TSMC”), which has manufactured products for us since 1989, as well as United Microelectronics Corporation (“UMC”), which is also located in Taiwan, Grace Semiconductor Manufacturing Corporation (“GSMC”), which is located in China, and other independent Asian foundries. Most of our products are currently fabricated using both mixed-signal and CMOS logic process technologies. Manufacturing requires raw materials and a variety of components to be manufactured to our specifications. We depend on a limited number of suppliers to obtain adequate supplies of quality raw materials on a timely basis. We do not generally have guaranteed supply arrangements with our suppliers, and we depend on foundries such as TSMC, UMC, GSMC and others for foundry capacity to produce products of acceptable quantity, quality and with acceptable manufacturing yields in a timely manner. As of December 31, 2007, we believe we have sufficient foundry capacity to meet our forecasted needs for the next 12 months.
After wafer fabrication by the foundry, all of our semiconductor products are assembled and tested by third-party vendors, primarily Advanced Semiconductor Engineering and Amkor Technology. We have internally designed and developed our own test software and purchased certain test equipment, which are provided to our test vendors. See Item 1A, “Risk Factors - Our products are manufactured by independent third parties.”
Competition
Our semiconductor markets are intensely competitive and are characterized by rapid technological change, price reductions and rapid product obsolescence. Competition typically occurs at the design stage, where the customer evaluates alternative design approaches that require integrated circuits. Because of shortened product life cycles, there are frequent design win competitions for next-generation systems. We expect competition to remain
intense from existing competitors and from companies that may enter our existing or future markets. In general, product prices in the semiconductor industry have decreased over the life of a particular product. The markets for our products are characterized by intense price competition. As the markets for our products mature and competition increases, we anticipate that prices for our products will continue to rapidly decline.
Our existing and potential competitors consist of medium and large domestic and international companies, many of whom 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 we have. Our competitors also include a number of smaller and emerging companies.
Recently Asian competitors, especially from Taiwan and China, have developed the expertise and ability to develop advanced semiconductor products competing with ESS. These competitors have significant cost advantages that have forced ESS to exit certain product lines and may force ESS to exit other product areas in the future.
In the Video business, our principal competitors in the DVD market include MediaTek Inc. (“MediaTek”), Zoran, Sony, Cheartek, Panasonic, STMicroelectronics, LSI Logic, and Sunplus. In addition, we expect that the DVD platform will face competition from other platforms including STBs, as well as multi-function game boxes. Some of our competitors may supply chips for multiple platforms, such as LSI Logic and STMicroelectronics, each of which makes chips for both DVD players and STBs. We also face strong competition from Sunplus and Samsung in the VCD market.
Many of our current and potential competitors have longer operating histories as well as greater name recognition than we have. Any of these competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements and to devote greater resources to the development, promotion and sale of their products than we can. This is especially true in the analog markets that we may enter in 2008. Many competitors in those markets are much bigger financially, have many more employees, have long established relationships with customers, have diversified product offerings and have broader technical and design expertise.
In addition, a number of companies with significantly greater resources than us could attempt to increase their presence in the market by acquiring or forming strategic alliances with our competitors resulting in increased competition to us. In the past years, LSI Logic acquired C-Cube Microsystems; Cirrus Logic acquired LuxSonor Semiconductors; Oak Technology acquired TeraLogic; and Zoran acquired Oak Technology.
Proprietary Technology
We rely on a combination of patents, trademarks, copyrights, trade secret laws and confidentiality procedures to protect our intellectual property rights. As of December 31, 2007, we had 156 patents granted in the United States, and more than 31 applications on file with the United States Patent and Trademark Office (“USPTO”). In addition, as of December 31, 2007 we had approximately 24 corresponding foreign patents granted and 59 applications pending. We intend to seek further U.S. and international patents on our technology whenever possible.
The semiconductor industry is characterized by vigorous protection and pursuit of intellectual property rights or positions, which have resulted in significant and often protracted and expensive litigation. As of December 31, 2007, there are no intellectual property litigation matters pending against us. See Part I, Item 3, “Legal Proceedings.”
We currently license certain of the technology we use in our products, and we expect to continue to do so in the future. We have, in the past, granted limited licenses to certain of our technology, some of which have expired. See Item 1A, “Risk Factors - We may not be able to adequately protect our intellectual property rights from unauthorized use and we may be subject to claims of infringement of third-party intellectual property rights.”
Backlog
Our products are generally sold pursuant to standard purchase orders, which are often issued only days in advance of shipment and are frequently revised to reflect changes in the customers’ requirements. Product deliveries are scheduled when we receive purchase orders. Generally, these purchase orders allow customers to reschedule delivery dates and cancel purchase orders without significant penalties. For these reasons, we believe that our
backlog is not a reliable indicator of future revenues. Delays in delivery schedules and/or a reduction of backlog during any particular period could have a material adverse effect on our business and results of operations. As of December 31, 2007, our backlog amounted to approximately $4.8 million.
Employees
As a result of our restructuring strategy, the total number of our employees has dropped significantly. As of December 31, 2007, we had 143 full-time employees, including 50 in research and development, 46 in marketing, sales and support, 28 in finance and administration and 19 in manufacturing. Our future success will depend, in part, on our 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 can be intense, particularly in the Silicon Valley. Our employees are not represented by any collective bargaining unit, and we have never experienced a work stoppage. We believe our relationship with our employees is good.
Available Information
Our website address is http://www.ESSTECH.com. We make available free of charge, on or through our website, our annual, quarterly and current reports, and any amendments to those reports, as soon as reasonably practicable after electronically filing such reports with the Securities and Exchange Commission (the “SEC”). In addition, our Code of Ethics as well as the respective charters for the Audit, Compensation and Corporate Governance and Nominating Committees of our Board of Directors are available on our website. Information contained on our website is not part of this Report.
Executive Officers of the Registrant
The following table sets forth certain information regarding our current executive officers:
Robert L. Blair has been our President and Chief Executive Officer since September 1999. Mr. Blair was elected as a director in 1999. Mr. Blair served as our Executive Vice President of Operations and member of the Office of the President from April 1997 to September 1999. From December 1994 to March 1997, he was our Vice President of Operations. From December 1991 to November 1994, he was Senior Vice President of 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 and General Manager at XEMAG, a division of Xidex Corporation. From 1973 to 1986, he held several positions including Vice President, High Reliability Operations at Precision Monolithics, Inc.
John A. Marsh has been our Chief Financial Officer since August 2007. Mr. Marsh has more than 20 years of experience in senior-level finance positions and joined us in April 2001 as our International Controller. In September 2004, Mr. Marsh became the Corporate Controller. From October 2006 to January 2007, Mr. Marsh was the North America Controller for VeriFone, Inc. Prior to joining ESS, he held senior management positions in finance with SSE Telecom, Inc. from November 1999 to April 2001 and Cylink Corporation from January 1997 to January 1999; previously, he held finance and accounting positions with National Semiconductor Corporation. He received a Bachelor of Science degree in business administration from San Jose State University and is a certified public accountant.
The information concerning compliance with Section 16 of the Securities Exchange Act of 1934 is incorporated by reference from the section in the proxy statement/prospectus for our annual and special meeting of shareholders to be held in 2008 entitled “Compliance under Section 16(a) of the Securities Exchange Act of 1934.”
Item 1A.
Item 1A.
Risk Factors
Risks Related to the Mergers
There may be unexpected delays in the consummation of the mergers, which would delay receipt of merger consideration by ESS Delaware stockholders.
The mergers are expected to close in the second quarter of 2008. However, certain events may delay the consummation of the mergers, including difficulties in obtaining the approval of the principal terms of the reincorporation merger and the other transactions contemplated by the merger agreement by our shareholders or in obtaining sufficient advance proxies necessary to adopt the merger agreement, delays in satisfaction of the closing conditions to which the mergers are subject, delisting of our shares by the NASDAQ Global Market or a determination by the NASDAQ Stock Market Listing Qualifications Panel not to list the shares of ESS Delaware to be issued in the reincorporation merger, or a lengthy SEC review process. If one or more of these events occur, the receipt of cash by ESS Delaware stockholders may be delayed and the mergers and the sale to Imperium ultimately may not be completed.
If the mergers are not completed, ESS California’s stock price and future business operations could be harmed.
The mergers are subject to a number of customary conditions to closing, including the approval by the shareholders of ESS California of the principal terms of the reincorporation merger and the consent of the stockholders of ESS Delaware to the adoption of the merger agreement, the accuracy of our representations and warranties, compliance with covenants, and the absence of a material adverse change in our business. In order to approve the reincorporation merger, a majority of the outstanding shares of ESS California common stock entitled to vote at the annual meeting must vote to approve the principal terms of the reincorporation merger. In order to approve the cash-out merger, a majority of the outstanding shares of common stock of ESS Delaware entitled to vote must adopt the merger agreement. If the shareholders of ESS California fail to approve the reincorporation merger or fail to submit sufficient advance proxies to execute and deliver the written consent adopting the merger agreement, we will not be able to complete the mergers and you will not receive the merger consideration. As a result, there can be no assurance that the mergers will be completed in a timely manner or at all.
If the mergers are not completed for any reason, the stock price of ESS California may decline, particularly if the current market price of our common stock reflects a positive market assumption that the mergers will be completed. Additionally, if the merger agreement is terminated, ESS California may be unable to find a partner willing to engage in a similar transaction on terms as favorable as those set forth in the merger agreement, or at all. This could limit ESS California’s ability to pursue its strategic goals.
Uncertainty about the mergers and diversion of management could harm ESS California, whether or not the mergers are completed.
Uncertainty about the effect of our pending acquisition by Imperium could adversely affect our business. This uncertainty could lead to a loss of customers, a decline in revenues, impairment in our ability to make necessary operational improvements in our business, an inability to retain or motivate current employees or attract new employees, and deterioration in our results of operations. These adverse affects may be enhanced by the diversion of management time and attention toward completing the mergers.
We may be delisted from the NASDAQ Global Market and the shares of common stock of ESS Delaware may not be listed on the NASDAQ Global Market.
In January 2008, the NASDAQ Stock Market Listing Qualifications Panel staff notified us of its decision to delist our common stock from the NASDAQ Global Market as a result of our failure to hold our annual meeting of shareholders in 2007 in accordance with the NASDAQ Global Market’s continued listing requirements. Our hearing to appeal the NASDAQ Stock Market Listing Qualifications Panel’s decision was held in February 2008, and we do not expect to receive a decision from the hearing panel until April 2008. The panel may decide not to grant us any extension of time to hold the annual meeting, or may not grant us sufficient time to hold our annual meeting and may
delist our common stock regardless of whether our shareholders elect directors or approve the sale to Imperium. Our next shareholder meeting will be the annual meeting for approval of the mergers, which we expect to hold in the second quarter of 2008. We do not expect to hold the annual meeting prior to June 2008 in light of the fact that the joint proxy statement/prospectus we need to deliver in connection with the mergers, which may be reviewed by the SEC, must be cleared by the SEC and mailed to our shareholders prior to the annual meeting and that it may take a significant amount of time to solicit a sufficient number of proxies to approve the principal terms of the reincorporation merger and a sufficient number of advance proxies to adopt the merger agreement.
In addition, we intend to apply for listing of the shares of common stock of ESS Delaware to be issued in the reincorporation merger on the NASDAQ Global Market. If our stock is delisted from the NASDAQ Global Market or the NASDAQ Stock Market Listing Qualifications Panel determines not to list the shares of common stock of ESS Delaware issued in the reincorporation merger, the mergers and our sale to Imperium may be substantially delayed or may not be completed at all. If our stock is no longer listed for trading on a national stock exchange, the reincorporation merger, which must be completed prior to closing of the cash-out merger, will require compliance with the individual securities laws, or “blue sky” laws, of each of the 50 states. Any blue sky law compliance would be time consuming and expensive, may not be possible, and could result in delay in the completion of the cash-out merger or termination of the merger agreement. In addition, if our stock is delisted from the NASDAQ Global Market or we are unable to list the shares of common stock of ESS Delaware on the NASDAQ Global Market following the reincorporation merger, and if the long-arm provision of Section 2115 of the California Corporations Code is held to apply to ESS Delaware, ESS Delaware may be subject to certain limitations on distributions to stockholders that could apply to the cash-out merger and may restrict or prevent consummation of the cash-out merger.
Following the reincorporation merger, your rights as a shareholder will be governed by Delaware law instead of California law and you should note the differences.
Your right to dissent from the cash-out merger and seek an appraisal of your shares will be governed by Delaware law instead of California law. In general, under both Delaware law and California law, the process of dissenting and exercising appraisal rights requires strict compliance with technical prerequisites. ESS Delaware stockholders wishing to dissent should consult with their own legal counsel in connection with compliance with Section 262 of the Delaware General Corporation Law or Chapter 13 of the California Corporations Code. There are several differences between the laws of Delaware and California with respect to dissenting stockholders’ appraisal rights.
Stockholders of ESS Delaware who are considering seeking appraisal of their shares of ESS Delaware common stock should consider that the fair value of their shares determined under Section 262 of the Delaware General Corporation Law or Chapter 13 of the California Corporations Code could be more than, the same as or less than the value of consideration to be issued and paid in the cash-out merger. Furthermore, ESS Delaware reserves the right to assert in any appraisal proceeding that, for purposes of the appraisal proceeding, the “fair value” of ESS Delaware common stock is less than the value of the consideration to be issued and paid in the cash-out merger.
Your ability to sell or otherwise transfer your shares of ESS Delaware common stock between the closing of the reincorporation merger and the closing of the cash-out merger may be limited.
Each of ESS California and Delaware Merger Sub has agreed, to the extent reasonably practicable and subject to compliance with all applicable laws and rules and regulations of the NASDAQ Global Market, to use its commercially reasonable efforts to cause trading in shares of ESS Delaware common stock on the NASDAQ Global Market (subsequent to listing thereof, if any) to be suspended immediately following the effective time of the reincorporation merger and to close the stock transfer books of ESS Delaware immediately following the effective time of the reincorporation merger, preventing any transfers of shares of ESS Delaware common stock on the records of ESS Delaware between the time of the reincorporation merger and the time of the cash-out merger. ESS California and Delaware Merger Sub have agreed to halt trading and to close the transfer books of ESS Delaware in order to determine the shareholders of record of ESS California immediately prior to the reincorporation merger, and to ensure that a sufficient number of effective advance proxies have been received to authorize the adoption of the merger agreement following the reincorporation merger and to ensure that the shares of common stock of ESS
Delaware that are the subject of such advance proxies are not transferred between the time of the consummation of the reincorporation merger and the consummation of the cash-out merger.
If we are able to cause trading in shares of ESS Delaware common stock on the NASDAQ Global Market to be suspended immediately following the effective time of the reincorporation merger and/or to close the stock transfer books of ESS Delaware immediately following the effective time of the reincorporation merger, your ability to sell or otherwise transfer shares of ESS Delaware common stock you would receive in the reincorporation merger will be limited and you may not be able to transfer any such shares of ESS Delaware common stock at all during the time period between the closing of the reincorporation merger and the closing of the cash-out merger. As a result, you may have significantly reduced or no liquidity in your investment in ESS Delaware between the time of the reincorporation merger and the cash-out merger and you may not be able to sell your shares of ESS Delaware in a timely manner or at all.
Certain directors and executive officers of ESS California may have potential conflicts of interest in recommending that you vote to approve the principal terms of the reincorporation merger and adopt the merger agreement.
ESS California’s directors and executive officers have interests in the mergers as individuals in addition to, and that may be different from, the interests of ESS California shareholders.
In certain instances, the merger agreement requires payment of a termination fee to Imperium and reimbursement of expenses of Imperium. Payment of these amounts could adversely affect ESS California’s financial condition or reduce the likelihood that another party proposes an alternative transaction to the mergers.
Under the terms of the merger agreement, ESS California may be required to pay Imperium a termination fee of $1,981,000 plus reimbursement of Imperium’s costs of up to $500,000 if the merger agreement is terminated under certain circumstances. The termination fee and expense reimbursement provisions could affect the structure, pricing and terms proposed by other parties seeking to acquire or merge with ESS California, including the possibility that any such other party might choose not to make an alternative transaction proposal to ESS California as a result of the termination fee and expense reimbursement provisions. In addition, should the merger agreement be terminated in circumstances under which such a termination fee and expense reimbursement is payable, the payment of such a fee would reduce the amount of cash available to ESS California going forward.
Risks Related to the Company’s Business
We have a history of losses and expect to continue to incur net losses in the near-term.
We have experienced operating losses in each quarterly and annual period since the quarter ended September 30, 2004. We incurred net income of $3.1 million for the fiscal year ended December 31, 2007 including the gain on sale of technology and tangible assets of $10.4 million and net losses of approximately $44.1 million, $99.6 million, and $35.6 million for the fiscal years ended December 31, 2006, 2005, and 2004, respectively. We had an accumulated deficit of approximately $129.5 million as of December 31, 2007. We will need to generate significant increases in our revenues and margins to achieve or maintain profitability or significantly reduce operating expenses or both. There can be no certainty that our efforts to restructure and reduce our operating expenses will reduce or eliminate these losses; indeed, the reductions and restructuring could increase losses due to reduced revenue levels. There can be no certainty that these operating losses will not continue and consume our working capital.
If our new business strategy is unsuccessful, it could significantly harm our business and operating results.
On September 18, 2006, we announced an ongoing review of our business strategy. In particular, we announced a business strategy to concentrate our standard DVD business activities on serving a few large customers and to look for business partners or acquirers for our high definition HD DVD and Blu-ray DVD business and our camera phone business. On November 3, 2006 we entered into a DVD Technology License
Agreement with Silan for the exclusive license of certain standard definition DVD technologies and also granted Silan a non-exclusive license for our remaining standard definition DVD technology, although Silan has recently notified us that it does not intend to proceed with the development, manufacture and sale of any of the DVD technology we licensed to Silan and we have sent Silan a notice to cure this breach of our agreements. As a result, we may not receive any license revenue from Silan with respect to our standard definition DVD technology licensed to Silan. On February 16, 2007, we entered into Asset Purchase Agreements with SiS to sell our HD-DVD and Blu-ray DVD assets and technologies and on the same date announced we were reducing operations of our camera phone business. In conjunction with this strategic review we are currently maintaining our remaining standard definition DVD business and entering into the business of designing, manufacturing and marketing analog processor chips. If the market for our licensed VCD and/or DVD businesses, our retained DVD standard definition businesses or the market for our new product offerings is smaller than we anticipated, our results of operations and business would be adversely affected. In addition, one of our new analog products for a new market we had hoped to enter in 2008 has been delayed beyond the key Christmas and Chinese New Years seasons and we do not expect to bring this new product to market until later in 2009. We expect this delay in bringing this new product to market, will delay our ability to derive revenues from such product. Selling and/or licensing of our standard definition DVD and high definition DVD businesses and shutting down our camera phone business may also reduce the scale of our business and income stream and result in our greater reliance on our remaining businesses. Our strategy to expand our digital audio and analog processor chip businesses is new, and unproven.
Our business strategy is currently going through significant evaluation and change.
We announced on September 18, 2006 that our business strategy has been going through a significant transition. This transition and our current strategy may fail to stop our operating losses, and we may take alternative measures. As part of this transition, we may not be able to make our current lines of business profitable and therefore may exit them. We may not be able to identify or acquire or transition to new lines of business that may be profitable, and we may not have enough resources to transition to certain alternative lines of business. We are also evaluating alternative business models, markets, products, industries and technologies. We may determine it is in the best interests of our shareholders to move us into alternative lines of business, industries and/or markets other than those in which we have historically operated.
Our business is highly dependent on the expansion of the consumer electronics market and our ability to respond to changes in such market.
Our focus has been developing products primarily for the consumer electronics market. Due to the short life-cycle of the products in this market, we must identify and capitalize on market opportunities in a timely manner to become a leader in these product areas. Historically, we have had to respond to market trends, identify key products and become the market leader for such products in order to succeed. Unfortunately, we have been unable to maintain our market position in recent periods. The DVD market and our role in that market have shifted, and, as a result, in November 2006 we granted a license for Silan to take over the design, manufacture and sale of certain of our standard definition DVD products, and we also recently sold and licensed our HD-DVD and Blu-ray DVD technologies to SiS. We have historically and we expect to continue to evaluate our strategies in our businesses to ensure that we focus on the technologies and markets that will provide us the best opportunities for the future. Nonetheless, our strategy in potential new markets may not be successful. If the markets for these products and applications decline or fail to develop as expected, or if we are not successful in our efforts to market and sell our products to manufacturers who incorporate our chip into their products, we could exit our historic lines of business and enter other lines of business outside of semiconductors, and it could have a material adverse effect on our business financial conditions and results of operations
We operate in highly competitive markets.
The markets in which we operate are intensely competitive and are characterized by rapid technological changes, rapid price reductions and short product life cycles. Competition typically occurs at the design stage, when customers evaluate alternative design approaches requiring integrated circuits. Because of short product life cycles, there are frequent design win competitions for next-generation systems.
We expect competition to increase in the future from existing competitors and from other companies that may enter our existing or future markets with products that may be provided at lower costs or provide higher levels of integration, higher performance or additional features. In some cases, our competitors have been acquired by even larger organizations, giving them access to even greater resources with which to compete. Advancements in technology can change the competitive environment in ways that may be adverse to us. Unless we are able to develop and deliver highly desirable products in a timely manner continuously and achieve market domination in one or more product lines, we will not be able to achieve long-term sustainable success in this fast consolidating industry. If we are only able to offer commodity products, our results of operations and long-term success will suffer and we will fall prey to stronger competitors. For example, today’s high-performance central processing units in PCs have enough excess computing capacity to perform many of the functions that formerly required a separate chip set, which has reduced demand for our PC audio chips, among other chips. Moreover, our VCD and standard definition DVD products have begun to experience commodity like pricing pressures as new technologies evolve. The announcements and commercial shipments of competitive products could adversely affect sales of our products and may result in increased price competition that would adversely affect the average selling price (“ASP”) and margins of our products.
The following factors may affect our ability to compete in our highly competitive markets:
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The timing and success of our new product introductions and those of our customers and competitors;
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The ability to control product cost and produce consistent yield of our products;
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The ability to obtain adequate foundry capacity and sources of raw materials;
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The price, quality and performance of our products and the products of our competitors;
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The emergence of new multimedia standards;
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The development of technical innovations;
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The rate at which our customers integrate our products into their products;
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The number and nature of our competitors in a given market; and
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The protection of our intellectual property rights.
We may need additional funds to execute our business plan, and if we are unable to obtain such funds, we may not be able to expand our business, and if we do raise such funds, the shareholders’ ownership in ESS may be subject to dilution.
We may be required to obtain substantial additional capital to finance our future growth, fund our ongoing research and development activities and acquire new technologies or companies. To the extent that our existing sources of liquidity and cash flow from operations are insufficient to fund our activities, we may need to seek additional equity or debt financing from time to time. Additional financing may not be available to us when needed or, if available, it may not be available on terms favorable to us. We may need to consummate a private placement or public offering of our capital stock at a lower price than you paid for your shares. If we raise additional capital through the issuance of new securities at a lower price than you paid for your shares, you will be subject to additional dilution. Further, such equity securities may have rights, preferences or privileges senior to those of our existing common stock.
To compete in our industry, we may need to acquire other companies and technologies and/or restructure our businesses, and we may not be successful acquiring key targets, integrating our acquisitions into our businesses or restructuring our businesses effectively.
We believe the semiconductor industry is experiencing a general industry consolidation. To remain competitive, a semiconductor company must be able to offer high-demand products and renew its product offerings in a timely manner. In order to meet such a high turn over in product offerings, in addition to our own research and development of new products, we regularly consider strategic additions or deletions of our product offerings to enhance our strategic position. To remain competitive in this rapidly changing market, we need to constantly update
our product offering and realign our cost structure to bring to the market more sophisticated and cost-effective products. However, we may not be able to identify and consummate suitable acquisitions and investments effectively. Conversely, we may not be able to restructure and realign our businesses effectively. Strategic transactions carry risks that could have a material adverse effect on our business, financial condition and results of operations, including:
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The failure of the acquired products or technology to attain market acceptance, which may result from our inability to leverage such products and technology successfully;
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The failure to integrate acquired products and business with existing products and corporate culture;
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The inability to restructure or realign our businesses effectively and cost-efficiently;
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The inability to retain key employees from the acquired company;
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Diversion of management attention from other business concerns;
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The potential for large write-offs of intangible assets;
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Issuances of equity securities dilutive to our existing shareholders;
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The incurrence of substantial debt and assumption of unknown liabilities; and
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Our ability to properly access and maintain an effective internal control environment over an acquired company in order to comply with public reporting requirements.
Our quarterly operating results are subject to fluctuations that may cause volatility or a decline in the price of our stock.
Historically, our quarterly operating results have fluctuated significantly. Our future quarterly operating results will likely fluctuate from time to time and may not meet the expectations of securities analysts and investors in a particular future period. The price of our common stock could decline due to such fluctuations. The following factors may cause significant fluctuations in our future quarterly operating results:
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Charges related to the net realizable value of inventories;
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Changes in demand or sales forecast for our products;
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Changes in the mix of products sold and our revenue mix;
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Changes in the cost of producing our products;
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The timely implementation of customer-specific hardware and software requirements for specific design wins;
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Increasing pricing pressures and resulting reduction in the ASP of any or all of our products;
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Availability and cost of foundry capacity;
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Gain or loss of significant customers;
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Seasonal customer demand;
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The cyclical nature of the semiconductor industry;
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The timing of our and our competitors’ new product announcements and introductions and the market acceptance of new or enhanced versions of our and our customers’ products;
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The timing of significant customer orders and/or design wins;
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Charges related to the impairment of other intangible assets;
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Loss of key employees which could impact sales or the pace of product development;
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The “turns” basis of most of our orders, which makes backlog a poor indicator of the next quarter’s revenue;
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The potential for large adjustments due to resolution of multi-year tax examinations;
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The lead time we normally receive for our orders, which makes it difficult to predict sales until the end of the quarter;
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Availability and cost of raw materials;
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Significant increases in expenses associated with the expansion of operations; and
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A shift in manufacturing of consumer electronic products away from Asia.
We often purchase inventories based on sales forecasts and if anticipated sales do not materialize, we may continue to experience significant inventory charges.
We currently place non-cancelable orders to purchase our products from independent foundries and other vendors on an approximately three-month rolling basis, while our customers generally place purchase orders (frequently with short lead times) with us that may be cancelled without significant penalty. Some of these customers may require us to demonstrate our ability to deliver in response to their short lead-time. In order to accommodate such customers, we have to commit to certain inventories before we have a firm commitment from our customers. If anticipated sales and shipments in any quarter are cancelled, do not occur as quickly as expected or become subject to declining ASPs, expense and inventory levels could be disproportionately high and we may be required to record significant inventory charges in our statement of operations in a particular period. In accordance with our accounting policy, we reduce the carrying value of our inventories for estimated slow-moving, excess, obsolete, damaged or otherwise unmarketable products by an amount based on forecasts of future demand and market conditions. As our business grows, we may increasingly rely on distributors, which may further impede our ability to accurately forecast product orders. Additionally, we may venture into new products with different supply chain and logistics requirements which may in turn cause excess or shortage of inventory.
Our research and development investments may fail to enhance our competitive position.
We invest a significant amount of time and resources in our research and development activities to enhance and maintain our competitive position. Technical innovations are inherently complex and require long development cycles and the commitment of extensive engineering resources. We incur substantial research and development costs to confirm the technical feasibility and commercial viability of a product that in the end may not be successful. If we are not able to successfully complete our research and development projects on a timely basis, we may face competitive disadvantages. There is no assurance that we will recover the development costs associated with these projects or that we will be able to secure the financial resources necessary to fund future research and development efforts.
We have recently significantly reduced the size of our research and development workforce and the remaining personnel may not be adequate to enable us to successfully manage existing projects or enter new product markets. Our margins may decrease to a point where we will be unable to sustain the research and development resources necessary to remain competitive.
Our success within the semiconductor industry depends upon our ability to develop new products in response to rapid technological changes and evolving industry standards.
The semiconductor industry is characterized by rapid technological changes, evolving industry standards and product obsolescence. Our success is highly dependent upon the successful development and timely introduction of new products at competitive prices and performance levels. Recently our financial performance has suffered because we were late with product introductions compared to our competition and we expect this trend in our financial performance to continue until we deliver new product offerings that are competitive and accepted by the market. The success of new products depends on a number of factors, including:
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Anticipation of market trends;
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Timely completion of design, development, and testing of both the hardware and software for each product;
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Timely completion of customer specific design, development and testing of both hardware and software for each design win;
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Market acceptance of our products and the products of our customers;
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Offering new products at competitive prices;
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Meeting performance, quality and functionality requirements of customers and OEMs; and
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Meeting the timing, volume and price requirements of customers and OEMs.
Our products are designed to conform to current specific industry standards; however, we have no control over future modifications to these standards. Manufacturers may not continue to follow the current standards, which would make our products less desirable to manufacturers and reduce our sales. Our success is highly dependent upon our ability to develop new products in response to these changing industry standards.
Our sales may fluctuate due to seasonality and changes in customer demand.
Since we are primarily focused on the consumer electronics market, we are likely to be affected both by changes in consumer demand and by seasonality in the sales of our products. Historically, over half of consumer electronics products are sold during the holiday seasons. Consequently, our results during a period that covers a non-holiday season may vary dramatically from a period that covers a holiday season. Consumer electronics product sales have historically been much higher during the holiday shopping seasons than during other times of the year, although the manufacturers’ shipments vary from quarter to quarter depending on a number of factors, including retail levels and retail promotional activities. In addition, consumer demand often varies from one product to another in consecutive holiday seasons and is strongly influenced by the overall state of the economy. Because the consumer electronics market experiences substantial seasonal fluctuations, seasonal trends may cause our quarterly operating results to fluctuate significantly and our inability to forecast these trends may adversely affect the market price of our common stock. For instance, as ASPs for DVD products decline, customer demands for VCD products, from which we enjoy a good product margin, even under our recent arrangement to license our VCD products, may shift to DVD products and ultimately render our VCD products obsolete. In the future, if the market for our products is not as strong during the holiday seasons, whether as a result of changes in consumer tastes, changes in our mix of products or because of an overall reduction in consumer demand due to economic conditions, we may fail to meet expectations of securities analysts and investors which could cause our stock price to fall.
Our products are subject to increasing pricing pressures.
The markets for most of the applications for our chips are characterized by intense price competition. The willingness of OEMs to design our chips into their products depends, to a significant extent, upon our ability to sell our products at cost-effective prices. We expect the ASP of our existing products (particularly our DVD decoder) to decline significantly over their product lives as the markets for our products mature, new products or technology emerge and competition increases. If we are unable to reduce our costs sufficiently to offset declines in product prices or are unable to introduce more advanced products with higher margins, our gross margins may decline in the future.
We may lose business to competitors who have significant competitive advantages.
Our existing and potential competitors consist, in part, 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 we have. These competitors may have more visibility into market trends, which is critically important in an industry characterized by rapid technological changes, evolving industry standards and product obsolescence. Our competitors also include a number of independent and emerging companies who may be able to better adapt to changing market conditions and customer demand. In addition, some of our current and potential competitors maintain their own semiconductor fabrication facilities and could benefit from certain capacity, cost and technical advantages. We expect that market experience to date and the predicted growth of the market will continue to attract and motivate more and stronger competitors.
In the Video business, DVD and VCD players face significant competition from video-on-demand, VCRs and other video formats. Further, VCD players, which tend to be viewed as a less expensive alternative, are being replaced by DVD players as DVD players come down in price. We expect that the DVD platform will face competition from other platforms including set-top-boxes, as well as multi-function game boxes being manufactured and sold by large companies. Some of our competitors may be more diversified than us and may supply chips for multiple platforms. Any of these competitive factors could reduce our sales and market share and may force us to lower our prices, adversely affecting our business, financial condition and results of operations.
As we focus on standard definition DVD technology and move away from HD-DVD and Blu-ray DVD technologies, demand may shift in such a way that we would no longer have the technology to address the market’s changing demand and be unable to remain competitive.
Our business is dependent upon retaining key personnel and attracting new employees.
Our success depends to a significant degree upon the continued contributions of our top management including Robert L. Blair, our President and Chief Executive Officer (“CEO”). Fred S.L. Chan, our Chairman of the Board, and James B. Boyd, our Chief Financial Officer, recently resigned and Bruce J. Alexander, who took over as our Chairman of the Board, recently passed away. The loss of the services of Mr. Blair or any of our other key executives could adversely affect our business. We may not be able to retain our other key personnel and searching for key personnel replacements could divert the attention of other senior management and increase our operating expenses. We currently do not maintain any key person life insurance.
Additionally, to manage our future operations effectively, we will need to hire and retain additional management personnel, design personnel as well as hardware and software engineers. We may have difficulty recruiting these employees or integrating them into our business. The loss of services of any of our key personnel, the inability to attract and retain qualified personnel in the future, or delays in hiring required personnel, particularly design personnel and software engineers, could make it difficult to implement our key business strategies, such as timely and effective product introductions.
Changes in stock option accounting rules may adversely impact our reported operating results prepared in accordance with generally accepted accounting principles, our stock price and our competitiveness in the employee marketplace.
Our success and competitiveness depend in large part on our ability to attract, retain and motivate key employees. Achieving this objective may be difficult due to many factors, including fluctuations in global economic and industry conditions, changes in our management or leadership, the effectiveness of our compensation programs, including our equity-based programs, and competitors’ hiring practices. In addition, we began recording a charge to earnings for stock options and ESPP shares in our first fiscal quarter of 2006. This requirement reduces the attractiveness of certain equity-based compensation programs as the expense associated with the grants decreases our profitability. We may make certain adjustments to our broad-based equity compensation programs. These changes may reduce the effectiveness of compensation programs. If we do not successfully attract, retain and motivate key employees as a result of these or other factors, our ability to capitalize on our opportunities and our operating results and may be materially and adversely affected.
We rely on distributors for a significant portion of our revenues and if these relationships deteriorate our financial results could be adversely affected.
Sales through our then-current largest distributor FE Global (a Singapore-based company) were approximately 18%, 32% and 37% of our net revenues for the fiscal year ended December 31, 2007, 2006 and 2005, respectively. As previously announced, on August 31, 2007, our distribution agreement with FE Global was terminated, and we signed a new distribution agreement with CKD (Hong Kong) High Tech Company Limited (“CKD”) who will perform similar functions as those previously provided by FE Global. In addition to FE Global, Weiking Industrial Company, Ltd. (Weiking) accounted for 11% of our revenues in 2007. Our distributors are not subject to any minimum purchase requirements and can discontinue marketing any of our products at any time. In addition, our distributors have rights of return for unsold products and rights to pricing allowances to compensate for rapid,
unexpected price changes. Therefore, we do not recognize revenue until sold through to our end-customers. If our relationship with our distributors deteriorates, our revenues could fluctuate significantly as we experience disruption to our sales and collection processes. We may increasingly rely on distributors, which may reduce our exposure to future sales opportunities. Although we believe that we could replace our distributors, there can be no assurance that we could replace them in a timely manner, or even if a replacement were found, that the new distributors would be as effective in generating revenue for us. The reduction, delay or cancellation of orders or the loss of a distributor could materially and adversely affect our business, financial condition and results of operations. In addition, any difficulty in collecting amounts due from our distributors could harm our financial condition.
Our customer base is highly concentrated, so the loss of a major customer could adversely affect our business.
A substantial portion of our net revenues has been derived from sales to a small number of our customers. During the fiscal year ended December 31, 2007, sales to our top five end-customers across business segments (including end-customers that buy our products from our former largest distributor FE Global) accounted for approximately 66% of our net revenues. We expect this concentration of sales to continue along with other changes in the composition of our customer base. The reduction, delay or cancellation of orders from one or more major customers or the loss of one or more major customers could materially and adversely affect our business, financial condition and results of operations. In addition, any difficulty in collecting amounts due from one or more key customers could harm our financial condition.
Because we are dependent upon a limited number of suppliers, we could experience delivery disruptions or unexpected product cost increases.
We depend on a limited number of suppliers to obtain adequate supplies of quality raw materials on a timely basis. We do not generally have guaranteed supply arrangements with our suppliers. If we have difficulty in obtaining materials in the future, alternative suppliers may not be available, or if available, these suppliers may not provide materials in a timely manner or on favorable terms. If we cannot obtain adequate materials for the manufacture of our products, we may be forced to pay higher prices, experience delays and our relationships with our customers may suffer.
In addition, we license certain technology from third parties that is incorporated into many of our key products. If we are unable to obtain or license the technology on commercially reasonable terms and on a timely basis, we will not be able to deliver products to our customers on competitive terms and in a timely manner and our relationships with our customers may suffer.
We may not be able to adequately protect our intellectual property rights from unauthorized use and we may be subject to claims of infringement of third-party intellectual property rights.
To protect our intellectual property rights we rely on a combination of patents, trademarks, copyrights and trade secret laws and confidentiality procedures. We have numerous patents granted in the United States with some corresponding foreign patents. These patents will expire at various times. We cannot assure you that patents will be issued from any of our 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. We may not be able to obtain patent protection in all countries where our products may be sold. Also, our competitors may be able to design around our patents. The laws of some foreign countries may not protect our products or intellectual property rights to the same extent, as do the laws of the United States. We cannot assure you that the actions we have taken to protect our intellectual property will adequately prevent misappropriation of our technology or that our competitors will not independently develop technologies that are substantially equivalent or superior to our technology.
The semiconductor industry is characterized by vigorous protection and pursuit of intellectual property rights or positions. Litigation by or against us could result in significant expense and divert the efforts of our technical and management personnel, whether or not such litigation results in a favorable determination for us. Any claim, even if without merit, may require us to spend significant resources to develop non-infringing technology or enter into royalty or cross-licensing arrangements, which may not be available to us on acceptable terms, or at all. We may be
required to pay substantial damages or cease the use and sale of infringing products, or both. In general, a successful claim of infringement against us in connection with the use of our technologies could adversely affect our business and our results of operations could be significantly harmed. See Part I, Item 3, “Legal Proceedings.” We may initiate claims or litigation against third parties for infringement of our proprietary rights or to establish the validity of our proprietary rights. In the event of an adverse result in any such litigation our business could be materially harmed.
We have significant international sales and operations that are subject to the special risks of doing business outside the United States.
Substantially all of our sales are to customers (including distributors) in China, Hong Kong, Taiwan, Indonesia and Korea. During the fiscal year ended December 31, 2007, sales to customers in China, Hong Kong, Taiwan, Indonesia and Korea were approximately 87% of our net revenues. If our sales in one of these countries or territories, such as Korea, were to fall, our financial condition could be materially impaired. We expect that international sales will continue to represent a significant portion of our net revenues. In addition, substantially all of our products are manufactured, assembled and tested by independent third parties in Asia. There are special risks associated with conducting business outside of the United States, including:
•
Unexpected changes in legislative or regulatory requirements and related compliance problems;
•
Political, social and economic instability;
•
Lack of adequate protection of our intellectual property rights;
•
Changes in diplomatic and trade relationships, including changes in most favored nations trading status;
•
Tariffs, quotas and other trade barriers and restrictions;
•
Longer payment cycles, greater difficulties in accounts receivable collection and greater difficulties in ascertaining the credit of our customers and potential business partners;
•
Potentially adverse tax consequences, including withholding in connection with the repatriation of earnings and restrictions on the repatriation of earnings;
•
Difficulties in obtaining export licenses for technologies;
•
Language and other cultural differences, which may inhibit our sales and marketing efforts and create internal communication problems among our U.S. and foreign counterparts; and
•
Currency exchange risks.
Our products are manufactured by independent third parties.
We rely on independent foundries to manufacture all of our products. Substantially all of our products are currently manufactured by TSMC, GSMC, and other independent Asian foundries in Asia. Our reliance on these or other independent foundries involves a number of risks, including:
•
Possibility of an interruption or loss of manufacturing capacity;
•
Reduced control over delivery schedules, manufacturing yields and costs; and
•
The inability to reduce our costs as rapidly as competitors who perform their own manufacturing and who are not bound by volume commitments to subcontractors at fixed prices.
Any failure of these third-party foundries to deliver products or otherwise perform as requested could damage our relationships with our customers and harm our sales and financial results.
To address potential foundry capacity constraints in the future, we may be required to enter into 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 us to purchase specified quantities of wafers over extended periods. These arrangements could require us to commit substantial
capital or to grant licenses to our technology. If we need to commit substantial capital, we may need to obtain additional debt or equity financing, which could result in dilution to our shareholders.
We have extended sales cycles, which increase our costs in obtaining orders and reduce the predictability of our earnings.
Our potential customers often spend a significant amount of time to evaluate, test and integrate our products. Our sales cycles often last for several months and may last for up to a year or more. These longer sales cycles require us to invest significant resources prior to the generation of revenues and subject us to greater risk that customers may not order our products as anticipated. In addition, orders expected in one quarter could shift to another because of the timing of customers’ purchase decisions. Any cancellation or delay in ordering our products after a lengthy sales cycle could adversely affect our business.
Our products are subject to recall risks.
The greater integration of functions and complexity of our products increase the risk that our customers or end users could discover latent defects or subtle faults in our products. These discoveries could occur after substantial volumes of product have been shipped, which could result in material recalls and replacement costs. Product recalls could also divert the attention of our engineering personnel from our product development needs and could adversely impact our customer relationships. In addition, we could be subject to product liability claims that could distract management, increase costs and delay the introduction of new products.
The semiconductor industry is subject to cyclical variations in product supply and demand.
The semiconductor industry is subject to cyclical variations in product supply and demand, the timing, length and volatility of which are difficult to predict. Downturns in the industry have been characterized by abrupt fluctuations in product demand, production over-capacity and accelerated decline of ASP. Upturns in the industry have been characterized by rising costs of goods sold and lack of production capacity at our suppliers. These cyclical changes in demand and capacity, upward and downward, could significantly harm our business. Our quarterly net revenues and gross margin performance could be significantly impacted by these cyclical variations. A prolonged downturn in the semiconductor industry could materially and adversely impact our business, financial condition and results of operations. We cannot assure you that the market will improve from a cyclical downturn or that cyclical performance will stabilize or improve.
The value of our common stock may be adversely affected by market volatility.
The price of our common stock fluctuates significantly. Many factors influence the price of our common stock, including:
•
Future announcements concerning us, our competitors or our principal customers, such as quarterly operating results, changes in earnings estimates by analysts, technological innovations, new product introductions, governmental regulations, or litigation;
•
Changes in accounting rules, particularly those related to the expensing of stock options and accounting for uncertainty in income taxes;
•
The liquidity within the market for our common stock;
•
Sales or purchases by us or by our officers, directors, other insiders and large shareholders;
•
Investor perceptions concerning the prospects of our business and the semiconductor industry;
•
Market conditions and investor sentiment affecting market prices of equity securities of high technology companies; and
•
General economic, political and market conditions, such as recessions or international currency fluctuations.
We are incurring additional costs and devoting more management resources to comply with increasing regulation of corporate governance and disclosure.
We are spending an increased amount of management time and external resources to analyze and comply with changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and the NASDAQ Global Market rules and listing requirements. Devoting the necessary resources to comply with evolving corporate governance and public disclosure standards may result in increased general and administrative expenses and attention to these compliance activities and divert management’s attention from our on-going business operations.
Failure to maintain effective internal controls could have a material adverse effect on our business, operating results and stock price.
Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we are required to include a report of management’s assessment of the design and effectiveness of our internal controls as part of our Annual Report on Form 10-K. In order to issue our report, our management must document both the design for our internal control over financial reporting and the testing processes, including those related to new systems and programs, that support management’s evaluation and conclusion. During the course of testing our internal controls each year, we may identify deficiencies which we may not be able to remediate, document and retest in time, due to difficulties including those arising from turnover of qualified personnel, to meet the deadline for management to complete its report. Upon the completion of our testing and documentation, certain deficiencies may be discovered that will require remediation, the costs of which could have a material adverse effect on our results of operations. In addition, if we fail to maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended from time to time we may not be able to ensure that our management can conclude on an ongoing basis that we have effective internal control over financial reporting in accordance with Section 404. In the future, if we are unable to assert that our internal control over financial reporting is effective, we could lose investor confidence in the accuracy and completeness of our financial reports, which in turn could have an adverse effect on our stock price.
We are exposed to fluctuations in the market values of our investments and in interest rates.
At December 31, 2007, we had $49.9 million in cash, cash equivalents and short-term investments. These balances represented over 50% of our total assets. We invest our cash in a variety of financial instruments, consisting principally of investments in commercial paper, money market funds, and highly liquid debt securities of corporations, and the United States government and its agencies. These investments are denominated in U.S. dollars. We do not have any investments in auction rate securities.
Investments in both fixed interest rate and floating interest rate instruments carry a degree of interest rate risk. Fixed rate debt securities may have their market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates or if the decline in fair value of our publicly traded equity investments is judged to be other-than-temporary. We may suffer losses in principal if we are forced to sell securities that decline in market value due to changes in interest rates. However, because any debt securities we hold are classified as “available-for-sale,” no gains or losses are recognized due to changes in interest rates unless such securities are sold prior to maturity. In addition, the credit worthiness of the issuer, relative values of alternative investments, the liquidity of the instrument, and other general market conditions may affect the fair values of interest rate sensitive investments.
Item 1B.
Item 1B.
Unresolved Staff Comment
None
Item 2.
Item 2.
Properties
We own nearly 12 acres of land in Fremont, California, on which we built our two-story, 93,000 square-foot corporate headquarters, as well as a 77,000 square-foot office building next to our corporate headquarters. In
addition we own an adjacent 11,000 square-foot dormitory building used to house visitors and guest workers. We also have an approximately 5,000 square-foot warehouse next to our corporate headquarters in Fremont, California. We also lease a small amount of office space to support our operations outside the United States.
In October 2007, we entered into an agreement with TC Fund Property Acquisitions, Inc. (“TC Fund”) to sell our real property assets located in Fremont, California, for $26.3 million. The agreement was subject to certain conditions to closing including a 30-day due diligence approval period. Prior to the expiration of the due diligence period, TC Fund notified us that they were terminating the agreement. The reason given for the termination was the continued uncertainty in the real estate market.
We consider the above facilities suitable and adequate to meet our current requirements. There are no liens on any of our owned land and buildings. We are currently working with a real estate company and actively considering the lease or sale of all or a portion of our land and facilities in Fremont, California.
Item 3.
Item 3.
Legal Proceedings
On September 12, 2002, following our downward revision of revenue and earnings guidance for the third fiscal quarter of 2002, a series of putative federal class action lawsuits were filed against us in the United States District Court, Northern District of California. The complaints alleged that we and certain of our present and former officers and directors made misleading statements regarding our business and failed to disclose certain allegedly material facts during an alleged class period of January 23, 2002 through September 12, 2002, in violation of federal securities laws. These actions were consolidated under the caption “In re ESS Technology Securities Litigation.” The plaintiffs sought unspecified damages on behalf of the putative class. Plaintiffs amended their consolidated complaint on November 3, 2003, which we then moved to dismiss on December 18, 2003. On December 1, 2004, the Court granted in part and denied in part our motion to dismiss, and struck from the complaint allegations arising prior to February 27, 2002. On December 22, 2004, based on the Court’s order, we moved to strike from the complaint all remaining claims and allegations arising prior to September 10, 2002. On February 22, 2005, the Court granted our motion in part and struck all remaining claims and allegations arising prior to August 1, 2002 from the complaint. In an order filed on February 8, 2006, the Court certified a plaintiff class of all persons and entities who purchased or otherwise acquired the Company’s publicly traded securities during the period beginning August 1, 2002, through and including September 12, 2002 (the “Class Period”), excluding officers and directors of the Company, their families and families of the defendants, and short-sellers of the Company’s securities during the Class Period. On March 24, 2006, plaintiff filed a motion for leave to amend their operative complaint, which the Court denied on May 30, 2006. Trial was tentatively set for January 2008. On November 12, 2006, the parties attended a mediation at which they agreed to settle the litigation for $3.5 million (to be paid by defendants’ insurance carriers), subject to appropriate documentation by the parties and approval by the Court. The Stipulation of Settlement and Release was filed with the Court on April 30, 2007. On May 8, 2007, the Court issued an order preliminarily approving the settlement and providing for class notice. At a fairness hearing on July 27, 2007, having received no objections to the settlement and no requests for exclusion, the Court entered a Final Judgment and Order of Dismissal With Prejudice as to all defendants. The time for appeal from the Final Judgment and Order of Dismissal With Prejudice has now passed. While defendants have denied and continue to deny any and all allegations of wrongdoing in connection with this matter, we believe that given the uncertainties and cost associated with litigation, the settlement is in the best interests of the Company and its stockholders. We recorded a $3.5 million loss for the settlement during the quarter ended March 31, 2007. In addition, a receivable from our insurance carriers was also recorded for the same amount, plus recoverable legal fees. Accordingly, there is no impact to the statement of operations because the amount of the settlement, including legal expenses, and the insurance recovery offset each other. The settlement was completed during the year ended December 31, 2007.
On September 12, 2002, following the same downward revision of revenue and earnings holders of our common stock, purporting to represent us, filed a series of derivative lawsuits in California state court, County of Alameda, against us as a nominal defendant and against certain of our present and former directors and officers as defendants. The lawsuits alleged certain violations of the federal securities laws, including breaches of fiduciary duty and insider trading. These actions were consolidated as a Consolidated Derivative Action with the caption “ESS Cases.” The derivative plaintiffs sought compensatory and other damages in an unspecified amount, disgorgement of profits, and other relief. On March 24, 2003, we filed a demurrer to the consolidated derivative
complaint and moved to stay discovery in the action pending resolution of the initial pleadings in the related federal action, described above. The Court denied the demurrer but stayed discovery. That stay was then lifted in light of the procedural progress of the federal action. The parties reached an agreement in principle to settle the litigation in exchange for certain minor modifications of the Company’s internal policies and payment of plaintiffs’ attorneys fees not to exceed $200,000 (to be paid by defendants’ insurance carriers). The agreement in principle to settle the litigation was then documented and finalized by the parties and submitted to the Court for approval. On October 1, 2007, the Stipulation and Agreement of Settlement became binding upon the Court’s entry of a final Judgment of Dismissal with prejudice as to all defendants in the action, subject to appeal as required by applicable state law. While defendants have denied and continue to deny any and all allegations of wrongdoing in connection with this matter, we believe that given the uncertainties and cost associated with litigation, the settlement is in the best interests of the Company and its stockholders. We recorded a $200,000 loss for the proposed settlement in the quarter ended June 30, 2007, as management has determined this amount probable of payment and reasonably estimable. In addition, because recovery from the insurance carriers is probable, a receivable was also recorded for the same amount. Accordingly, there is no impact to the statement of operations because the amount of the settlement and the insurance recovery offset each other.
On October 4, 2006, Ali Corporation (“Ali”) filed a lawsuit in Alameda County Superior Court against the company that alleged claims for breach of contract, common counts, quantum meruit, account stated and for an open book account. All of the claims arose from a Joint Development Agreement between the company and Ali, originally entered into on December 14, 2001 and subsequently amended on several occasions. Ali’s complaint sought damages in the amount of $2.5 million. The company answered Ali’s complaint and on April 6, 2007 the parties settled this matter in the course of a formal mediation. A Settlement Agreement was executed whereby the Company has settled the case by paying $1.7 million to Ali during the year ended December 31, 2007.
From time to time, we are subject to various claims and legal proceedings. If management believes that a loss arising from these matters is probable and can reasonably be estimated, we would record the amount of the loss, or the minimum estimated liability when the loss is estimated using a range, and no point within the range is more probable than another. As additional information becomes available, any potential liability related to these matters is assessed and the estimates are revised, if necessary. Based upon consultation with the outside counsel handling our defense in the legal proceedings listed above, and an analysis of potential results, we have accrued sufficient amounts for potential losses related to these proceedings. Based on currently available information, management believes that the ultimate outcome of these matters, individually and in the aggregate, will not have a material adverse effect on the Company’s financial position, cash flows or overall trends in results of operations. However, litigation is subject to inherent uncertainties, and unfavorable rulings could occur. An unfavorable ruling could include monetary damages or an injunction prohibiting us from selling one or more products. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on the results of operations of the period in which the ruling occurs, or future periods, could result.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders
None
PART II
Item 5.
Item 5.
Market for the Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities
Our common stock has been trading on the NASDAQ Global Market, previously known as the NASDAQ National Market, under the symbol “ESST” since October 6, 1995. The following table sets forth the high and low closing prices for our common stock as reported by the NASDAQ Global Market during the periods indicated.
As of March 1, 2008, there were approximately 156 record holders of our common stock. Since most shareholders are listed under their brokerage firm’s names, the actual number of beneficial shareholders is higher.
ISSUER PURCHASES OF EQUITY SECURITIES
(1)
We announced on April 16, 2003 that our Board of Directors authorized us to repurchase up to 5,000,000 shares of our common stock. As of December 31, 2007, we had approximately 688,000 shares remaining available for repurchase under this program, for which there is no stated expiration. In addition, we announced on February 16, 2007 that our Board of Directors authorized us to repurchase up to an additional 5,000,000 shares of our common stock with no stated expiration for this program.
Dividend Policy
We have never declared or paid cash dividends. We currently intend to retain all available funds and any future earnings for use in the operation of our business and do not anticipate paying any cash dividends in the foreseeable future.
The remaining information called for by this item relating to “Equity Compensation Plan Information” is reported in Item 12 of this Report.
Item 6.
Item 6.
Selected Financial Data
The following data should be read in conjunction with “Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the financial statements and related notes thereto included in Item 8 of this Report.
We derived the selected consolidated statement of operations data for the years ended December 31, 2007, 2006 and 2005 and the selected consolidated balance sheet data as of December 31, 2007 and 2006 from our audited consolidated financial statements appearing elsewhere in this Report. We derived the selected consolidated statement of operations data for the years ended December 31, 2004 and 2003 and the selected consolidated balance sheet data as of December 31, 2005, 2004 and 2003 from our audited consolidated financial statements, which are not included in this Report.
(1)
In 2006 and 2007, the cost of product revenues, research and development expenses, and selling, general and administrative expenses include the effect of the adoption of SFAS No. 123(R). See Note 12, “Stock-Based Compensation” to our consolidated financial statements for additional information.
(2)
In 2007, we sold certain tangible assets and licensed intellectual property related to our HD-DVD and Blu-ray DVD technologies. See Note 9 “Gain on Sale of Technology and Tangible Assets” to our consolidated financial statements for additional information.
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Certain information contained in or incorporated by reference in the following Management’s Discussion and Analysis of Financial Condition and Results of Operations, in Item 1A, Risk Factors, and elsewhere in this Report, contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements include statements concerning the future of our industry, our product development, our business strategy, our future acquisitions, the continued acceptance and growth of our products, and our dependence on significant customers. Actual results may differ materially from those projected in the forward-looking statements as a result of various factors including those discussed in Item 1A, Risk Factors, and elsewhere in this Report. In some cases, these statements can be identified by terminologies such as “may,” “will,” “expect,” “anticipate,” “estimate,” “continue,” other similar terms or the negative of these terms. Although we believe that the assumptions underlying the forward-looking statements contained in this Report are reasonable, they may be inaccurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such statements should not be regarded as a representation by us or any other person that the results or conditions described in such statements will be achieved. We undertake no obligation to revise or update publicly any forward-looking statements for any reason.
Executive Overview
We were incorporated in California in 1984 and became a public company in 1995. We have historically operated in two primary business segments, Video and Digital Imaging, both in the semiconductor industry serving the consumer electronics and digital media marketplace.
In our Video business, we design, develop and market highly integrated analog and digital processor chips and digital amplifiers. Our digital processor chips drive digital video and audio devices, including DVD players, Video CD (“VCD”) players, consumer digital audio players and digital media players. We continue to sell certain legacy products we have in inventory including chips for use in recordable DVD players, modems, other communication devices and PC audio products. On September 18, 2006 we announced an ongoing strategic review of our operations and business plan. In connection with this strategic review, on November 3, 2006, we licensed to Hangzhou Silan Microelectronics Co., Ltd. (“Silan”) the development, manufacture and sale of our next generation standard definition DVD chips, the Phoenix II and LMX II, and also granted Silan a non-exclusive license for our standard definition DVD technology. Silan has recently notified us, however, that it does not intend to proceed with the development, manufacture and sale of any of the chips or technology we licensed to Silan and we have sent Silan a notice to cure this breach of our agreements. On February 16, 2007, we sold to Silicon Integrated Systems Corporation and its affiliates (“SiS”) our tangible and intangible assets relating to the development of high definition DVD chips based on next generation blue laser technology. Also, in connection with this restructuring strategy, during the first quarter of 2007 we substantially terminated the production and sale of our camera phone image sensors, which were the only remaining products of our Digital Imaging segment. We plan to license our image sensor patents in exchange for royalties, but we will no longer sell imaging sensor semiconductor chips. We continue to design, develop and market highly integrated analog and digital processor chips and digital amplifiers, including chips for standard definition DVD players primarily for the Korean market, and chips for digital audio players and digital media players for all markets. We are now concentrating on our standard definition DVD chip business and evaluating opportunities to develop profitable operations.
We market our products worldwide through our direct sales force, distributors and sales representatives. Substantially all of our sales are to distributors, direct customers and end-customers in China, Hong Kong, Taiwan,
Japan, Korea, Indonesia and Singapore. We employ sales and support personnel located outside of the United States in China, Hong Kong, Taiwan and Korea to support these international sales efforts. We expect that international sales will continue to represent a significant portion of our net revenues. In addition, substantially all of our products are manufactured, assembled and tested by independent third parties in Asia. We also have a number of employees engaged in research and development efforts outside of the United States. There are unique risks associated with conducting business outside of the United States.
On February 21, 2008, ESS Technology, Inc., a California corporation (“ESS California”), Echo Technology (Delaware), Inc., a Delaware corporation and a wholly owned subsidiary of ESS California (“Delaware Merger Subsidiary”), Semiconductor Holding Corporation, a Delaware corporation and wholly owned subsidiary of Imperium Master Fund, Ltd. (“Parent”), and Echo Mergerco, Inc., a Delaware corporation and a wholly owned subsidiary of Parent (“Merger Subsidiary”) entered into an Agreement and Plan of Merger (the “Merger Agreement”) pursuant to which (i) ESS California will, subject to the satisfaction or waiver of the conditions set forth in the Merger Agreement, merge with and into Delaware Merger Subsidiary (the “Reincorporation Merger”), the separate corporate existence of ESS California shall cease and Delaware Merger Subsidiary shall be the successor or surviving corporation of the merger (“ESS Delaware”), and (ii) following the Reincorporation Merger, Merger Subsidiary will, subject to the satisfaction or waiver of the conditions set forth in the Merger Agreement, including the consummation of the Reincorporation Merger, merge with and into ESS Delaware (the “Merger”), the separate corporate existence of Merger Subsidiary shall cease and ESS Delaware shall be the successor or surviving corporation of the merger and wholly owned subsidiary of the Parent.
Upon the consummation of the Reincorporation Merger, ESS California will become a Delaware corporation, each share of ESS California common stock will be converted into one share of ESS Delaware common stock and each option to acquire ESS California common stock granted pursuant to ESS California’s stock plans and outstanding immediately prior to the consummation of the Reincorporation Merger, whether vested or unvested, exercisable or unexercisable, will be automatically converted into the right to receive an option to acquire one share of ESS Delaware common stock for each share of ESS California common stock subject to such option, on the same terms and conditions applicable to the option to purchase ESS California common stock (each, an “ESS Delaware Option”).
Upon the consummation of the Merger, (i) ESS Delaware will become a wholly owned subsidiary of Parent and (ii) each share of ESS Delaware common stock will be converted into the right to receive $1.64 in cash, unless the stockholder properly exercises appraisal rights. In addition, each ESS Delaware Option, whether vested or unvested, exercisable or unexercisable, will be converted into the right to receive an amount in cash equal to the product obtained by multiplying (x) the aggregate number of shares of ESS Delaware common stock subject to such ESS Delaware Option and (y) the excess, if any, of the Merger Consideration less the exercise price per share of ESS Delaware common stock subject to such ESS Delaware Option, after which it shall be cancelled and extinguished.
The parties to the Merger Agreement intend to consummate the Merger as soon as practicable after the Reincorporation Merger and ESS California will not consummate the Reincorporation Merger unless the parties are in a position to consummate the Merger. ESS California and Delaware Merger Subsidiary have made customary representations and warranties in the Merger Agreement and agreed to certain customary covenants, including covenants regarding operation of the business of ESS California and its subsidiaries, including Delaware Merger Subsidiary, prior to the closing and covenants prohibiting ESS California from soliciting, or providing information or entering into discussions regarding, proposals relating to alternative business combination transactions, except in limited circumstances to permit the board of directors of ESS California to comply with its fiduciary duties under applicable law.
The transactions contemplated by the Merger Agreement are subject to ESS California shareholder approval, delivery of ESS California’s audited financial statements for the year ended December 31, 2007 and other customary closing conditions. The Merger Agreement contains certain termination rights for both ESS California and Parent and further provides that, upon termination of the Merger Agreement under certain circumstances, ESS California may be obligated to pay Parent a termination fee of $1,981,000 plus reimbursement of Parent’s and its affiliates’ reasonable expenses incurred in connection with the transactions contemplated by the Merger Agreement up to, but not in excess of, $500,000.
The Merger Agreement contains representations and warranties by ESS California and Delaware Merger Subsidiary, on the one hand, and by Parent and Merger Subsidiary, on the other hand, made solely for the benefit of the other. The assertions embodied in those representations and warranties are qualified by information in confidential disclosure schedules that the parties have exchanged in connection with signing the Merger Agreement. The disclosure schedules contain information that modifies, qualifies and creates exceptions to the representations and warranties set forth in the Merger Agreement. Moreover, certain representations and warranties in the Merger Agreement were made as of a specified date, may be subject to a contractual standard of materiality different from what might be viewed as material to shareholders, or may have been used for the purpose of allocating risk between ESS California and Delaware Merger Subsidiary, on the one hand, and Parent and Merger Subsidiary, on the other hand. Accordingly, the representations and warranties and other disclosures in the Merger Agreement should not be relied on by any persons as characterizations of the actual state of facts about ESS California, Delaware Merger Subsidiary, Parent or Merger Subsidiary at the time they were made or otherwise.
Critical Accounting Policies and Estimates
Use of Estimates
Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions upon which we rely are reasonable based upon information available to us at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected. The significant accounting policies that we believe are the most critical in understanding and evaluating our reported financial results include the following:
•
Revenue Recognition
•
Inventories and Inventory Reserves
•
Impairment of Long-Lived Assets
•
Income Taxes
•
Legal Contingencies
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Stock-based Compensation
In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application. There are also cases in which management’s judgment is required in selecting appropriate accounting treatment among available alternatives under GAAP. Our management has reviewed these critical accounting policies and related disclosures with our Audit Committee. See notes to consolidated financial statements in Item 8 of this Report for additional information regarding our accounting policies and other disclosures required by GAAP.
Revenue Recognition
Revenue is primarily generated by product sales and is recognized at the time of shipment when persuasive evidence of an arrangement exists, the price is fixed or determinable and collection of the resulting receivable is reasonably assured, except for products sold to certain distributors with certain rights of return for unsold products and rights to pricing adjustments, in which case, revenue is deferred until such a distributor resells the products to a third party. Such deferred revenue related to distributor sales, net of deferred cost of goods sold are recorded as deferred margin included in accrued expenses on our balance sheets. License and royalty revenue is recognized as the services provided have been completed, or based on the units sold and reported to us by the third party licensee provided collection of the resulting receivable is reasonably assured.
We provide for rebates based on current contractual terms and future returns based on historical experiences at the time revenue is recognized as reductions to product revenue. Actual amounts may be different from management’s estimates. Such differences, if any, are recorded in the period they become known.
Inventories and Inventory Reserves
Our inventory is comprised of raw materials, work-in-process and finished goods, all of which are manufactured by third-party contractors. Inventory is valued at the lower of standard cost (which approximates actual cost on a first-in, first-out basis) or market. We reduce the carrying value of inventory for estimated slow-moving, excess, obsolete, damaged or otherwise unmarketable products by an amount based on forecasts of future demand and market conditions.
We evaluate excess or obsolete inventory primarily by estimating demand for individual products within specific time horizons, typically one year or less. We generally provide a 100% reserve for the cost of products with on-hand and committed quantities in excess of the estimated demand after considering factors such as product life cycles. Once established, reserves for excess or obsolete inventory are only released when the reserved products are scrapped or sold. We also evaluate the carrying value of inventory at the lower of standard cost or market on an individual product basis, and these evaluations are based on the difference between net realizable value and standard cost. Net realizable value is the forecasted selling price of the product less the estimated costs of completion and disposal. When necessary, we will reduce the carrying value of inventory to net realizable value.
The estimates of future demand, forecasted sales prices and market conditions used in the valuation of inventory form the basis for our published and internal earnings forecast. If actual results are substantially lower than the forecast, we may be required to record additional write-downs of product inventory in future periods and this may have a negative impact on gross margins.
Impairment of Long-Lived Assets
We review long-lived assets and certain identifiable intangibles assets to be held and used for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We evaluate any possible impairment of long-lived assets and certain intangible assets using estimates of undiscounted future cash flows. If an impairment loss is to be recognized, it is measured as the amount by which the carrying amount of the asset exceeds the fair value of the asset. Management evaluates the fair value of its long-lived assets and certain intangibles assets using primarily the estimated discounted future cash flows method. Management uses other alternative valuation techniques whenever the estimated discounted future cash flows method is not appropriate.
Income Taxes
We account 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 timing differences between the carrying amounts and the tax bases of assets and liabilities. U.S. deferred income taxes are not provided on un-remitted earnings of our foreign subsidiaries as such earnings are considered permanently invested. Assumptions underlying recognition of deferred tax assets and non-recognition of U.S. income tax on un- remitted earnings can change if our business plan is not achieved or if Congress adopts changes in the Internal Revenue Code of 1986, as amended.
Effective January 1, 2007, the Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”). This interpretation clarifies the criteria for recognizing income tax benefits under FASB Statement No. 109, Accounting for Income Taxes, and requires additional disclosures about uncertain tax positions. Under FIN 48 the financial statement recognition of the benefit for a tax position is dependent upon the benefit being more likely than not to be sustainable upon audit by the applicable taxing authority. If this threshold is met, the tax benefit is then measured and recognized at the largest amount that is greater than 50 percent likely of being realized upon ultimate settlement.
Legal Contingencies
From time to time, we are subject to legal proceedings and claims, including claims of alleged infringement of patents, trademarks, copyrights and other intellectual property rights and other claims arising out of the ordinary course of business. Further, we have previously been engaged in certain shareholder class action and derivative lawsuits.
These contingencies require management judgment in order to assess the likelihood of any adverse judgments or outcomes and the potential range of probable losses. Liabilities for legal matters are accrued for when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated, based upon current law and existing information. Estimates of contingencies may change in the future due to new developments or changes in legal approach.
Stock-based Compensation
Effective January 1, 2006, we adopted the provisions of SFAS No. 123(R), which requires us to measure all employee stock-based compensation awards using a fair value method and record such expense in our consolidated financial statements. We estimate the fair value of stock options using a Black-Scholes valuation model, consistent with the provisions of SFAS No. 123(R), Staff Accounting Bulletin No. 107 and our prior period pro forma disclosures of net earnings, including stock-based compensation (determined under a fair value method as prescribed by SFAS No. 123). The Black-Scholes valuation model requires the input of subjective assumptions, including the option’s expected life, the price volatility of the underlying stock, and forfeiture rate. These assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management’s judgment. We elected to adopt the modified prospective application transition method as provided by SFAS No. 123(R).
Recent Accounting Pronouncements
In September 2006, the Financial Accounting Standard Board (“FASB”) issued statement No. 157, “Fair Value Measurements” (“SFAS No. 157”). This standard defines fair value, establishes a framework for measuring fair value in accounting principles generally accepted in the United States of America, and expands disclosure about fair value measurements. This pronouncement applies under other accounting standards that require or permit fair value measurements. Accordingly, this statement does not require any new fair value measurement. In February 2008, the FASB issued FASB Staff Position (FSP) 157-1, “Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13” (FSP 157-1) and FSP 157-2, “Effective Date of FASB Statement No. 157” (FSP 157-2). FSP 157-1 amends SFAS No. 157 to remove certain leasing transactions from its scope. FSP 157-2 delays the effective date of SFAS No. 157 for all non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until the beginning of the first quarter of fiscal 2009. The measurement and disclosure requirements related to financial assets and financial liabilities are effective for us beginning in the first quarter of fiscal 2008. We are currently evaluating the requirements of SFAS No. 157 and have not yet determined the impact on our consolidated financial statements.
In February 2007, the FASB issued statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”). SFAS No. 159 permits companies to choose to measure certain financial instruments and certain other items at fair value. The standard requires that unrealized gains and losses on items for which the fair value option has been elected be reported in earnings. SFAS No. 159 is effective for us beginning in the first quarter of fiscal year 2008, although earlier adoption is permitted. We are currently evaluating the impact that SFAS No. 159 may have on our consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (SFAS No. 141(R)). Under SFAS No. 141(R), an entity is required to recognize the assets acquired, liabilities assumed, contractual contingencies, and contingent consideration at their fair value on the acquisition date. It further requires that acquisition-related costs be recognized separately from the acquisition and expensed as incurred, restructuring costs generally be expensed in periods subsequent to the acquisition date, and changes in accounting for deferred tax asset
valuation allowances and acquired income tax uncertainties after the measurement period impact income tax expense. In addition, acquired in-process research and development (IPR&D) is capitalized as an intangible asset and amortized over its estimated useful life. The adoption of SFAS No. 141(R) will change our accounting treatment for business combinations on a prospective basis beginning in the first quarter of fiscal year 2009.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements - an amendment of ARB No. 51” (SFAS No. 160). SFAS No. 160 changes the accounting and reporting for minority interests, which will be recharacterized as non-controlling interests and classified as a component of equity. SFAS No. 160 is effective for us on a prospective basis for business combinations with an acquisition date beginning in the first quarter of fiscal year 2009. As of December 29, 2007, we did not have any minority interests. The adoption of SFAS No. 160 will not impact our consolidated financial statements.
Comparison of Year ended December 31, 2007 and December 31,
Results of Operations
The following table sets forth our results of operations for the fiscal years ended December 31, 2007 and 2006:
Net Revenues
Net revenues were $68.3 million in 2007 and $100.5 million in 2006. Net revenues decreased by $32.2 million, or 32.0%, from 2006 to 2007, due to decreased revenues in all product categories in both of our business segments except revenue from legacy products which include PC Audio chips, communication modem, consumer digital media and other miscellaneous chips.
The following table summarizes percentage of net revenue by our two business segments and their major product categories:
Video business revenues included revenues from DVD, VCD, Recordable, License and Royalty payments for DVD technologies and Other.
DVD revenue includes revenue from sales of DVD decoder chips and recordable chips. DVD revenues were $53.7 million in 2007, a decrease of $14.4 million, or 21.1%, from 2006 to 2007, primarily due to lower overall sales volume and partially offset by the improvement in average selling price (“ASP”). Sales volume decreased by 8.2% and ASP increased by 10.0%. We sold approximately 15.6 million units and 17.0 million units in 2007 and 2006, respectively. We plan to continue sales in certain niche markets of the larger DVD market but do not intend to compete for a very large portion of the overall DVD market, therefore, our market share continues to decrease with relatively flat revenue in 2008. On November 3, 2006, we licensed to Hangzhou Silan Microelectronics Co., Ltd. (“Silan”) the development, manufacture and sale of our next generation standard definition DVD chips, the Phoenix II and LMX II, and also granted Silan a non-exclusive license for our standard definition DVD technology, although Silan has recently notified us that it does not intend to proceed with the development, manufacture and sale of any of the chips or technology we licensed to Silan and we have sent Silan a notice to cure this breach of our agreements.
VCD revenue includes revenue from sales of VCD chips. We have experienced a significant decline in our VCD business over the last few years. VCD revenues were $4.8 million in 2007, a decrease of $13.4 million, or 73.6%, from 2006 to 2007, primarily due to lower sales volume. Sales volume decreased by 12.2 million units, or 83.6%, to 2.4 million units from 14.6 million units in 2006. The decline in VCD business is due to the replacement of the VCD market with lower priced DVD units. In September 2005, we licensed to Silan the right to manufacture and market our VCD technology to customers in China and India. In 2007, Silan started shipping a new integrated version, utilizing Silan’s front-end optical controller and our back-end video processor VCD chip for which they pay us a royalty . Royalty revenue from this agreement has to date been insignificant. We expect VCD revenues, including licence revenue will continue to decrease in 2008 as the VCD market continues to be replaced with lower end DVD units.
License and royalty consists of license payments from Silan and NEC Electronics Corporation (“NEC”). License and royalty revenue were $0.8 million and $2.7 million for the year ended December 31, 2007 and 2006, respectively. The $0.8 million in 2007 was from Silan. The $2.7 million in 2006 consists of $2.3 million from Silan and $0.4 million from NEC for using certain of our TV audio decoder technology. All payments from Silan were related to the DVD Technology License Agreement that we entered in November 2006.
Other revenue includes revenues from legacy products which includes sales of PC Audio chips, communication, consumer digital media and other miscellaneous chips. Other revenue was $8.9 million in 2007, an increase of $2.1 million, or 30.9%, from 2006 to 2007 primarily due to higher sales volume of consumer digital media products. Units sold for other revenue products increased by 75.0%. We sold approximately 2.1 million units and 1.2 million units in 2007 and 2006, respectively.
Digital Imaging revenues were comprised of revenues from sales of image sensor chips, image processor chips and camera lens modules. Digital Imaging revenues were $0.2 million in 2007, a decrease of $4.6 million, or 95.7%, from 2006 to 2007. As part of our reorganization plan previously discussed, on February 16, 2007, we reduced operation of our camera phone image sensor business. We plan to pursue licensing of our patents for image sensor technology but we will no longer design, develop and market imaging sensor chips. We do not expect any revenue from this segment in 2008.
International revenues accounted for approximately 100% of the revenue in both 2007 and 2006. All of our international sales are denominated in U.S. dollars. We expect that international sales will continue to remain a high percentage of our net revenues in the foreseeable future.
Gross Profit
Gross profit was $25.7 million or 37.6% of net revenue for the year ended December 31, 2007 compared to a gross profit of $2.8 million or 2.8% of net revenue for the year ended December 31, 2006. Gross profit for the years ended December 31, 2007 and 2006 include license and royalty income of $0.8 million and $2.7 million, respectively. License and royalty revenues had no related cost of sales. During the year ended December 31, 2007, we recognized approximately $6.2 million of revenue on products for which the inventory costs were fully reserved in a prior year. Further, during 2007 we provided new or increased inventory reserves of approximately $1.3 million on other unsold products in inventory. Accrued adverse purchase commitments of approximately $1.5 million as of December 31, 2006 were released in 2007 when it was determined that this amount would not be required. For the year ended December 31, 2006, we recognized approximately $6.2 million of revenue on products for which inventory costs were fully reserved in a prior year. Further, during 2006 we provided new or increased inventory reserves of approximately $14.6 million on other unsold products in inventory. Also, contributing to the increase in gross margin in fiscal 2007 were increased ASPs and a decrease in average cost per unit. ASPs increased due to the decision to substantially reduce shipments to customers in China due to competitiveness and due to increased shipments of the newer Phoenix I DVD products. The relative increase in Phoenix I shipments as compared to older Vibratto II DVD products has also reduced average cost per unit both due to lower manufacturing costs and elimination of royalties payable on shipment of Vibratto II products. Further, as a result of our downsizing, the Company has significantly reduced fixed overhead expenses.
Research and Development Expenses
Research and development expenses were $12.6 million, or 18.4% of net revenues in 2007 and $36.0 million, or 35.9% of net revenues in 2006. The $23.4 million, or 65.0%, decrease in research and development from 2006 to 2007 was primarily due to the strategic review announced previously and is comprised of the followings: $13.3 million decrease in salaries and fringe benefits, $1.3 million decrease in stock-based compensation expense under SFAS 123(R), $2.6 million decrease in engineering test materials and operating supplies, $1.9 million decrease in depreciation, $1.3 million decrease in mask sets, $0.9 million decrease in facility related expenses, and an approximate $1.1 million decrease in other expenses. Excluding approximately $2.8 million of expenses incurred by our Digital Imaging segment in early 2007, we expect research and development expenses to remain relatively flat in 2008.
Selling, General and Administrative Expenses
Selling, general and administrative expenses were $18.2 million, or 26.7% of net revenues in 2007 and $27.6 million, or 27.4% of net revenues in 2006. The $9.4 million, or 34.1%, decrease in selling, general and administrative expenses from 2006 to 2007 was primarily due to the strategic review announced previously and is substantially all a result of a decrease in compensation expense, including expense resulting from SFAS 123(R). We expect selling, general and administrative expenses to remain relatively flat in 2008.
Impairment of Property, Plant and Equipment
In connection with the strategic review of operations and business plan announced in September 2006, we substantially terminated the operations of our camera phone image sensor business during the first quarter of 2007.
As a result, we have recorded a $0.9 million impairment charge for property, plant and equipment related to our image sensor business.
Gain on Sale of Technology and Tangible Assets
On February 16, 2007, we entered into asset purchase agreements with SiS, pursuant to which we transferred employees, sold certain tangible assets and licensed intellectual property related to our HD-DVD and Blu-ray DVD technologies for aggregate proceeds of approximately $13.5 million. Of this amount, $9.5 million was received during the first quarter of 2007, $2.0 million was received during the second quarter upon SiS’ final certification of all transferred and licensed technology, with the remaining $2.0 million subject to adjustment upon settlement of any escrow claims by SiS through August 16, 2008. The gain recognized during the year ended December 31, 2007 includes the proceeds received, net of the book value of assets sold and certain transaction expenses related to the sale. We have not recognized any revenue related to HD-DVD or Blu-ray DVD products in any period.
Non-operating Income (Loss), Net
Non-operating income, net was $1.7 million in 2007 compared to non-operating loss, net was $0.7 million in 2006. In 2007, non-operating income, net consisted primarily of interest income of $2.0 million and currency exchange gain of $0.3 million, partially offset by investment write-down of $0.6 million. In 2006, non-operating loss, net consisted primarily of investment write-downs of $3.5 million of which $3.0 million related to the investment in Best Elite International Limited, partially offset by interest income of $2.6 million.
Provision for (Benefit from) Income Taxes
Our effective tax provision was $3.1 million, or 50.1% for 2007 compared to a tax benefit of $17.3 million, or 28.2% for 2006. The primary reason for the change in our effective tax rate for 2007 was additional interest expense on unrecognized tax benefits recorded during 2007 and a benefit recognized during 2006 related to the expiration of the statute of limitations on various uncertain tax positions.
Our effective tax rate of 50.1% for 2007 was higher than the federal and state statutory rate of 40% due to interest expense on unrecognized tax benefits offset, in part, by foreign income taxed at lower rates. The effective tax rate of 28.2% for 2006 was lower than the combined federal and state statutory rate primarily as a result of foreign losses which could not be benefited, partially offset by benefits related to U.S. tax losses and research and development tax credits.
Effective January 1, 2007, the Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”). This interpretation clarifies the criteria for recognizing income tax benefits under FASB Statement No. 109, Accounting for Income Taxes, and requires additional disclosures about uncertain tax positions. Under FIN 48 the financial statement recognition of the benefit for a tax position is dependent upon the benefit being more likely than not to be sustainable upon audit by the applicable taxing authority. If this threshold is met, the tax benefit is then measured and recognized at the largest amount that is greater than 50 percent likely of being realized upon ultimate settlement.
Our general policy is to permanently reinvest the net earnings of our foreign subsidiaries. Accordingly, these earnings have not been subject to U.S. income taxes. Under certain circumstances, if we were to repatriate this cash, or a portion thereof, to the U.S., we could be required to pay U.S. income taxes on the transfer; however, it is not practicable to determine the amount of this liability.
Comparison of Year ended December 31, 2006 and December 31,
Results of Operations
The following table sets forth our results of operations for the fiscal years ended December 31, 2006 and 2005:
Net Revenues
Net revenues were $100.5 million in 2006 and $181.9 million in 2005. Net revenues decreased by $81.4 million, or 44.8%, from 2005 to 2006, due to decreased revenues in all product categories in both of our business segments except revenue from legacy products which include PC Audio chips, communication modem, consumer digital media and other miscellaneous chips.
The following table summarizes percentage of net revenue by our two business segments and their major product categories:
Video business revenues included revenues from DVD, VCD, Recordable, License and Royalty payments for DVD technologies and Other.
DVD revenue includes revenue from sales of DVD decoder chips and recordable chips. DVD revenues were $68.1 million in 2006, a decrease of $35.2 million, or 34.1%, from 2005 to 2006, primarily due to lower overall unit sales as a result of intense competition, partially offset by a higher average selling price (“ASP”). Sales volume decreased by 43.3% whereas ASP increased by 16.2%. We sold approximately 22.8 million units and 40.2 million units in 2006 and 2005, respectively. In 2006, we recognized $2.7 million in license revenue and in 2005 we recognized $20.0 million in royalty revenue from MediaTek for a copyright infringement settlement.
VCD revenue includes revenue from sales of VCD chips. We have experienced a significant decline in our VCD business over the last few years. VCD revenues were $18.2 million in 2006, a decrease of $13.3 million, or 42.2%, from 2005 to 2006, primarily due to lower overall ASP and sales volume. ASP decreased by 25.0% and units sold decreased by 23.0%. We sold approximately 15.1 million units of our VCD chip products in 2006 as compared to approximately 19.6 million units in 2005. The decline in VCD business is due to the replacement of the VCD market with lower priced DVD units. In September 2005, we entered into the Silan-ESS Cooperation in VCD Agreement with Silan, where we license to Silan the right to produce and distribute our VCD backend decoding chips in China and India and to collaborate with Silan to produce a single-chip VCD product, where we will share with Silan the gross margin of each single-chip VCD sold in the future.
License and royalty revenue consists of license payments from Silan and NEC Electronics Corporation (“NEC”), and royalty payments from MediaTek. The royalty and license revenue was $2.7 million for the year ended December 31, 2006 and consists of $2.3 million from Silan related to the DVD Technology License Agreement that we entered in November 2006 and $0.4 million from NEC for using certain of our TV audio decoder technology. Silan has recently notified us of its intention not to proceed under the DVD Technology License Agreement and we have sent Silan a demand to cure. Royalty revenue was $20.0 million from MediaTek for the year ended December 31, 2005. Under the settlement agreement between ESS and MediaTek dated June 11, 2003 for a non-exclusive license to our proprietary DVD user interface and other key DVD software, MediaTek was obligated to pay us ongoing royalties with a quarterly cap of $5.0 million and lifetime cap of $45.0 million. All contractual payments have been received from MediaTek as of December 31, 2005.
In addition, we also have other revenue from legacy and other products which includes sales of PC Audio chips, communication, consumer digital media and other miscellaneous chips. Other revenue was $7.0 million in 2006, an increase of $2.3 million, or 48.9%, from 2005 to 2006 primarily due to higher sales volume. Units sold for other revenue products increased by 50.0%. We sold approximately 1.2 million units and 0.8 million units in 2006 and 2005, respectively.
Digital Imaging revenues were comprised of revenues from sales of image sensor chips, image processor chips and camera lens modules. Digital Imaging revenues were $4.7 million in 2006, a decrease of $17.7 million, or 79.0%, from 2005 to 2006, primarily due to lower sales volume and ASP as a result of our decision to exit lower resolution products and focus on the development of higher resolution products. For the year ended December 31, 2006, units sold decreased by 67.9% and ASP decreased by 33.2% from 2005. We sold approximately 2.5 million units and 7.8 million units in 2006 and 2005, respectively. As part of our new business strategy previously discussed, on February 16, 2007, we reduced operation of our camera phone image sensor business. We plan to pursue licensing of our patents for image sensor technology but we will no longer design, develop and market imaging sensor chips.
International revenues accounted for approximately 100% of the revenue in 2006 and almost all of the revenue in 2005. All of our international sales are denominated in U.S. dollars. We expect that international sales will continue to remain a high percentage of our net revenues in the foreseeable future.
Gross Profit
Gross profit was $2.8 million or 2.8% of net revenue for the year ended December 31, 2006 compared to a gross profit of $12.6 million or 6.9% of net revenue for the year ended December 31, 2005. The decrease in gross profit was primarily due to a decrease of $20.0 million in MediaTek royalty revenue from 2005 to 2006. For the years ended December 31, 2006 and 2005, new or increased inventory reserves exceeded revenue derived from products fully reserved in a prior year. The net effect on gross profit was a decrease of approximately $8.5 million for 2006 and $2.3 million for 2005.
Research and Development Expenses
Research and development expenses were $36.0 million, or 35.9% of net revenues in 2006 and $34.0 million, or 18.6% of net revenues in 2005. Research and development expenses increased by $2.0 million, or 6.1%, from 2005 to 2006, primarily due to the $1.9 million increase in accrued bonus expense, $1.7 million increase in stock-based compensation expense under SFAS No. 123(R), $0.5 million increase in consulting and outside services, and
$0.2 million increase in travel expense, which was partially offset by $1.0 million decrease in salaries expense resulting from the shift of research and development headcount to Asia, $1.0 million decrease in mask sets and $0.4 million decrease in depreciation expense.
Selling, General and Administrative Expenses
Selling, general and administrative expenses were $27.6 million, or 27.4% of net revenues in 2006 and $35.0 million, or 19.2% of net revenues in 2005. Selling, general and administrative expenses decreased by $7.4 million, or 21.2%, from 2005 to 2006, primarily due to the $3.0 million decrease in legal expenses as more expenses were incurred in 2005 related to the litigation with Brent Townshend over unfair competition and patent misuse, as well as patent filing, $2.5 million decrease in outside commission due to lower revenue, $2.2 million decrease in salaries and fringe benefits due to lower headcount, $1.3 million decrease in amortization of intangible assets as they became fully amortized during 2006, and $1.1 million decrease in other expenses; which was partially offset by $1.7 million increase in stock-based compensation expense under SFAS No. 123(R), $0.6 million increase in depreciation expense related to the newly upgraded Oracle software version 11i at the beginning of 2006, and $0.2 million increase in consulting and contract labor.
Impairment of Goodwill and Intangible Assets
In 2005, our review of intangible assets in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” (“SFAS No. 144”) indicated that other intangible assets associated with the acquisition of Divio, Inc. of $1.3 million had been impaired. In addition, we conducted an annual goodwill impairment review during the fourth quarter in accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and other Intangible Assets,” (“SFAS No. 142”). The result of the analysis indicated that all of the $41.4 million goodwill on our balance sheet was impaired. This goodwill arose from the acquisitions of Pictos Technologies, Inc., which was completed on June 9, 2003, and Divio, Inc., which was completed on August 15, 2003.
Non-operating Income (Loss), Net
Non-operating loss, net was $0.7 million in 2006 compared to non-operating income, net of $1.3 million in 2005. In 2006, non-operating loss, net consisted primarily of investment write downs of $3.5 million, partially offset by interest income of $2.6 million. In 2005, non-operating income, net consisted primarily of interest income of $2.2 million and rental income of $0.3 million, which was partially offset by investment write down of $1.3 million.
Provision for (Benefit from) Income Taxes
Our effective tax benefit was $17.3 million, or 28.2% for 2006 compared to a tax provision of $1.8 million, or 1.8% for 2005. The primary reason for the change in our effective tax rate for 2006 was a benefit related to the expiration of the statute of limitations on various uncertain tax positions.
Our effective tax benefit rate of 28.2% for 2006 and effective tax provision rate of 1.8% for 2005 were lower than the combined federal and state statutory rate of 40% primarily as a result of foreign losses which could not be benefited, partially offset by benefits related to U.S. tax losses and research and development tax credits.
Liquidity and Capital Resources
Since inception, we have financed our cash requirements from cash generated by operations, the sale of equity securities, and short-term and long-term debt. At December 31, 2007, we had cash, cash equivalents and short-term investments of $49.9 million and working capital of $56.0 million.
Net cash used in operating activities was $4.5 million for the year ended December 31, 2007, $48.2 million for the year ended December 31, 2006, and $25.0 million for the year ended December 31, 2005. After adjusting for net gains and losses of $8.8 million relating to the sale of technology and tangible assets to SiS, impairment and sale of property, plant and equipment and write-down of equity investments, the net cash used in operating activities for the year ended December 31, 2007 was primarily attributable to a decrease in accounts payable and accrued expenses of
$12.5 million due to lower accrued compensation of $3.9 million resulting from lower headcount, lower accrued adverse inventory commitments of $3.4 million, and lower accounts payable trade and other of $3.0 million resulting from the our strategic review of operations announced in September 2006, partially offset by a decrease in accounts receivable of $3.9 million, depreciation of $3.6 million, and net income of $3.1 million. The net cash used in operating activities for the year ended December 31, 2006 was primarily attributable to a net loss of $44.1 million, a decrease in accounts payable and accrued expenses of $15.5 million due to a decrease in production activities and a decrease in income tax payable and deferred income taxes of $19.4 million due to a favorable tax adjustments of $15.3 million related to the expiration of certain statutes of limitations and certain tax refunds, partially offset by a decrease in accounts receivables of $5.8 million, a decrease in other receivables of $4.6 million, a decrease in net inventories of $4.2 million, and depreciation and amortization of $6.8 million. The net cash used in operating activities for the year ended December 31, 2005 was primarily attributable to a net loss of $99.6 million, and a decrease in accounts payable and accrued expenses of $14.7 million, partially offset by an impairment charge for goodwill and intangible assets of $42.7 million, and a decrease in net inventories of $33.2 million, and depreciation and amortization of $10.3 million.
Net cash provided by investing activities was $13.8 million for the year ended December 31, 2007, $18.9 million for the year ended December 31, 2006, and $52.6 million for the year ended December 31, 2005. The net cash provided by investing activities for the year ended December 31, 2007 was primarily attributable to the proceeds from sale of technology and tangible assets of $11.4 million and the maturities and sales of short-term investments of $8.3 million, partially offset by the purchase of short-term investments of $4.8 million and purchase of property, plant and equipment of $0.6 million. During 2007 we made a $0.5 million long-term investment that was subsequently determined to be impaired. The net cash provided by investing activities for the year ended December 31, 2006 was primarily attributable to the proceeds from the maturities and sales of short-term investments of $35.4 million, partially offset by the purchase of short-term investments of $14.4 million and purchase of property, plant and equipment of $1.9 million. The net cash provided by investing activities for the year ended December 31, 2005 was primarily attributable to the proceeds from the maturities and sales of short-term investments of $98.6 million, partially offset by the purchase of short-term and long-term investments of $44.1 million and purchase of property, plant and equipment of $4.7 million.
Net cash provided by financing activities was $30,000 for the year ended December 31, 2007, and net cash used in financing activities was $5.6 million for the year ended December 31, 2006, and $0.5 million for the year ended December 31, 2005. The net cash provided by the financing activities for the year ended December 31, 2007 was attributable to the proceeds from the issuance of common stock under the employee stock purchase plan. The net cash used in financing activities for the year ended December 31, 2006 was attributable to cash paid for repurchase of common stock of $5.9 million, offset by the proceeds from the issuance of common stock under the employee stock purchase plan and stock option plans of $0.2 million. The net cash used in financing activities for the year ended December 31, 2005 was attributable to cash paid for repurchase of common stock of $1.2 million, offset by the proceeds from the issuance of common stock under the employee stock purchase plan and stock option plans of $0.7 million.
To date, we have not declared or paid cash dividends to our shareholders and do not anticipate paying any dividend in the foreseeable future due to a number of factors, including the volatile nature of the semiconductor industry and the potential requirement to finance working capital in the event of a significant upturn in business. We reevaluate this practice from time to time but are not currently contemplating the payment of a cash dividend.
For the years ended December 31, 2006 and 2005, we incurred significant operating losses and negative cash flows. For the year ended December 31, 2007, operating income was only achieved through a gain on sale of assets and technology while operating cash flow was still negative. We believe that we have the cash resources to fund our operations for at least the next twelve months. The semiconductor industry in which we operate is characterized by rapid technological advances, short product lives and significant price reductions. If we are unable to meet these challenges, then we will not achieve profitable operations. We may determine that we require additional capital to achieve our business objectives. There can be no assurances that such capital will be available or available on terms that are acceptable to us, which could adversely affect our financial position, results of operations or cash flows.
Contractual Obligations, Commitments and Contingencies
The following table sets forth the amounts of payments due under specified contractual obligations, aggregated by category of contractual obligations, as of December 31, 2007:
As of December 31, 2007, our commitments to purchase inventory from the third-party contractors aggregated approximately $4.6 million. Additionally, as of December 31, 2007, commitments for service, license and other operating supplies totaled $4.3 million.
Due to the uncertainty with respect to the timing of future cash flows associated with our unrecognized tax benefits at December 31, 2007, we are unable to make reasonably reliable estimates of the period of cash settlement with respective taxing authorities. Therefore, $35.7 million of unrecognized tax benefits that may result in a cash payment have been excluded from the contractual obligations table above. See Note 7 “Income Taxes,” to the consolidated financial statements for a discussion on income taxes.
The total rent expense under all operating leases was approximately $2.8 million, $4.3 million and $4.6 million for fiscal years 2007, 2006 and 2005, respectively.
We enter into various agreements in the ordinary course of business. Pursuant to these agreements, we may agree to indemnify our customers for losses suffered or incurred by them as a result of any patent, copyright, or other intellectual property infringement claims by any third party with respect to our products. These indemnification obligations may have perpetual terms. We estimate the fair value of our indemnification obligations as insignificant, based upon our history of litigation concerning product and patent infringement claims. Accordingly, we have no liabilities recorded for indemnification under these agreements as of December 31, 2007.
We have agreements whereby our officers and directors are indemnified for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. However, we have a directors and officers’ insurance policy that may reduce our exposure and enable us to recover a portion of any future amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements is minimal.
From time to time, we are subject to legal proceedings and claims, including claims of alleged infringement of trademarks, copyrights and other intellectual property rights and other claims arising out of the ordinary course of business. We may incur substantial expenses in litigating claims against third parties and defending against existing and future third-party claims that may arise. In the event of a determination adverse to us, we may incur substantial monetary liability and be required to change our business practices. Either of these results could have a material adverse effect on our financial position, results of operations or cash flows. See Part I, Item 3, “Legal Proceedings.”
Off-Balance Sheet Arrangements
We are not a party to any agreements with, or commitments to, any special purpose entities that would constitute material off-balance sheet financing other than the operating lease obligations listed above.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures about Market Risk
We are exposed to the impact of foreign currency fluctuations and interest rate changes which may lead to changes in the market values of our investments.
Foreign Exchange Risks
We fund our operations with cash generated by operations, the sale of marketable securities and short and long-term debt. Since most of our revenues are international, as we operate primarily in Asia, we are exposed to market risk from changes in foreign exchange rates, which could affect our results of operations and financial condition. In order to reduce the risk from fluctuation in foreign exchange rates, our product sales and all of our arrangements with our foundries and test and assembly vendors are denominated in U.S. dollars. We have operations in China, Taiwan, Hong Kong, Korea and Canada. Expenses of our international operations are denominated in each country’s local currency and therefore are subject to foreign currency exchange risk; however, through December 31, 2007 we have not experienced any significant negative impact on our operations as a result of fluctuations in foreign currency exchange rates. We performed a sensitivity analysis assuming a hypothetical 10% adverse movement over one quarter in foreign exchange rates to the foreign subsidiaries and the underlying exposures described above. As of December 31, 2007, the analysis indicated that these hypothetical market movements could impact our non-operating income (loss), net, by approximately $0.6 million. We have not entered into any currency hedging activities.
Interest Rate Risks
We also invest in short-term investments. Consequently, we are exposed to fluctuation in interest rates on these investments. Increases or decreases in interest rates generally translate into decreases and increases in the fair value of these investments. For instance, one percentage point decrease in interest rates would result in approximately a $0.5 million decrease in our annual interest income. In addition, the credit worthiness of the issuer, relative values of alternative investments, the liquidity of the instrument, and other general market conditions may affect the fair values of interest rate sensitive investments. In order to reduce the risk from fluctuation in rates, we invest in highly liquid corporate and governmental notes and bonds with contractual maturities of less than two years. All of the investments in debt securities have been classified as available-for-sale, and on December 31, 2007, the fair market value of our investments approximated their costs.
Investment Risk
We are exposed to market risk as it relates to changes in the market value of our investment in a public company. We invest in equity instruments of public companies for business and strategic purposes and we have classified these securities as available-for-sale. These available-for-sale equity investments, primarily in technology companies, are subject to significant fluctuations in fair market value due to the volatility of the stock market and the industries in which these companies participate. Our objective in managing our exposure to stock market fluctuations is to minimize the impact of stock market declines to our earnings and cash flows. There are, however, a number of factors beyond our control. Continued market volatility, as well as mergers and acquisitions, have the potential to have a material impact on our results of operations in future periods.
We are also exposed to changes in the value of our investments in non-public companies, including start-up companies. These long-term equity investments in technology companies are subject to significant fluctuations in fair value due to the volatility of the industries in which these companies participate and other factors.
Item 8.
Item 8.
Financial Statements and Supplementary Data
The following documents are filed as part of this Report:
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders and Board of Directors of ESS Technology, Inc.:
In our opinion, the consolidated financial statements listed in the index appearing under Item 8(1) present fairly, in all material respects, the financial position of ESS Technology, Inc. and its subsidiaries at December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 8(3) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards 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 our opinion.
As discussed in Note 2 to the consolidated financial statements, the Company changed the manner in which it accounts for stock-based compensation in 2006.
As discussed in Note 2 to the consolidated financial statements, the Company changed the manner in which it accounts for uncertain tax positions in 2007.
/s/ PricewaterhouseCoopers LLP
San Jose, California
March 31, 2008
1.
Financial Statements:
ESS TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these consolidated financial statements.
ESS TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these consolidated financial statements.
ESS TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
The accompanying notes are an integral part of these consolidated financial statements.
ESS TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these consolidated financial statements.
ESS TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1.
Nature of Business
We were incorporated in California in 1984 and became a public company in 1995. We have historically operated in two primary business segments, Video and Digital Imaging, both in the semiconductor industry and serving the consumer electronics and digital media marketplace.
In our Video business, we design, develop and market highly integrated analog and digital processor chips and digital amplifiers. Our digital processor chips drive digital video and audio devices, including DVD players, Video CD (“VCD”) players, consumer digital audio players and digital media players. We continue to sell certain legacy products we have in inventory including chips for use in recordable DVD players, modems, other communication devices and PC audio products. On September 18, 2006 we announced an ongoing strategic review of our operations and business plan. In connection with this strategic review, on November 3, 2006, we licensed to Hangzhou Silan Microelectronics Co., Ltd. (“Silan”) the development, manufacture and sale of our next generation standard definition DVD chips, the Phoenix II and LMX II, and also granted Silan a non-exclusive license for our standard definition DVD technology. Silan has recently notified us, however, that it does not intend to proceed with the development, manufacture and sale of any of the chips or technology we licensed to Silan and we have sent Silan a notice to cure this breach of our agreements. On February 16, 2007, we sold to Silicon Integrated Systems Corporation and its affiliates (“SiS”) our tangible and intangible assets relating to the development of high definition DVD chips based on next generation blue laser technology. Also, in connection with this restructuring strategy, during the first quarter of 2007 we substantially terminated the production and sale of our camera phone image sensors, which were the only remaining products of our Digital Imaging segment. We plan to license our image sensor patents in exchange for royalties, but we will no longer sell imaging sensor semiconductor chips. We continue to design, develop and market highly integrated analog and digital processor chips and digital amplifiers, including chips for standard definition DVD players primarily for the Korean market, and chips for digital audio players and digital media players for all markets. We are now concentrating on our standard definition DVD chip business and evaluating opportunities to develop profitable operations.
Our strategy is to focus on the design and development of our chip products while outsourcing all of our chip fabrication, assembly, and test operations. All of our products are manufactured, assembled and tested by independent third parties primarily in Asia. We market our products worldwide through our direct sales force, distributors and sales representatives. Substantially all of our sales are to distributors, direct customers and end-customers in China, Hong Kong, Taiwan, Japan, Korea, Indonesia and Singapore. We employ sales and support personnel located outside of the United States in China, Hong Kong, Taiwan and Korea to support these international sales efforts. We expect that international sales will continue to represent a significant portion of our net revenues. We also have a number of employees engaged in research and development efforts outside of the United States. There are special risks associated with conducting business outside of the United States.
On February 21, 2008, ESS Technology, Inc., a California corporation (“ESS California”), Echo Technology (Delaware), Inc., a Delaware corporation and a wholly owned subsidiary of ESS California (“Delaware Merger Subsidiary”), Semiconductor Holding Corporation, a Delaware corporation and wholly owned subsidiary of Imperium Master Fund, Ltd. (“Parent”), and Echo Mergerco, Inc., a Delaware corporation and a wholly owned subsidiary of Parent (“Merger Subsidiary”) entered into an Agreement and Plan of Merger (the “Merger Agreement”) pursuant to which (i) ESS California will, subject to the satisfaction or waiver of the conditions set forth in the Merger Agreement, merge with and into Delaware Merger Subsidiary (the “Reincorporation Merger”), the separate corporate existence of ESS California shall cease and Delaware Merger Subsidiary shall be the successor or surviving corporation of the merger (“ESS Delaware”), and (ii) following the Reincorporation Merger, Merger Subsidiary will, subject to the satisfaction or waiver of the conditions set forth in the Merger Agreement, including the consummation of the Reincorporation Merger, merge with and into ESS Delaware (the “Merger”), the separate corporate existence of Merger Subsidiary shall cease and ESS Delaware shall be the successor or surviving corporation of the merger and wholly owned subsidiary of the Parent.
ESS TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Upon the consummation of the Reincorporation Merger, ESS California will become a Delaware corporation, each share of ESS California common stock will be converted into one share of ESS Delaware common stock and each option to acquire ESS California common stock granted pursuant to ESS California’s stock plans and outstanding immediately prior to the consummation of the Reincorporation Merger, whether vested or unvested, exercisable or unexercisable, will be automatically converted into the right to receive an option to acquire one share of ESS Delaware common stock for each share of ESS California common stock subject to such option, on the same terms and conditions applicable to the option to purchase ESS California common stock (each, an “ESS Delaware Option”).
Upon the consummation of the Merger, (i) ESS Delaware will become a wholly owned subsidiary of Parent and (ii) each share of ESS Delaware common stock will be converted into the right to receive $1.64 in cash, unless the stockholder properly exercises appraisal rights. In addition, each ESS Delaware Option, whether vested or unvested, exercisable or unexercisable, will be converted into the right to receive an amount in cash equal to the product obtained by multiplying (x) the aggregate number of shares of ESS Delaware common stock subject to such ESS Delaware Option and (y) the excess, if any, of the Merger Consideration less the exercise price per share of ESS Delaware common stock subject to such ESS Delaware Option, after which it shall be cancelled and extinguished.
The parties to the Merger Agreement intend to consummate the Merger as soon as practicable after the Reincorporation Merger and ESS California will not consummate the Reincorporation Merger unless the parties are in a position to consummate the Merger. ESS California and Delaware Merger Subsidiary have made customary representations and warranties in the Merger Agreement and agreed to certain customary covenants, including covenants regarding operation of the business of ESS California and its subsidiaries, including Delaware Merger Subsidiary, prior to the closing and covenants prohibiting ESS California from soliciting, or providing information or entering into discussions regarding, proposals relating to alternative business combination transactions, except in limited circumstances to permit the board of directors of ESS California to comply with its fiduciary duties under applicable law.
The transactions contemplated by the Merger Agreement are subject to ESS California shareholder approval, delivery of ESS California’s audited financial statements for the year ended December 31, 2007 and other customary closing conditions. The Merger Agreement contains certain termination rights for both ESS California and Parent and further provides that, upon termination of the Merger Agreement under certain circumstances, ESS California may be obligated to pay Parent a termination fee of $1,981,000 plus reimbursement of Parent’s and its affiliates’ reasonable expenses incurred in connection with the transactions contemplated by the Merger Agreement up to, but not in excess of, $500,000.
Note 2.
Summary of Significant Accounting Policies
Basis of Presentation
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United Sates of America.
The consolidated financial statements include the accounts of ESS Technology, Inc. and all of its subsidiaries. All significant inter-company accounts and transactions have been eliminated.
Certain reclassifications have been made to the consolidated financial statements in order to conform with current year presentation. These reclassifications had no impact on previously reported results of operations, operating cash flows or working capital.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts
ESS TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenue and expenses during the reporting period. Actual results could differ materially from those estimates.
Foreign Currency Translation
Our subsidiaries primarily use the U.S. dollar as their functional currency. Accordingly, assets and liabilities of these subsidiaries are translated using exchange rates in effect at the end of the period, except for non-monetary assets that are translated using historical exchange rates. Revenues and costs are translated using average exchange rates for the period, except for costs related to those balance sheet items that are translated using historical exchange rates. The resulting transaction gains and losses are recorded as non-operating income (loss), net in the Consolidated Statement of Operations as incurred and were $0.3 million, $0.2 million and $(0.1) million for the years ended December 31, 2007, 2006 and 2005, respectively.
Cash, Cash Equivalents, and Short-Term Investments
We consider all highly liquid investments with a maturity of 90 days or less at the time of purchase to be cash equivalents and investments with maturity dates of greater than 90 days at the time of purchase to be short-term investments.
Short-term investments are primarily comprised of debt instruments and marketable securities. Short-term investments are accounted for as available-for-sale and are reported at fair value with unrealized gains and losses, net of related tax, recorded as accumulated other comprehensive income in shareholders’ equity until realized in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” Gains and losses on securities sold are based on the specific identification method and are included in our Consolidated Statement of Operations as non-operating income (loss), net.
Fair Value of Financial Instruments
The reported amounts of certain of our financial instruments, including cash and cash equivalents, short-term investments, accounts receivable, accounts payable and accrued expenses approximate fair value due to their short maturities.
Inventory
Our inventory is comprised of raw materials, work-in-process and finished goods, all of which are manufactured by third-party contractors. Inventory is valued at the lower of standard cost (which approximates actual cost on a first-in, first-out basis) or market. We reduce the carrying value of inventory for estimated slow-moving, excess, obsolete, damaged or otherwise unmarketable products by an amount based on forecasts of future demand and market conditions.
Property, Plant and Equipment
Property, plant and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are generally computed using the straight-line method over the shorter of the estimated useful lives of the assets, or the lease term of the respective assets, if applicable.
Repairs and maintenance costs are expensed as incurred, and improvements are capitalized.
ESS TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Equity Investments
Equity investments, representing ownership of less than 20% of the investee in which we do not have the ability to exert significant influence, are accounted for using the cost method. The Company reviews its investments on a regular basis and considers factors including the operating results, available evidence of the market value and economic outlook of the relevant industry sector. When the Company concludes that an other-than-temporary impairment has resulted, the difference between the fair value and the carrying value is written off and recorded as an impairment charge in the statement of operations.
Impairment of Long-Lived Assets
We review long-lived assets and certain identifiable intangibles assets to be held and used for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We evaluate any possible impairment of long-lived assets and certain intangible assets using estimates of undiscounted future cash flows. If an impairment loss is to be recognized, it is measured as the amount by which the carrying amount of the asset exceeds the fair value of the asset. Management evaluates the fair value of its long-lived assets and certain intangibles assets using primarily the estimated discounted future cash flows method. Management uses other alternative valuation techniques whenever the estimated discounted future cash flows method is not appropriate.
Revenue Recognition
Revenue is primarily generated by product sales and is recognized at the time of shipment when persuasive evidence of an arrangement exists, the price is fixed or determinable and collection of the resulting receivable is reasonably assured, except for products sold to certain distributors with certain rights of return for unsold products and rights to pricing adjustments, in which case, revenue is deferred until such a distributor resells the products to a third party. Such deferred revenue related to distributor sales, net of deferred cost of goods sold are recorded as deferred margin included in accrued expenses on our balance sheets. License and royalty revenue is recognized as the services provided have been completed, or based on the units sold and reported to us by the third party licensee provided collection of the resulting receivable is reasonably assured.
We provide for rebates based on current contractual terms and future returns based on historical experiences at the time revenue is recognized as reductions to product revenue. Actual amounts may be different from management’s estimates. Such differences, if any, are recorded in the period they become known.
Research and Development Costs
We expense research and development costs as incurred.
Income Taxes
We account 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 timing differences between the carrying amounts and the tax bases of assets and liabilities. U.S. deferred income taxes are not provided on un-remitted earnings of our foreign subsidiaries as such earnings are considered permanently invested. Assumptions underlying recognition of deferred tax assets and non-recognition of U.S. income tax on un-remitted earnings can change if our business plan is not achieved or if Congress adopts changes in the Internal Revenue Code of 1986, as amended.
Effective January 1, 2007, the Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”). This interpretation clarifies the criteria for recognizing income tax benefits under FASB Statement No. 109, Accounting for Income Taxes, and requires additional disclosures about uncertain tax positions. Under FIN 48 the financial statement recognition of the benefit for a tax position is dependent upon the benefit being more likely than not to be sustainable upon audit by the applicable taxing authority. If this threshold is met, the
ESS TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
tax benefit is then measured and recognized at the largest amount that is greater than 50 percent likely of being realized upon ultimate settlement.
Net Income(Loss) per Share
Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is calculated using the weighted average number of outstanding shares of common stock plus potential dilutive shares. Potential dilutive shares consist of stock options using the treasury stock method based on the average stock price for the period. The calculation of diluted net income (loss) per share excludes potential dilutive shares if the effect is anti-dilutive.
Stock-Based Compensation
Effective January 1, 2006, the Company began accounting for share-based compensation under the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payments,” (“SFAS No. 123(R)”), which requires the recognition of the fair value of share-based compensation. Under the fair value recognition provisions for SFAS No. 123(R), share-based compensation is estimated at the grant date based on the fair value of the awards expected to vest and recognized as expense ratably over the requisite service period of the award. We have used the Black-Scholes valuation model to estimate fair value of share-based awards, which requires various assumptions including estimating stock price volatility, forfeiture rates and expected life. We elected to adopt the modified prospective application transition method as provided by SFAS No. 123(R).
The Company has elected to use the “with and without” approach as described in EITF Topic No. D-32 in determining the order in which tax attributes are utilized. As a result, the Company will only recognize a tax benefit from stock-based awards in additional paid-in capital if an incremental tax benefit is realized after all other tax attributes currently available to the Company have been utilized. In addition, the Company has elected to not account for the indirect effects of stock-based awards on other tax attributes, such as the research tax credit, through the income statement.
Warranty
We provide standard warranty coverage for twelve months. We account for the general warranty cost as a charge to cost of product revenues when revenue is recognized. The estimated warranty cost is based on historical product performance and field expenses. In addition to the general warranty reserves, we also provide specific warranty reserves for certain parts if there are potential warranty issues. The following table shows the details of the product warranty accrual.
Risks and Uncertainties
The semiconductor industry in which we operate is characterized by rapid technological advances, changes in customer requirements and evolving industry standards. Our failure to anticipate or respond to such advances and changes could have a material adverse effect on our business and operating results.
ESS TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Concentration of Credit Risk
Financial instruments, which potentially subject us to concentrations of credit risk, consist primarily of cash equivalents, short-term investments, and accounts receivable. By policy, we place our investments, other than U.S. Government Treasury instruments, only with financial institutions meeting our investment guidelines. The composition and maturities of our cash equivalents and investments are regularly monitored by management.
For a discussion of significant customers and distributors, see Note 13, “Business Segment Information and Concentration of Certain Risks.”
A substantial portion of our net revenues has been derived from sales to a small number of customers. Sales to our top five end-customers accounted for approximately 66% of our net revenues in 2007 compared to 55% of our net revenues in 2006. See Note 13, “Business Segment Information and Concentration of Certain Risks.”
We believe that the concentration of credit risk on accounts receivable is substantially mitigated by our evaluation process and relatively short collection terms. We perform ongoing credit evaluations of our customers’ financial condition and limit the amount of credit extended as necessary but generally require no collateral. We maintain an allowance for potential credit losses. In estimating the allowance, we take into consideration the overall quality and aging of the receivable portfolio and specifically identified customer risks. Through December 31, 2007 credit losses have been within our expectations.
Recent Accounting Pronouncements
In September 2006, the Financial Accounting Standard Board (“FASB”) issued statement No. 157, “Fair Value Measurements” (“SFAS No. 157”). This standard defines fair value, establishes a framework for measuring fair value in accounting principles generally accepted in the United States of America, and expands disclosure about fair value measurements. This pronouncement applies under other accounting standards that require or permit fair value measurements. Accordingly, this statement does not require any new fair value measurement. In February 2008, the FASB issued FASB Staff Position (FSP) 157-1, “Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13” (FSP 157-1) and FSP 157-2, “Effective Date of FASB Statement No. 157” (FSP 157-2). FSP 157-1 amends SFAS No. 157 to remove certain leasing transactions from its scope. FSP 157-2 delays the effective date of SFAS No. 157 for all non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until the beginning of the first quarter of fiscal 2009. The measurement and disclosure requirements related to financial assets and financial liabilities are effective for us beginning in the first quarter of fiscal 2008. We are currently evaluating the requirements of SFAS No. 157 and have not yet determined the impact on our consolidated financial statements.
In February 2007, the FASB issued statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”). SFAS No. 159 permits companies to choose to measure certain financial instruments and certain other items at fair value. The standard requires that unrealized gains and losses on items for which the fair value option has been elected be reported in earnings. SFAS No. 159 is effective for us beginning in the first quarter of fiscal year 2008, although earlier adoption is permitted. We are currently evaluating the impact that SFAS No. 159 may have on our consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (SFAS No. 141(R)). Under SFAS No. 141(R), an entity is required to recognize the assets acquired, liabilities assumed, contractual contingencies, and contingent consideration at their fair value on the acquisition date. It further requires that acquisition-related costs be recognized separately from the acquisition and expensed as incurred, restructuring costs generally be expensed in periods subsequent to the acquisition date, and changes in accounting for deferred tax asset valuation allowances and acquired income tax uncertainties after the measurement period impact income tax expense. In addition, acquired in-process research and development (IPR&D) is capitalized as an intangible asset and amortized
ESS TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
over its estimated useful life. The adoption of SFAS No. 141(R) will change our accounting treatment for business combinations on a prospective basis beginning in the first quarter of fiscal year 2009.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements - an amendment of ARB No. 51” (SFAS No. 160). SFAS No. 160 changes the accounting and reporting for minority interests, which will be recharacterized as non-controlling interests and classified as a component of equity. SFAS No. 160 is effective for us on a prospective basis for business combinations with an acquisition date beginning in the first quarter of fiscal year 2009. As of December 29, 2007, we did not have any minority interests. The adoption of SFAS No. 160 is not expected to impact our consolidated financial statements.
Note 3.
Balance Sheet Components
During the years ended December 31, 2007, 2006 and 2005, we recognized approximately $6.2 million, $6.2 million and $5.2 million, respectively, of net revenue on products for which the inventory costs were fully reserved in a prior year. Further, during the years ended December 31, 2007, 2006 and 2005, we provided new or increased inventory reserves of approximately $1.3 million, $14.6 million and $7.5 million, respectively, on other unsold products in inventory. As of December 31, 2006, we had accrued approximately $3.1 million as non-cancelable, adverse purchase order commitments. Of this amount, $1.5 million was released to cost of product revenues in 2007 when it was determined that payment would not be required.
ESS TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
ESS TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 4.
Marketable Securities
The amortized costs and estimated fair value of securities available-for-sale as of December 31, 2007 and December 31, 2006 are as follows:
The contractual maturities of debt securities classified as available-for-sale as of December 31, 2007, are as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Even though certain stated maturity dates of these investments exceed one year beyond the balance sheet dates, we have classified all marketable debt investments as short-term investments. In accordance with Accounting Research Bulletin No. 43, Chapter 3A, “Working Capital-Current Assets and Current Liabilities,” we view our available-for-sale portfolio as available for use in our current operations. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties, and we may need to sell the investment to meet our cash needs. Gross realized gains and gross realized losses for the twelve months ended December 31, 2007, 2006 and 2005 were not material to our financial position or results of operations.
Long-term marketable securities consists of our investment in MosChip Semiconductor Technology Limited (“MosChip”). In April 2002, we acquired 1,600,000 shares of MosChip common stock for approximately $1,012,000 in cash. In December 2003, we acquired an additional 500,000 shares for approximately $298,000. In July 2004, we acquired an additional 229,092 shares for approximately $176,000. Our total investments represent approximately a 5% equity interest in MosChip on a fully diluted basis. MosChip is a publicly traded company based in Hyderabad, India, specializing in designing, manufacturing and marketing very large integrated circuits (“ICs”), with particular focus on consumer and data communication ICs. Due to a decrease in the fair market value of Moschip common stock that we considered to be other than temporary, in the second quarter of 2006 we wrote down our investment to $1,233,000 and recorded a corresponding charge of $252,000 to non-operating income (loss), net. During the year ended December 31, 2007, the Company recorded an unrealized gain of $727,000.
Note 5.
Investments in Equity Securities
In January 2003, we acquired 4,545,400 shares of Convertible Non-Cumulative Preference Series B shares of Best Elite International Limited (“Best Elite”) for approximately $5,000,000 in cash. In January 2004, we acquired an additional 4,545,455 shares for approximately $5,000,000 in cash, on the same terms and price as the initial investment. Our investments represent approximately 1.3% equity interest in Best Elite on a fully diluted basis. Best Elite is a privately held company organized under the laws of the British Virgin Islands as an investment vehicle primarily for the purposes of operating a semiconductor foundry in China. During the year ended December 31, 2006, we wrote down the investment to $7,000,000, which represented our equity interest in Best Elite’s book value. A similar write down of the investment to $6,857,000 was recorded in 2007. We believe that book value represents fair value.
Note 6.
Non-Operating Income (Loss), Net
The following table lists the major components of Non-Operating Income (Loss):
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Note 7.
Income Taxes
Income (loss) before provision for (benefit from) income taxes consisted of the following:
Provision for (benefit from) income taxes consisted of the following:
Reconciliation between the provisions for (benefit from) income taxes computed at the federal statutory rate of 35% and the provision for (benefit from) income taxes is as follows:
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Deferred tax assets (liabilities) are comprised of the following:
As of December 31, 2007, state net operating loss carryforwards for income tax purposes were approximately $6.2 million. If not utilized, the state net operating loss carryforwards will begin to expire in 2016. The Company’s federal and state research tax credit carryforwards for income tax purposes are approximately $0.4 million and $2.6 million, respectively. If not utilized, the federal tax credit carryforwards will begin to expire in 2016, while the state credits may be carried forward indefinitely. Utilization of these state net operating loss and federal and state tax credit carryforwards may be subject to a substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code of 1986, as amended, and similar state provisions.
We have evaluated our deferred tax assets and concluded that a valuation allowance is required for that portion of the total deferred tax assets that are not considered more likely than not to be realized in future periods. To the extent that the deferred tax assets with a valuation allowance become realizable in future periods, we will have the ability, subject to carryforward limitations, to benefit from these amounts. As of December 31, 2007, management has concluded that it is more likely than not that the Company’s $5.8 million of net deferred tax assets will be realized.
We have not provided for U.S. federal income and state income taxes on non-U.S. subsidiaries’ undistributed earnings as of December 31, 2007, because such earnings are intended to be reinvested in the operations and potential acquisitions of our international subsidiaries indefinitely. Upon distribution of those earnings in the form of dividends of otherwise, we would be subject to applicable U.S. federal and state income taxes; however, it is not practicable to determine the amount of this liability.
Uncertain Income Tax Positions
Effective January 1, 2007, the Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”). This interpretation clarifies the criteria for recognizing income tax benefits under FASB Statement No. 109, Accounting for Income Taxes, and requires additional disclosures about uncertain tax positions. Under FIN 48 the financial statement recognition of the benefit for a tax position is dependent upon the benefit being more likely than not to be sustainable upon audit by the applicable taxing authority. If this threshold is met, the
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tax benefit is then measured and recognized at the largest amount that is greater than 50 percent likely of being realized upon ultimate settlement. The cumulative effect of adopting FIN No. 48 was an increase of $4.1 million as a credit to tax liabilities and an increase to the January 1, 2007 accumulated deficit balance. Upon adoption, the tax liability at January 1, 2007 was $33.6 million, which includes $24.1 million that was reclassified from current to non-current liabilities because payment of cash was not anticipated within one year of the balance sheet.
A reconciliation of the beginning and ending amount of the unrecognized income tax benefits during the tax year ended December 31, 2007 is as follows:
The total amount of unrecognized tax benefits that would affect our effective tax rate if recognized is $23.0 million as of December 31, 2007 and $23.3 million as of January 1, 2007. We do not believe that the total amounts of unrecognized tax benefits will significantly increase or decrease within 12 months of the reporting date. We recognize interest and penalties related to uncertain tax positions in income tax expense. As of January 1, 2007 and December 31, 2007, we had approximately $4.1 million and $6.2 million of accrued interest related to uncertain tax positions, respectively.
Our only major tax jurisdictions are the United States, California, and Hong Kong. The tax years 2003 through 2007 remain open and subject to examination by the appropriate governmental agencies in the U.S., 2003 through 2007 in California, and 2000 through 2007 in Hong Kong.
Note 8.
Impairment of Property, Plant and Equipment
In connection with the strategic review of operations and business plan announced in September 2006, we substantially terminated the operations of our camera phone image sensor business during the first quarter of 2007. As a result, we have recorded a $0.9 million impairment charge for property, plant and equipment related to our image sensor business.
Note 9.
Gain on Sale of Technology and Tangible Assets
On February 16, 2007, we entered into asset purchase agreements with SiS, pursuant to which we transferred employees, sold certain tangible assets, and sold and licensed intellectual property related to our HD-DVD and Blu-ray DVD technologies for aggregate proceeds of approximately $13.5 million. Of this amount, $9.5 million was received during the first quarter of 2007, and $2.0 million was received during the second quarter of 2007. The remaining $2.0 million is to be paid on or about August 16, 2008 subject to adjustment upon settlement of any escrow claims by SiS. The gain recognized during the year ended December 31, 2007 includes the proceeds received, net of the book value of assets sold of $870,000 and certain transaction expenses related to the sale to SiS amounting to $149,000. We have not recognized any revenue related to HD-DVD or Blu-ray DVD products in any period.
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Note 10.
Net Income (Loss) Per Share
Statement of Financial Accounting Standards No. 128, “Earnings per Share” (“SFAS No. 128”) requires us to report both basic net income (loss) per share, which is based on the weighted-average number of common shares outstanding excluding contingently assumable or returnable shares such as unvested common stock or shares that contingently convert into common stock upon certain events, and diluted net income (loss) per share, which is based on the weighted average number of common shares outstanding and dilutive potential common shares outstanding.
The following tables set forth the computation of net income (loss) per share of common stock:
For the year ending December 31, 2007, options representing 5,079,000 equivalent shares were excluded from the earnings per share calculation as they were anti-dilutive. Because we incurred net losses during the years ended December 31, 2006 and 2005, options for approximately 7,287,000 and 9,753,000 shares were excluded from the calculation of net loss per share.
Note 11.
Shareholders’ Equity
Common Stock
Stock Repurchase
From time-to-time our Board of Directors has authorized management, at their discretion, to repurchase shares of our common stock on the open market as conditions warrant.. During the year ended December 31, 2006, we repurchased 4,185,000 shares of our common stock for an aggregate price of $5.9 million at market prices ranging from $0.97 to $3.52 per share. We did not repurchase any shares in 2007. Upon repurchase, all shares are retired and no longer deemed outstanding.
On February 16, 2007, our Board of Directors authorized us to repurchase an additional 5 million shares of our common stock, in addition to all shares that remain available for repurchase under previously announced programs, on the same terms and conditions as these prior repurchase programs. To date, we have not repurchased any shares under the February 16, 2007 repurchase program.
As of December 31, 2007, management was authorized to repurchase an aggregate of 5,688,000 shares. There is no stated expiration for this program.
Equity Incentive Plan
In August 1995, we adopted the 1995 Equity Incentive Plan (the “1995 Plan”), which provides for the grant of stock options and stock bonuses and the issuance of restricted stock to our employees, directors and others. Under the 1995 Plan, options granted generally vest 25% at the end of the first year, after the anniversary date of the date of grant, and ratably thereafter over the remaining vesting period. A total of 3,000,000 shares of our common stock was reserved for issuance under the 1995 Plan.
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This plan is no longer active and we will no longer issue options under this plan. The 1995 Plan terminated in July 2005; however, outstanding options issued under this plan will remain exercisable until they expire.
Employee Stock Purchase Plan
In August 1995, we adopted the 1995 Employee Stock Purchase Plan (the “Purchase Plan”) and reserved a total of 225,000 shares of our common stock for issuance thereunder. The Purchase Plan, as most recently amended on May 29, 2003, authorizes the aggregate issuance of 1,425,000 shares under the Purchase Plan. The Purchase Plan permits eligible employees to acquire shares of our common stock through payroll deductions at a price equal to the lower of 85% of the fair market value of our common stock at the beginning of the offering period or on the purchase date. The Purchase Plan provides a 24-month rolling period beginning on each enrollment date and the purchase price is automatically adjusted to reflect the lower enrollment price. As of December 31, 2007, 1,293,000 shares have been issued under this plan.
1995 Directors Stock Option Plan
In August 1995, we adopted the 1995 Directors Stock Option Plan (the “Directors Plan”) and reserved a total of 300,000 shares of our common stock for issuance thereunder. The Directors Plan, as amended in April 2001, authorizes the issuance of 600,000 shares. The Directors Plan allows for granting of stock options to non-employee members of the Board of Directors of the Company. The plan was amended as of July 24, 2004 to extend the termination date from 2005 to 2015 and increase the number of authorized shares by 400,000. The plan was amended as of November 23, 2004 to provide a 3-year post-termination exercise period for termination of service for any reason by a non-employee director.
Equity Incentive Plan
In May 1997, we adopted the 1997 Equity Incentive Plan (the “1997 Incentive Plan”) and reserved a total of 3,000,000 shares of our common stock for issuance thereunder. The 1997 Incentive Plan, as most recently amended in May 2003, authorizes the issuance of 13,000,000 shares. The terms of the 1997 Incentive Plan are similar to those of the 1995 Incentive Plan outlined above. This plan is no longer active and we will no longer issue options under this plan. The 1997 Plan terminated in April 2007; however, outstanding options issued under this plan will remain exercisable until they expire.
Non-executive Stock Option Plan
In May 2002, we adopted the 2002 Non-Executive Stock Option Plan (the “2002 Plan”) and reserved a total of 2,000,000 shares of our common stock for issuance thereunder. The 2002 Plan allows for granting of stock options to our non-executive employees and consultants, and options granted under the 2002 Plan are Non-statutory Stock Options. The vesting schedule of the 2002 Plan is generally similar to those of the 1995 Plan outlined above.
Note 12.
Stock-Based Compensation
Effective January 1, 2006, we adopted the provisions of SFAS No. 123(R), which requires the measurement and recognition of compensation expense for all stock-based payment awards made to employees and directors, including employee stock options and employee stock purchases related to the Employee Stock Purchase Plan, based on estimated fair values. We had previously applied Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) and related Interpretations and provided the required pro forma disclosures of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”) which was superseded by SFAS No. 123(R). The Company has also applied the provisions of Staff Accounting Bulletin No. 107 (“SAB 107”) in the adoption of SFAS No. 123(R).
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Impact of the Adoption of SFAS No. 123(R)
We elected to adopt the modified prospective application transition method as provided by SFAS No. 123(R). In accordance with the modified prospective transition method, consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS No. 123(R). Stock-based compensation expense recorded under SFAS No. 123(R) for the year ended December 31, 2007 and 2006 was $0.9 million and $3.6 million, respectively. Stock-based compensation expense recorded during the year ended December 31, 2005 was not significant.
The effect of recording stock-based compensation for 2007 and 2006 were as follows (in thousands, except per share data):
During the year ended December 31, 2007, we granted approximately 226,000 stock options with an estimated total grant-date fair value of $129,000. As of December 31, 2007, total unrecognized stock-based compensation cost related to stock options was $245,000 after estimated forfeitures, which will be recorded as compensation expense over an estimated weighted average period of approximately one year. During the year ended December 31, 2006, we granted approximately 293,000 stock options with an estimated total grant-date fair value of $381,000.
No stock based compensation costs were capitalized as inventory at December 31, 2007 and 2006 because the amounts were not material.
Valuation Assumptions
SFAS No. 123(R) requires companies to estimate the fair value of stock options on the date of grant using a valuation model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the consolidated statement of operations. Prior to the adoption of SFAS No. 123(R), we accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under SFAS No. 123. Under the intrinsic value method, no stock-based compensation expense had been recognized in the consolidated statement of operations, other than as related to acquisitions and investments, because the exercise price of the our stock options granted to employees and directors equaled the fair market value of the underlying stock at the date of grant.
Stock-based compensation expense recognized in the consolidated statement of operations for the year ended December 31, 2007 and 2006 included compensation expense for stock options granted prior to, but not yet vested as of January 1, 2006 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS No. 123 and compensation expense for the stock options granted subsequent to January 1, 2006 based on the
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grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). Stock-based compensation expense recognized in the Consolidated Statements of Operations for the year ended December 31, 2007 and 2006 has been reduced for estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. In the pro forma information required under SFAS No. 123 for the prior periods, the Company accounted for forfeitures as they occurred.
We estimate the fair value of stock options using the Black-Scholes valuation model, consistent with the provisions of SFAS No. 123(R), SAB 107 and our prior period pro forma disclosures of net earnings, including stock-based compensation. The Black-Scholes valuation model was developed for use in estimating the fair value of short-lived exchange traded options that have no vesting restrictions and are fully transferable. In addition, valuation models require the input of subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. The Black-Scholes valuation model for stock compensation expense requires us to make several assumptions and judgments about the variables to be assumed in the calculation including expected life of the stock option, historical volatility of the underlying security, an assumed risk-free interest rate and estimated forfeitures over the expected life of the option. The dividend yield of zero is based on the fact that we have never paid cash dividends and have no present intention to pay cash dividends. The expected life represents the weighted average period of time that options granted are expected to be outstanding giving consideration to vesting schedules and our historical exercise patterns; expected volatilities are based on historical volatilities of our common stock; the risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the option; and we consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option valuation model and the following assumptions:
We have several equity incentive plans that are intended to attract and retain qualified management, technical and other employees, and to align stockholder and employee interests as detailed in Note 11. These equity incentive plans provide that non-employee directors, officers, key employees, consultants and all other employees may be granted options to purchase shares of our stock, restricted stock units and other types of equity awards. Through December 31, 2007, we have only granted stock options under our various plans. These stock options generally have a vesting period of four years, are exercisable for a period not to exceed ten years from the date of issuance and are granted at prices not less than the fair market value of our common stock at the grant date.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Combined Activity
The following table summarizes the combined activity under the equity incentive plans for the indicated periods:
At December 31, 2007, we had an aggregate of 2,051,000 options available to grant. The aggregate intrinsic value of options vested and expected at December 31, 2007 to vest in the future, based on our closing stock price of $1.33 as of December 31, 2007, was approximately $43,000.
The weighted average grant date fair value of options, as determined under SFAS No. 123(R), granted during the year ended December 31, 2007 and 2006 were $0.57 and $1.30 per share, respectively. The total intrinsic value of options exercised during the year ended December 31, 2006 was $7,000. There were no stock option exercised during the year ended December 31, 2007. The total cash received from employees as a result of employee stock option exercises during the year ended December 31, 2006 was $17,000. In connection with these exercises, we realized no tax benefits.
We settle employee stock option exercises with newly issued common shares.
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Prior to the Adoption of SFAS No. 123(R)
Prior to the adoption of SFAS No. 123(R), we provided the disclosures required under SFAS No. 123. The pro forma information for the year ended December 31, 2005 as follows (in thousands, except per share data):
Note 13.
Business Segment Information and Concentration of Certain Risks
Business Segments
We have historically operated in two reportable business segments: the Video segment and the Digital Imaging segment. In the Video segment, we primarily develop and market digital processor chips which are the primary processors driving digital video and audio devices, including DVD, VCD, consumer digital audio players, and digital media players. The Video segment markets encoding processors for digital video recorders and recordable DVD players and continues to sell certain legacy products we have in inventory including chips for use in modems, other communication devices, and PC audio products. Our Digital Imaging segment has historically developed and marketed imaging sensor chips for cellular camera phone applications. The method for determining what information to report is based on the way that management organized the operating segments within the Company for making operational decision and assessments of financial performance. Our chief operating decision maker is considered to be the Chief Executive Officer.
The following table summarizes revenue percentages by major product categories:
DVD revenue includes revenue from sales of DVD decoder chips, integrated encoder and decoder chips and non-integrated encoder and decoder chipsets. VCD revenue includes revenue from sales of VCD chips. Royalty and License revenue consists of revenue from license of DVD Technology to MediaTek, Silan and from license of TV
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audio technology to NEC. Digital Imaging revenue includes revenue from sales of image sensor chips and image processor chips.
We evaluate operating segment performance based on net revenues and operating income (loss) of our segments. The accounting policies of the operating segments are the same as those described in the summary of accounting policies. Information about reported segments follows:
The following is a reconciliation of the totals reported for the operating segments to the applicable line items in the consolidated financial statements:
Geographic Information
We sell and market to leading consumer OEMs worldwide. International sales comprise substantially all of our revenues. The following schedule of geographic location of our revenues for 2007, 2006 and 2005 was based upon destination of the shipment. Thus, our sales to our current and former distributors, CKD and FE Global, were categorized as sales to Hong Kong, even though CKD and FE Global eventually sell products to other parts of China. The following table summarizes net revenue and long-lived assets for the years ended December 31, 2007, 2006 and 2005:
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Significant Customers and Distributors
We sell to both direct customers and distributors. We use both a direct sales force as well as sales representatives to help us sell to our direct customers. FE Global (China) Limited (“FE Global”) was our largest distributor. On August 31, 2007, our distribution agreement with FE Global was terminated. On August 31, 2007, we signed a new distribution agreement with CKD (Hong Kong) High Tech Company Limited (“CKD”) who will perform similar functions as those previously provided by FE Global. We work directly with many of our customers in Hong Kong and China on product design and development. Whenever one of these customers buys our products; however, the order is processed through our distributor, which functions much like a trading company. Our distributor manages the order processing, arranges shipment into China and Hong Kong, manages the letters of credit, and provides credit and collection expertise and services. The title and risk of loss for the inventory are transferred to the distributor upon shipment of inventory and the distributor is legally responsible to pay our invoices regardless of when the inventories are sold to end-customers. During the year ended December 31, 2007, 2006, and
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2005, FE Global accounted for approximately 18%, 32%, and 37% of our net revenues, respectively. In addition to FE Global, Weikeng Industrial Company, Ltd (“Weikeng”), our other distributor, accounted for approximately 11% of our net revenues in 2007 and less than 10% in 2006 and 2005. Revenues on sales to FE Global, CKD and Weikeng are deferred until the products are subsequently sold to end-customers.
The following table sets forth end-customers representing greater than 10% of net revenues:
Customers representing greater than 10% of gross accounts receivable were:
Note 14.
Related Party Transactions with Vialta, Inc.
In April 2001, our Board of Directors decided to spin off Vialta, Inc. (“Vialta”), our majority-owned subsidiary. The spin-off transaction, by which Vialta became a public company, was completed in August 2001. On October 7, 2005, Vialta completed its going-private transaction. We do not have any contractual obligations that are expected to have a material impact upon our revenues, operating results or cash flows under any of the spin-off agreements. We leased certain office space to Vialta. In February 2006, Vialta moved out of our building and we have terminated the lease agreements.
Our former Chairman of the Board of Directors, Fred S.L. Chan, is the chairman of Vialta and acquired Vialta through a going-private transaction in October 2005. In addition to the lease we had with Vialta, from time-to-time, we also sold semiconductor products and provided certain services to Vialta. The following is a summary of major transactions between Vialta and us for the periods presented:
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Note 15.
Commitments and Contingencies
The following table sets forth the amounts of payments due under specified contractual obligations, aggregated by category of contractual obligations, as of December 31, 2007:
As of December 31, 2007, our commitments to purchase inventory from the third-party contractors aggregated approximately $4.6 million. Additionally, as of December 31, 2007, commitments for service, license and other operating supplies totaled $4.3 million
The total rent expense under all operating leases was approximately $2.8 million, $4.3 million and $4.6 million for fiscal years 2007, 2006 and 2005, respectively.
We enter into various agreements in the ordinary course of business. Pursuant to these agreements, we may agree to indemnify our customers for losses suffered or incurred by them as a result of any patent, copyright, or other intellectual property infringement claims by any third party with respect to our products. These indemnification obligations may have perpetual terms. We estimate the fair value of our indemnification obligations as insignificant, based upon our history of litigation concerning product and patent infringement claims. Accordingly, we have no liabilities recorded for indemnification under these agreements as of December 31, 2007.
We have agreements whereby our officers and directors are indemnified for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. However, we have a directors and officers’ insurance policy that may reduce our exposure and enable us to recover a portion of any future amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements is minimal.
Legal Proceeding
On September 12, 2002, following our downward revision of revenue and earnings guidance for the third fiscal quarter of 2002, a series of putative federal class action lawsuits were filed against us in the United States District Court, Northern District of California. The complaints alleged that we and certain of our present and former officers and directors made misleading statements regarding our business and failed to disclose certain allegedly material facts during an alleged class period of January 23, 2002 through September 12, 2002, in violation of federal securities laws. These actions were consolidated under the caption “In re ESS Technology Securities Litigation.” The plaintiffs sought unspecified damages on behalf of the putative class. Plaintiffs amended their consolidated complaint on November 3, 2003, which we then moved to dismiss on December 18, 2003. On December 1, 2004, the Court granted in part and denied in part our motion to dismiss, and struck from the complaint allegations arising prior to February 27, 2002. On December 22, 2004, based on the Court’s order, we moved to strike from the complaint all remaining claims and allegations arising prior to September 10, 2002. On February 22, 2005, the
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Court granted our motion in part and struck all remaining claims and allegations arising prior to August 1, 2002 from the complaint. In an order filed on February 8, 2006, the Court certified a plaintiff class of all persons and entities who purchased or otherwise acquired the Company’s publicly traded securities during the period beginning August 1, 2002, through and including September 12, 2002 (the “Class Period”), excluding officers and directors of the Company, their families and families of the defendants, and short-sellers of the Company’s securities during the Class Period. On March 24, 2006, plaintiff filed a motion for leave to amend their operative complaint, which the Court denied on May 30, 2006. Trial was tentatively set for January 2008. On November 12, 2006, the parties attended a mediation at which they agreed to settle the litigation for $3.5 million (to be paid by defendants’ insurance carriers), subject to appropriate documentation by the parties and approval by the Court. The Stipulation of Settlement and Release was filed with the Court on April 30, 2007. On May 8, 2007, the Court issued an order preliminarily approving the settlement and providing for class notice. At a fairness hearing on July 27, 2007, having received no objections to the settlement and no requests for exclusion, the Court entered a Final Judgment and Order of Dismissal With Prejudice as to all defendants. The time for appeal from the Final Judgment and Order of Dismissal With Prejudice has now passed. While defendants have denied and continue to deny any and all allegations of wrongdoing in connection with this matter, we believe that given the uncertainties and cost associated with litigation, the settlement is in the best interests of the Company and its stockholders. We recorded a $3.5 million loss for the settlement during the quarter ended March 31, 2007. In addition, a receivable from our insurance carriers was also recorded for the same amount, plus recoverable legal fees. Accordingly, there is no impact to the statement of operations because the amount of the settlement, including legal expenses, and the insurance recovery offset each other. The settlement was completed during the year ended December 31, 2007.
On September 12, 2002, following the same downward revision of revenue and earnings holders of our common stock, purporting to represent us, filed a series of derivative lawsuits in California state court, County of Alameda, against us as a nominal defendant and against certain of our present and former directors and officers as defendants. The lawsuits alleged certain violations of the federal securities laws, including breaches of fiduciary duty and insider trading. These actions were consolidated as a Consolidated Derivative Action with the caption “ESS Cases.” The derivative plaintiffs sought compensatory and other damages in an unspecified amount, disgorgement of profits, and other relief. On March 24, 2003, we filed a demurrer to the consolidated derivative complaint and moved to stay discovery in the action pending resolution of the initial pleadings in the related federal action, described above. The Court denied the demurrer but stayed discovery. That stay was then lifted in light of the procedural progress of the federal action. The parties reached an agreement in principle to settle the litigation in exchange for certain minor modifications of the Company’s internal policies and payment of plaintiffs’ attorneys fees not to exceed $200,000 (to be paid by defendants’ insurance carriers). The agreement in principle to settle the litigation was then documented and finalized by the parties and submitted to the Court for approval. On October 1, 2007, the Stipulation and Agreement of Settlement became binding upon the Court’s entry of a final Judgment of Dismissal with prejudice as to all defendants in the action, subject to appeal as required by applicable state law. While defendants have denied and continue to deny any and all allegations of wrongdoing in connection with this matter, we believe that given the uncertainties and cost associated with litigation, the settlement is in the best interests of the Company and its stockholders. We recorded a $200,000 loss for the proposed settlement in the quarter ended June 30, 2007, as management has determined this amount probable of payment and reasonably estimable. In addition, because recovery from the insurance carriers is probable, a receivable was also recorded for the same amount. Accordingly, there is no impact to the statement of operations because the amount of the settlement and the insurance recovery offset each other.
On October 4, 2006, Ali Corporation (“Ali”) filed a lawsuit in Alameda County Superior Court against the company that alleged claims for breach of contract, common counts, quantum meruit, account stated and for an open book account. All of the claims arose from a Joint Development Agreement between the company and Ali, originally entered into on December 14, 2001 and subsequently amended on several occasions. Ali’s complaint sought damages in the amount of $2.5 million. The company answered Ali’s complaint and on April 6, 2007 the
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parties settled this matter in the course of a formal mediation. A Settlement Agreement was executed whereby the Company has settled the case by paying $1.7 million to Ali during the year ended December 31, 2007.
From time to time, we are subject to various claims and legal proceedings. If management believes that a loss arising from these matters is probable and can reasonably be estimated, we would record the amount of the loss, or the minimum estimated liability when the loss is estimated using a range, and no point within the range is more probable than another. As additional information becomes available, any potential liability related to these matters is assessed and the estimates are revised, if necessary. Based upon consultation with the outside counsel handling our defense in the legal proceedings listed above, and an analysis of potential results, we have accrued sufficient amounts for potential losses related to these proceedings. Based on currently available information, management believes that the ultimate outcome of these matters, individually and in the aggregate, will not have a material adverse effect on the Company’s financial position, cash flows or overall trends in results of operations. However, litigation is subject to inherent uncertainties, and unfavorable rulings could occur. An unfavorable ruling could include monetary damages or an injunction prohibiting us from selling one or more products. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on the results of operations of the period in which the ruling occurs, or future periods, could result.
Note 16.
Employee Benefit Plan
We have a 401(K) Plan (the “401(K) Plan”), which covers substantially all employees. Each eligible employee may elect to contribute to the 401(K) Plan, through payroll deductions, up to 25% of their compensation, subject to current statutory limitations. We made no contributions through December 31, 2007.
2.
Supplementary Data:
Selected Quarterly Financial Data (unaudited)
The following table presents unaudited quarterly financial information for each of our last eight quarters. This information has been derived from our 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 state fairly the quarterly results.
(a)
Benefit from income taxes includes a favorable tax adjustment of $14.9 million.
(b)
See Note 8, “Impairment of Property, Plant and Equipment.”
(c)
See Note 9, “Gain on Sale of Technology and Tangible Assets.”
3.
Financial Statement Schedule:
VALUATION AND QUALIFYING ACCOUNTS
All other schedules are omitted as the required information is inapplicable or the information is presented in the Consolidated Financial Statements under Item 8, Part III of this Annual Report on Form 10-K.
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A(T).
Item 9A(T).
Controls and Procedures
Evaluation of Disclosure Controls and Procedures
We maintain “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), that are designed to ensure that the information required to be disclosed by us in reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.
Based on their evaluation as of December 31, 2007, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective as of December 31, 2007.
Management’s Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting in accordance with Exchange Act Rule 12a-15. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of the Company’s financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions and dispositions of assets; providing reasonable assurance that transactions are recorded as necessary for preparation of our financial statements in accordance with accounting principles generally accepted in the United States of America; providing
reasonable assurance that our receipts and expenditures are made in accordance with authorizations of our management and board of directors; and providing reasonable assurance that unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a misstatement of our financial statements would be prevented or detected.
Management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework and criteria established in Internal Control - Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. This evaluation included review of the documentation of controls, evaluation of the design effectiveness of controls, testing of the operating effectiveness of controls and a conclusion on this evaluation. Based on this evaluation, management concluded that our internal control over financial reporting was effective as of December 31, 2007.
This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the Security and Exchange Commission that permit the Company to provide only management’s report in this annual report.
Changes in Internal Control over Financial Reporting
There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) identified in connection with management’s evaluation during our last fiscal quarter that has materially effected, or is reasonably likely to materially effect, our internal control over financial reporting.
Item 9B.
Item 9B.
Other Information
None.
PART III
Certain information required by Part III is omitted from this Report and is incorporated by reference from the proxy statement/prospectus for our annual and special meeting of shareholders to be held in 2008 (the “Proxy Statement”) to be filed with the Securities and Exchange Commission.
Item 10.
Item 10.
Directors, Executive Officers and Corporate Governance
The information concerning our directors and certain information concerning our Executive Officers required by this Item are incorporated by reference from our Proxy Statement. The notes concerning our executive officers required by this Item is set forth at the end of Part I in a section captioned “Executive Officers of the Registrant” above.
The Company has adopted a Code of Ethics that applies to its principal executive officer, principal financial and accounting officer, controller and certain other senior financial management. The Code of Ethics is posted on the Company’s website at http://www.ESSTECH.com. If any substantive amendments are made to the Code of Ethics or grant of any waiver, including any implicit waiver, from a provision of the Code of Ethics to the Company’s Chief Executive Officer, Chief Financial Officer or Controller, the Company will disclose the nature of such amendment or waiver on its website or in a report on Form 8-K.
Item 11.
Item 11.
Executive Compensation
The information required by this Item is incorporated by reference from the sections in our Proxy Statement entitled “Executive Compensation.”
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters
The security ownership information required by this Item is incorporated by reference from the Proxy Statement.
The following table summarizes information with respect to options under our equity compensation plans at December 31, 2007:
Equity Compensation Plan Information(1)
(1)
Includes only options outstanding under ESS’ stock option plans, as no stock warrants or rights were outstanding as of December 31, 2007.
(2)
Includes 132,493 shares of common stock reserved for future issuance under the ESS Technology, Inc. 1995 Employee Stock Purchase Plan.
The equity compensation plans not approved by security holders have generally the same features as those approved by security holders. For further details regarding ESS’ equity compensation plans, see Note 11, “Shareholders’ Equity,” in the consolidated financial statements in Item 8 of this report.
Item 13.
Item 13.
Certain Relationships and Related Transactions, and Director Independence
The information required by this Item is incorporated by reference from the Proxy Statement.
Item 14.
Item 14.
Principal Accounting Fees and Services
The information required by this Item is incorporated by reference from the Proxy Statement.
PART IV
Item 15.
Item 15.
Exhibits and Financial Statement Schedules
(a)(1) Financial Statements
The consolidated financial statements of the registrant as set forth under Item 8(1) are filed as part of the Form 10-K.
(a)(2) Financial Statement Schedule
The consolidated financial statement schedule of the registrant as set forth under Item 8(3) are filed as part of the Form 10-K.
The independent registered public accounting firm’s report with respect to the financial statements and financial statement schedule listed in Item 15(a)(1) and 15(a)(2) above is on page 44 of this Report.
(a)(3) Exhibits
The exhibits listed in the accompanying Index to Exhibits are filed or incorporated by reference as part of this Annual Report on Form 10-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized.
ESS TECHNOLOGY, INC.
(Registrant)
By:
/s/ ROBERT L. BLAIR
Robert L. Blair
President and Chief Executive Officer
Date: March 31, 2008
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints Robert L. Blair and John A. Marsh, and each of them severally, his or her true and lawful attorneys-in-fact, each with full power of substitution, for him or her in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto and all documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all each of said attorneys-in-fact or any of them, or his or their substitute or substitutes, may lawfully do or cause to be done or by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this registration statement has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
INDEX TO EXHIBITS
*
Represents a management contract or compensatory plan or arrangement.
**
Confidential treatment has been granted with respect to certain portions of this agreement.