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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-K

Commission File Number 0-26660

ESS Technology, Inc.

Registrant’s telephone number, including area code:

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes þ          No o

      Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.     o

      The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant, based upon the closing price of the Common Stock on March 5, 2002 of $23.01 as reported on the NASDAQ National Market, was approximately $747,298,945. Shares of Common Stock held by each officer and director and by each person who owned 5% or more of the registrant’s outstanding Common Stock on that date have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

      As of March 5, 2002, registrant had outstanding 45,363,776 shares of Common Stock.

DOCUMENTS INCORPORATED BY REFERENCE

      Portions of the Proxy Statement for Registrant’s 2002 Annual Meeting of Shareholders are incorporated by reference in Part III.

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ESS TECHNOLOGY, INC.

2001 FORM 10-K

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      The discussion in this report contains forward-looking statements that involve risks and uncertainties. The statements contained in this report that are not purely historical are 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 including statements regarding the Company’s expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this report are based on information available to the Company on the date hereof, and the Company assumes no obligation to update any such forward-looking statements. The Company’s actual results could differ materially from those discussed herein. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in “Factors That May Affect Future Results,” in the Management’s Discussion and Analysis Section and elsewhere in this report. References herein to “we,” “our,” “us” and similar words or phrases are references collectively to ESS Technology, Inc. and its subsidiaries.

PART I

      We are a leading designer, developer and marketer of highly-integrated digital system processor chips. These chips are the primary processors driving digital video and audio players including DVD, video CD and MP3 players. Our chips use multiple processors and a programmable architecture that enable us to offer a broad array of features and functionality. We believe that multi-featured DVD players will serve as a platform for the digital home system, or DHS, integrating various digital home entertainment and information delivery products into a single box. We are also a supplier of chips for use in modems and similar communication products, and a supplier of PC audio chips. We outsource all of our chip fabrication and assembly as well as the majority of our test operations, allowing us to focus on our design and development strengths.

      ESS was incorporated in California in 1984 and became a public company in 1995. In April 1999, we expanded our business in the semiconductor segment by establishing Vialta, a subsidiary that would operate in the internet segment. In April 2001, our board of directors adopted a plan to distribute to our shareholders all of our shares of Vialta. The Vialta spin-off was completed on August 21, 2001. Vialta is reported separately as a discontinued operation.

Industry Background

      From large screen televisions to VCRs to DVD players, technology continues to improve the home entertainment experience. Technology advancements have enhanced the clarity, color, sound, functionality and convenience of television home entertainment. In particular, the transition from analog to digital formats has allowed audio and video data to be compressed with little or no perceptible image degradation, improving storage and transmission efficiency. Digital formats provide users with several benefits, including random access to data, superior editing capabilities and enhanced security features such as protection against unauthorized copying. The development of digital media has created markets for new products such as video CD and DVD players. As digital processing and transmission technology improves, we believe additional home entertainment products will continue to be introduced.

      Some of the more significant digital home entertainment products include:

	•	DVD Players. DVD players provide significantly higher quality playback than is possible with VCR or video CD technology through the use of MPEG-2 video decoding and high quality digital audio technologies. We believe we are currently the leading supplier of DVD processor chips.
	•	Video CD Players. Video CD players are music CD players that have been modified to display video on a television and typically sell for slightly less than a low end VCR. Video CD offers quality comparable to VCRs, but is limited to approximately 73 minutes of video information, using an MPEG format standard for compression. The video CD market is divided into the standard video CD, or VCD, and the subsequently developed super video CD, or SVCD. VCD is popular in many developing countries while SVCD is almost exclusively sold in China. We are currently the leading supplier of video CD processor chips.

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	•	Digital Set-Top Box (STB) and Digital Video Recorder (DVR). Digital STBs enable subscriber-based digital television through cable, terrestrial broadcast, digital subscriber line (DSL) and satellite transmissions. DVRs provide local storage similar to a VCR and enable storage and playback of live video streams on a real-time basis. Industry analysts expect that digital STB manufacturers will incorporate DVR capabilities to enhance their functionality. We do not currently supply chips to the STB market.
	•	Digital Audio Systems. Digital audio systems can include multi-channel surround sound products with movie theater quality sound systems, compressed audio (such as MP3) players and digital audio (such as music CD) players. Our chips incorporate these digital audio systems as components of a home entertainment system.

      The television, telephone and personal computer (PC) have emerged as the three principal home systems that manage digital entertainment and information. The television and the PC are the principal devices for viewing and manipulating digital content. Set-top boxes, DVD players and game consoles connected to televisions, are emerging as the principal platforms for viewing home entertainment, while PCs remain the principle platform for storing data and accessing the internet.

      Increasing advances in semiconductor technology are allowing digital products to converge, resulting in cost savings and added convenience for consumers. For example, CD players were initially developed to play audio content in the CD format only. Then, DVD players were introduced, combining video with the CD audio format. Now, additional audio formats, such as MP3, and other features are being added. Consumers can currently buy separate set-top boxes that provide internet connectivity, separate digital video recorders as well as boxes that deliver digital programming. In the future, all of these features and functions may become available through a single DVD platform. At the same time, advances in communication devices allow better distribution of information and home entertainment content to the home and within the home, and provide opportunities for further development of multimedia products.

      As digital home entertainment systems converge and become increasingly complex, makers of these systems increasingly require sophisticated semiconductor chips that are multi-featured, adaptable and cost-effective. Companies, such as ESS, that provide a highly-integrated chip with multiple processors and a programmable architecture to address the needs of the latest digital home system products, are well placed to benefit from the growth in this market.

Our Solution

      Our chips are the primary processors driving multi-featured DVD products that play DVD, CD, MP3, WMA (Windows Media Audio and Video), full-featured karaoke and other audio and video formats, through home entertainment systems. Our DVD chips support high quality video formats such as Progressive Scan, and high quality audio formats, including Dolby Digital, DTS Surround, DVD audio and Sony’s SACD audio. Our DVD chips also allow consumers to browse the internet and view digital photo CDs on their television. Our chips use multiple processors and a programmable architecture that enable us to offer a broad array of features and functionality. We believe that multi-featured DVD players will serve as the platform for a digital home system, or DHS, integrating various digital home entertainment and information delivery products into a single box. We are also a supplier of chips for use in video CD players, MP3 players, modems and similar communication products, and we are a supplier of PC audio chips.

      We believe we have the following competitive advantages:

	•	our highly programmable chips are more flexible allowing us efficiently to add new capabilities that address advances in home entertainment technologies and enable our customers to accelerate their time to market;
	•	our DVD chips offer a broad array of advanced features and functionality;
	•	our large workforce of engineers (approximately 60% of our employees) is continually developing sophisticated solutions to our customer’s evolving needs using our chips;

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	•	we have approximately 100 sales and support personnel worldwide delivering outstanding customer service;
	•	we work closely with our customers to develop cost-effective design solutions incorporating our high-functionality chips that enable our customers to lower their total manufacturing cost; and
	•	our longstanding strategic relationships in China position us to capture additional business as consumer electronics manufacturing increasingly migrates to China.

Our Strategy

      Our objective is to become the leading supplier of system processor chips for the digital home system, or DHS, based on a DVD platform. To achieve our objective, we are pursuing the following strategies:

      Leverage Our Proprietary Technology. Our chips are based on a programmable architecture that uses multiple processors working independently, which provides us with several advantages:

	•	Multiple Processors. We believe our design approach of using multiple processors allows us to provide efficient, cost-effective solutions for our customers. We believe this design approach will allow us to develop an entire digital home entertainment system processor on a single chip.
	•	Highly Programmable Chips. Our highly programmable chips enable us to add or modify features more quickly than competitors whose chips are less programmable. In the past we have successfully added significant features such as MP3 and Kodak picture CD formats through software enhancements without requiring hardware redesign and refabrication. This programmability also enables us to tailor our chips to meet our customers’ specific needs by making minor modifications that allow our customers to enhance features and improve time-to-market with new products.

      Develop the Next Generation System Processor Chip for the DHS. We are developing the next generation DVD chip that will incorporate many new advanced capabilities. We are designing this chip with a third independent processor to enable us to support the following standard operating systems: Linux, PocketPC (formerly WinCE) and VxWorks. By supporting standard operating systems, we can leverage third party software applications, such as standard web browsers, and third party software drivers to support printers, digital cameras and other consumer electronics products.

      Offer a Low-Cost Total Solution. Our engineers have significant system design expertise at the consumer product 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 manufacturing cost. We work in close collaboration with our customers in their product development process. By helping our customers design their products using our chips, we can lower their total manufacturing costs. We believe this approach enables us to provide our customers with a low-cost total solution.

      Leverage Our Relationships with Low-Cost Manufacturers to Capture Additional Worldwide Market Share. We believe that consumer electronics companies will continue to move contract manufacturing to lower-cost manufacturers located in China. We are a leading supplier of video system processor chips to original equipment manufacturers, or OEMs, located in China. Our customers in China manufacture and sell DVD and video CD players both as contract manufacturers for well known brand labels and under their own brands. We believe we can leverage our position in China to gain design wins with additional key consumer electronics companies as they migrate their manufacturing to China.

      Expand Relationships with Leading Consumer Electronics Companies. We are increasing our sales efforts to, and actively pursuing key design wins with, leading consumer electronics companies located in Asia, Europe and South America.

      Employ Our Software Expertise to Develop New Technologies. Approximately 60% of our employees are engineers, a significant portion of whom are software engineers. We have a diversified base of technologies and a strong track record for developing new technologies in-house. We intend to leverage our software expertise to continue to develop new technologies and add features to our products.

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      Pursue Acquisitions of Complementary and Advanced Technologies. We have in the past acquired and will continue to consider acquiring complementary technology or product lines to enhance our own product offerings and to accelerate our time to market. In addition, we will continue to form agreements with other companies to develop technologies. For example, we recently entered into an agreement with NEC Electronics to develop enhanced versions of NEC’s system controller chips used in digital consumer electronics devices, such as set-top boxes.

Products

      We offer a broad array of DVD chips, video CD chips, communication chips and PC audio chips.

      DVD Chips. Our customers can choose from a variety of DVD chips with various feature combinations and price points. We provide highly-integrated chips using multiple processors and a programmable architecture that enables us to offer a broad array of features and functionality. At the high end, our DVD chips enable consumers to play DVD, CD, MP3, WMA (Windows Media Audio and Video), full-featured karaoke and other audio and video formats through their home entertainment systems and to browse the internet and view digital photo CDs on their television. Our DVD chips support high quality video formats such as Progressive Scan, and high quality audio formats, including Dolby Digital, DTS Surround, DVD audio and Sony’s SACD audio. These chips can also be used as the primary processor in MP3 players.

      Video CD Chips. Our video CD products consist of both the standard VCD chips and the enhanced version known as SVCD chips. Our customers can choose from a variety of VCD and SVCD chip products, each with various feature combinations and price points. Our VCD chips include an MPEG-1 video and audio system decoder. They deliver full-screen, full-motion video at 30 frames per second with selectable CD-quality audio. Our SVCD chips include MPEG-2 video and MPEG-1 audio system decoders. The video quality of SVCD is roughly comparable to that of a high-quality VCR, and VCDs have slightly lower quality video. These chips are used in relatively low-cost video CD players that are sold primarily in China, Malaysia, India and other emerging markets.

      Communication Chips. Internet-related applications, such as voice e-mail, internet radio, audio home pages and news-on-demand, are increasing the demand for integrated audio and computer fax/ modem/ network functions on the PC. Our communication products enable PC manufacturers to provide fax/ modem/ network capabilities to add-on cards and directly onto the motherboards of desktops and notebook PCs. We provide a full line of modem chips that are compliant with current worldwide modem standards and have various feature combinations and price points.

      PC Audio Chips. Our PC audio chips enable PC manufacturers to provide audio capabilities on add-in sound cards and directly on the motherboards of desktop and notebook computers. We were a pioneer in this market, offering the first single-chip PC audio solution with high-quality sound reproduction. We provide a full line of PC audio chips with various feature combinations and price points, but we are no longer emphasizing this business and expect that sales of PC audio chips will continue to decline.

      Sales of these products accounted for the following percentages of our net revenues in the past three years:

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Technology and Research and Development

      Our DVD chips incorporate a digital signal processor (DSP) and a reduced instruction set computer processor (RISC). The two processors work asynchronously on separate tasks, which allows us to build a highly-integrated chip. We believe this architecture will enable us to efficiently add many additional features and functionality to our DVD chips as we pursue our overall DHS strategy.

      We are developing the next generation DVD chip that will incorporate many new advanced capabilities. We are designing this chip with a third independent processor to enable us to support the following standard operating systems: Linux, PocketPC (formerly WinCE) and VxWorks. By supporting standard operating systems, we can leverage third party software applications, such as standard web browsers, and third party software drivers to support printers, digital cameras and other consumer electronics products.

      We must continually design, develop and introduce new products that take advantage of market opportunities and address emerging technical standards. We intend to leverage our base of design expertise, analog, digital and mixed-signal design capabilities and process technologies, and software and systems expertise to continue to develop audio, video and communication solutions for the consumer electronics marketplace.

      Our design environment is based on workstations, dedicated product simulators, system simulation with hardware and software modeling, and a high-level, design-description language. We invest regularly in new advanced equipment and software tools and we intend to maintain and enhance our library of core cells.

      On research and development activities, we spent approximately $28 million during 2001, $27.8 million during 2000, excluding a one-time pre- and post-tax charge of $2.6 million related to acquired research and development in-process from the acquisition of NetRidium Communications, Inc. in the first quarter of 2000, and $36.0 million during 1999.

Customers

      We sell our chips to distributors and OEMs of DVD, video CD, MP3, 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. As a result, our chips can be found in a diverse array of DVD, video CD and PC products on store shelves in the United States, Asia and Europe. For example, our chips can be found in certain branded DVD players, such as Sharp, RCA, GE and Toshiba, as well as in lower-cost DVD players, such as Apex.

      A limited number of customers have accounted for a substantial portion of our net revenues. Sales to our top five customers, including sales to distributors, accounted for approximately 73% of our net revenues in 2001, 56% of our net revenues in 2000, and 53% of our net revenues in 1999. In 2001, Dynax Electronics accounted for approximately 56% of our net revenues. As a distributor, Dynax Electronics resells our products to OEMs and other customers. We expect that a limited number of customers may account for a substantial portion of our net revenues for the foreseeable future. In 2000, Dynax Electronics accounted for approximately 35% of our net revenues and Digital AV accounted for approximately 10% of our net revenues. In 1999, Dynax Electronics, our largest distributor, accounted for approximately 22% of our net revenues and Digital AV (formerly Shinco) accounted for approximately 13% of our net revenues.

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 and in several other countries.

      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.

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      International sales comprised approximately 97% of our net revenues in 2001, 93% of our net revenues in 2000 and 95% of our net revenues in 1999. Our international revenues in 2001, 2000 and 1999 were derived primarily from Asian customers who manufacture DVD, video CD, communications and PC products. Companies in Asia manufacture a large percentage of the worldwide supply of these products. We believe a significant portion of our DVD chip products are incorporated into DVD players that are ultimately sold into the United States. We have direct sales personnel and technical staff located in Hong Kong and Taiwan, where a significant portion of our sales have historically been derived. Our products are also sold internationally through distributors and sales representatives located in China, Korea, Japan, and Singapore. 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, our distributors typically have rights of return for unsold product and rights to pricing allowances to compensate for rapid, unexpected price changes.

Manufacturing

      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 two independent foundries that use advanced manufacturing technologies to fabricate our chips. Substantially all of our products are manufactured by Taiwan Semiconductor Manufacturing Company, or TSMC, which has manufactured products for us since 1989, and by United Microelectronics Corporation, or UMC, which is also located in Taiwan. Most of our products are currently fabricated using both mixed-signal and logic CMOS 0.35 to 0.22 micron process technologies.

      After wafer fabrication by the foundry, all of our semiconductor products are assembled and tested by third-party vendors, primarily Advanced Semiconductor Engineering, or ASE, Orient Semiconductor Electronics, or OSE, and Sampo Semiconductor in Taiwan. We have internally designed and developed our own test software and certain test equipment, which are provided to our test vendors. See “Factors That May Affect Future Results — Our products are manufactured by independent third parties.”

Competition

      Our 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 most of the applications 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 decline.

      Our existing and potential competitors consist principally of large domestic and international companies that have substantially greater financial, manufacturing, technical, marketing, distribution and other resources, greater intellectual property rights, broader product lines and longer-standing relationships with customers than we have. Our competitors also include a number of smaller and emerging companies.

      Our principal competitors include LSI Logic, Zoran and Cirrus Logic. In addition, we expect that the DVD platform for the digital home system will face competition from other platforms including set-top-boxes, 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 set-top-boxes.

      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.

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      In addition, as the market for the digital home system develops, 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. For example, LSI Logic acquired C-Cube Microsystems and Cirrus Logic acquired LuxSonor Semiconductors.

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, 2001, we had 15 patents granted in the United States, which are going to expire over time commencing in 2008 and ending in 2019. In addition, as of December 31, 2001 we had 11 corresponding foreign patents, which are going to expire over time commencing in 2002 (the patents expiring in 2002 consist of two audio-related Japanese patents) and ending in 2015. We have several patent applications pending and we have a continuous program and intent to seek further U.S. and international patents on our technology whenever possible.

      We have created significant intellectual property in our software programs that run on our chips. We protect this software as a trade secret.

      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, 2001, there were several intellectual property litigation matters pending against us which we are vigorously defending and believe will not have a material adverse effect on our business.

      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. We have not derived material revenues from these licenses in recent periods. See “Factors That May Affect Future Results — 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.”

Employees

      As of March 5, 2002, we had approximately 440 full-time employees, including 194 in research and development, 135 in marketing, sales and support, 57 in operations, finance and administration and 54 in manufacturing. Approximately 60% of our employees are engineers, a significant portion of them are software engineers. 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.

Backlog

      Our products are generally sold pursuant to standard purchase orders, which are frequently revised to reflect changes in the customer’s 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, while useful for scheduling production, is not necessarily a reliable indicator of revenues.

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 building next to our corporate headquarters, which we are currently leasing to Vialta, Inc., our former subsidiary. In addition we own an adjacent 11,000 square-foot dormitory building used to house visitors and guest workers. We also maintain leased office space in various locations. We believe our existing facilities are adequate to meet our current requirements.

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Item 3.     Legal Proceedings

      On April 9, 1999, we filed a complaint in the U.S. District Court for the Northern District of California, Case No. C-99 20292 RMW, against PCTEL, Inc., alleging violations of the antitrust laws and other claims relating to PCTEL’s failure to provide a license to us covering certain patents that PCTEL maintains are essential to the manufacture and sale of modems. On August 7, 2000, PCTEL filed an answer and cross-complaint alleging infringement of such patents, and in an amended cross-complaint filed October 4, 2000 PCTEL asserted infringement of three additional patents. In a related proceeding, on September 15, 2000, we were named, along with another respondent, in a complaint filed by PCTEL with the International Trade Commission requesting exclusion orders and other relief directed at products imported into the United States that contain our modem products alleged to infringe two of the patents that were asserted in the district court action mentioned above. On February 6, 2002, we jointly announced the settlement of all pending litigation matters between us and PCTEL. As part of the settlement, we entered into a cross-license agreement involving the PCTEL patents asserted in the proceedings described above and involving our modem patent portfolio. PCTEL will receive royalty payments and additional technology from us. We believe this settlement will have no material effect on our business or financial performance.

      On March 12, 2001, we filed a complaint in the U.S. District Court for the Northern District of California, Case No. C01-20208, against Brent Townshend alleging unfair competition and various violations of the Sherman Act relating to monopolization and antitrust. Our complaint seeks specific performance of contractual obligations and declarations of patent misuse, unenforceability, and estoppels against asserting patent rights. All of the claims relate to the refusal of Mr. Townshend to provide us with a license on reasonable and nondiscriminatory terms, as we believe is required by applicable standards. The license and patent issue relate to the manufacture and sale of high-speed modems. We believe that the license terms offered are unreasonable and discriminatory, and we will vigorously pursue this litigation. Mr. Townshend has yet to answer the complaint, and no trial date has been set.

Item 4.     Submission of Matters to a Vote of Security Holders

      We did not submit any matter to a vote of security holders during the quarter ended December 31, 2001.

Executive Officers of the Registrant

      The following table sets forth certain information regarding the Company’s current executive officers:

      Fred S.L. Chan has been a director since January 1986 and has served as Chairman of the Board since October 1992. Mr. Chan is the Chairman of the Board for Vialta, Inc. and has served in that capacity since September 1999. Mr. Chan served as President and Chief Executive Officer of Vialta from September 1999 to August 2001. Mr. Chan served as our President from November 1985 until October 1996 and from February 1997 to September 1999. He served as our Chief Executive Officer from June 1994 until September 1999. Mr. Chan served as our Chief Financial Officer from October 1992 to May 1995. From 1984 to 1985, Mr. Chan was founder, President and Chief Executive Officer of AC Design, Inc., a VLSI chip design center providing computer aided design (CAD), engineering and other design services. From 1982 to 1984, he was co-founder, President and Chief Executive Officer of CADCAM Technology, Inc., a company in the business of computer aided engineering (CAE) systems development. Mr. Chan holds B.S.E.E. and M.S.C. degrees from the University of Hawaii. Mr. Chan is the spouse of Annie M.H. Chan, another of our directors.

      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 from April 1997

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      Patrick Ang has served as Chief Operating Officer and Executive Vice President whose responsibilities include worldwide sales and marketing since December 2001. From March 1998 to September 2001, Mr. Ang served as President and Chief Executive Officer of Broadxent, Inc. (formerly known as Digicom Systems, Inc.), a broadband communications equipment manufacturer, and from November 1997 to December 1999 Mr. Ang served as President of Ectiva, Inc., an internet appliance manufacturer which was acquired by Creative Technology Ltd. in November, 1997. From December 1993 to November 1997, Mr. Ang was employed as Division President for OPTi, Inc., a supplier of semiconductor products for the personal computer market. He was the founder of MediaSonics and co-founder of MediaChips, which was acquired by OPTi, Inc. in November 1993. Mr. Ang has more than 17 years of management, systems and semiconductor experience and has held various R&D positions at Telmos, Sierra Semiconductor and Triptech Microelectronics. Mr. Ang holds a B.S. in Electrical Engineering from the National University of Singapore. He is serving on the boards of directors for Sunrise Telecom, Inc. and Photoniko, Inc.

      James B. Boyd was appointed Chief Financial Officer in August 2000. Mr. Boyd was also elected as Assistant Secretary in August 2000. Prior to joining ESS, Mr. Boyd served from March 1998 until July 2000 as Chief Financial Officer of Gatefield Corporation, a Fremont-based manufacturer of field programmable electronic circuits used in PCs and consumer electronics. From August of 1997 until January of 1998, he was Chief Financial Officer of AirMedia, a developer of wireless communications software and from March of 1996 until August of 1997, he was Corporate Controller at Farallon Communications. He has also held senior management positions with Fritz Companies, GTE Sprint Communications and Southern Pacific Companies. Mr. Boyd holds a B.S. degree in accounting and an MBA in finance from the University of Wisconsin — Madison, and a J.D. from Golden Gate University.

      The information concerning compliance with Section 16 of the Securities Exchange Act of 1934 is incorporated by reference to the section in the proxy statement for the 2002 Annual Shareholders’ Meeting entitled “Compliance under Section 16(a) of the Securities Exchange Act of 1934.”

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PART II

      The Company’s Common Stock has been trading on the NASDAQ National Market under the symbol “ESST” since October 6, 1995. The following table sets forth the high and low last reported sales prices for the Common Stock as reported by the NASDAQ National Market during the period indicated.

      As of March 5, 2002, there were approximately 205 record holders of the Company’s Common Stock. Since most shareholders are listed under their brokerage firm’s names, the actual number of shareholders is higher.

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 following data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the financial statements and related notes thereto included elsewhere in this report. All of the data presented has been adjusted to give effect to the treatment of Vialta as a discontinued operation.

      We derived the selected consolidated statement of operations data for the years ended December 31, 2001, 2000 and 1999 and the selected consolidated balance sheet data as of December 31, 2001 and 2000 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, 1998 and 1997 and the selected

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      The following Management’s Discussion and Analysis of Financial Condition and Results of Operations, as well as information contained in “Factors that May Affect Future Results” below and elsewhere in this Report, contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. 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. In some cases, these statements can be identified by terminologies such as “may,” “will,” “expect,” “anticipate,” “estimate,” “continue,” or other similar words.

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      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.

Overview

      We are a leading designer, developer and marketer of highly-integrated digital system processor chips. These chips are the primary processors driving digital video and audio players including DVD, video CD and MP3 players. Our chips use multiple processors and a programmable architecture that enable us to offer a broad array of features and functionality. We believe that multi-featured DVD players will serve as the platform for a digital home system, or DHS, integrating various digital home entertainment and information delivery products into a single box. We are also a supplier of chips for use in modems and similar communication products, and a supplier of PC audio chips. We outsource all of our chip fabrication and assembly as well as the majority of our test operations, allowing us to focus on our design and development strengths.

      In April 2001, our board of directors adopted a plan to distribute all of our shares of Vialta, a startup company with historical losses that is developing a multi-featured DVD player with internet connectivity and other advanced features. The Vialta spin-off was completed on August 21, 2001. Vialta is reported separately as a discontinued operation.

      In February 2000, we acquired NetRidium, a development stage company, for $5.3 million in cash. NetRidium is a developer of broadband communication products enabling high-speed networking over existing phone lines in the home. The acquisition was recorded using the purchase method of accounting and accordingly, the results of operations and cash flows of such acquisition have been included from the date of acquisition.

      At the end of 1995, we purchased 16 acres of land in Fremont, California, on which we built our corporate campus. In October 2000, we sold the remaining undeveloped 4.32 acres of this land.

Critical Accounting Policies

     Use of Estimates

      The preparation of the financial statements and accompanying notes in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions related to the reporting of assets and liabilities and the disclosures of contingent assets and liabilities. Actual results could differ from those estimates.

     Revenue Recognition

      The Company provides for rebates and future returns based on historical experiences at the time revenue is recognized. Actual expenses may be different from management’s estimate; such differences, if any, are recorded in the period they become known.

     Inventories

      Inventories are stated at the lower of cost or market, with cost being determined by the first-in, first-out method. We write down inventories to net realizable value based on forecasted demand and market conditions. Actual demand and market conditions may be different from those projected by our management. This could have a material effect on our operating results and financial position. These charges have been included in cost of sales in our consolidated statements of operations.

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     Impairment of Long-Lived Assets

      Pursuant to Statement of Financial Accounting Standards No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of” (“SFAS 121”), the Company reviews long-lived assets based upon a gross cash flow basis and will reserve for impairment whenever events or changes in circumstances indicate the carrying amount of the assets may not be fully recoverable. On January 1, 2002, SFAS No. 144 “Accounting for the Impairment or Disposal of Long-lived Assets” (“SFAS 144”), became effective. This standard supersedes SFAS No. 121 and requires that one accounting model be used for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired. The adoption of SFAS No. 144 will not have a material effects on our financial statements.

     Income Taxes

      The Company accounts for income taxes under an asset and liability approach that requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of timing differences between the carrying amounts and the tax bases of assets and liabilities. U.S. deferred income taxes are not provided on all un-remitted earnings of the Company’s 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.

Results of Operations

      Our consolidated financial information presents the net effect of the discontinued operation separate from the results of our continuing operations. Historical financial information has been reclassified to present consistently the discontinued operation. The discussion and analysis that follows below generally focus on the continuing operations. Inflation has not had any material impact on our business to date.

      The following table sets forth certain operating data as a percentage of net revenues:

Net Revenues

      Net revenues were $271.4 million in 2001, $303.4 million in 2000 and $310.7 million in 1999. Net revenues decreased 11% from 2000 to 2001 primarily due to the continuing softness in the PC marketplace , which more than offset the growth in our DVD business. Net revenues from 2000 to 2001 decreased by $64.6 million in our PC audio business, decreased by $16.1 million in our video CD chip business, increased by $54.6 million in our DVD chip business and decreased by $6.0 million in our communication and other businesses. We expect our DVD chip business will continue to grow as a percentage of our net revenues, while

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Gross Profit

      Gross profit was $91.1 million in 2001, $111.0 million in 2000 and $119.1 million in 1999, representing corresponding gross margins of 33.6% of net revenues in 2001, 36.6% of net revenues in 2000 and 38.3% of net revenues in 1999. The decrease in gross margin from 2000 to 2001 was primarily due to the underabsorption of fixed overhead: certain fixed costs remained relatively constant for the two periods, while production levels for 2001 were lower than for 2000. We recorded $7.0 million of excess and obsolete inventory charges during 2001, a decrease of $3.3 million from 2000. We expect gross margins to return to historic levels in the future, based upon an increasing percentage of our sales generated by our higher-margin DVD chip business. The decrease in gross margin from 1999 to 2000 was primarily due to $10.3 million in inventory charges in 2000. Excluding the $10.3 million inventory charges, gross margin would have been 39.5% of net revenues in 2000 compared to 38.3% of net revenues in 1999, due to higher-margin product mix partially offset by reduced average selling prices.

      During 2000, we purchased inventory based on our then current sales forecast and our intent to build up inventory on key products from our foundries due to a forecasted tight wafer capacity. However, during 2001, the overall market for PC products declined significantly, and, as a result, the demand for these products did not meet our forecasts resulting in those inventory charges described above.

      As a result of intense competition in our markets, we expect the overall average selling prices for our existing products to decline over the product life. We believe that in order to maintain or increase gross profit, we must achieve higher unit volume shipments, reduce costs, add new features and introduce new products.

Operating Expenses

      Research and development expenses were $28.0 million, or 10.3% of net revenues, in 2001; $27.8 million or 9.2% of net revenues, in 2000; and $36.0 million, or 11.6% of net revenues, in 1999. The increase in research and development expenses from 2000 to 2001 was the result of normal variations in project workload. We expect that research and development will continue to be critical to our business as we introduce new products. The decrease in research and development expenses from 1999 to 2000 was primarily due to a decrease in internal projects and reimbursement of consulting and other services provided to Vialta.

      Operating expenses in 2000 included an additional $2.6 million for in-process research and development due to the purchase of NetRidium, which is not included in the foregoing research and development expenses.

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      Selling, general and administrative expenses were $40.7 million, or 15.0% of net revenues, in 2001; $36.2 million, or 11.9% of net revenues, in 2000; and $38.6 million, or 12.4% of net revenues, in 1999. The increase in selling, general and administrative expenses from 2000 to 2001 resulted primarily from the increase in legal expenses. The decrease in selling, general and administrative expenses from 1999 to 2000 resulted primarily from the completion of a co-operative marketing campaign and a decrease in bad debt expenses partially offset by an increase in salary and legal expenses. The Company expects selling, general and administrative expenses will remain relatively constant, at approximately 15-17% of net revenues in the foreseeable future.

Non-Operating Income (Loss), Net

      Net non-operating income (loss) was ($18.8) million in 2001, $41.8 million in 2000 and $4.7 million in 1999. In 2001, net non-operating loss consisted primarily of a $21.2 million loss from the sale of 565,178 shares of Cisco Systems stock in June of 2001, partially offset by interest income and rental income from Vialta. In 2000, net non-operating income consisted primarily of a pre-tax gain of $35.0 million on our exchange of preferred stock in Komodo Technology for restricted shares of common stock of Cisco Systems in September 2000, in addition to a $2.9 million gain from the sale of land and property, plant and equipment, and $2.4 million of net interest income on cash, cash equivalents and short-term investments. In 1999, net non-operating income consisted primarily of interest income.

Income Taxes

      During the fourth quarter of 1997, we established a wholly owned foreign subsidiary in the Cayman Islands, British West Indies, which has reduced our effective tax rate.

      The Company’s effective tax rate was (241%), 37%, and 15% for 2001, 2000, and 1999, respectively. Our effective tax rate, excluding the provision taken on the exchange of Komodo Technology shares for Cisco Systems shares and subsequent sale of Cisco Systems stock, was 5% for 2001 and 17% for 2000. The Company used an estimated 40% tax rate on the $21.3 million loss from sale of the investment, which resulted in an $8.5 million tax benefit. The tax rate for 2001 of 5% was lower than the combined federal and state statutory rate of 40% primarily as a result of the lower foreign tax rate on earnings from the Company’s foreign subsidiary that was considered to be permanently reinvested. The tax rate for 2000 of 17% was lower than the combined federal and state statutory rate of 40% primarily as a result of the lower foreign tax rate on earnings from the Company’s foreign subsidiary that was considered to be permanently reinvested.

Net Income From Continuing Operations

      Net income from continuing operations was $11.0 million in 2001, $63.2 million in 2000 and $41.3 million in 1999. The decreased net income from continuing operations during 2001 compared to 2000 was primarily due to the $21.2 million loss incurred on sale of investments in 2001, as compared to the $35.0 million gain recorded in 2000, the decrease in net revenues and the lower-margin product mix. The increased net income from continuing operations during 2000 compared to 1999 was primarily due to the $35.0 million gain on the Komodo investment and offset by an increase in inventory charges.

Net Loss From Discontinued Operation

      Net loss from discontinued operation was $12.8 million in 2001, $14.9 million in 2000 and $1.2 million in 1999. The increased net loss from discontinued operation during 2001 compared to 2000 was primarily due to the $13.3 million loss from disposal of discontinued operation recorded in the first quarter of 2001 for the estimated spin-off cost and anticipated losses, net of minority interest, from operating the Vialta business between April 1, 2001 and the estimated completion date for the spin-off, which was completed earlier than estimated on August 21, 2001. The increased loss from discontinued operation during 2000 compared to 1999

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Eight Quarters Ended December 31, 2001

      The following table sets forth our statement of operations data for each of the eight quarters ended December 31, 2001. All of the data presented has been restated to reflect Vialta as a discontinued operation. We believe that going forward we will be more seasonal, depending on the timing of customer orders and demand for the holiday season, which typically occur during the third and fourth quarters. The operating results for any quarter are not necessarily indicative of results for any future period.

Liquidity and Capital Resources

      Since inception, we have financed our cash requirements from cash generated by operations, the sale of equity securities, bank lines of credit and short-term and long-term debt. At December 31, 2001, we had cash, cash equivalents and short-term investments of $129.0 million and working capital (excluding net assets of the discontinued operation) of $157.0 million. At December 31, 2001, we had a $15.0 million unsecured line of credit, which will expire on May 1, 2002. We expect to be able to renew this line of credit . This line of credit requires us to maintain certain financial ratios and operating results. On December 31, 2001, we were in compliance with these borrowing criteria. There were no borrowings under the line of credit at December 31, 2001.

      In 2001, we generated $93.5 million of cash from operating activities. This amount resulted primarily from the selling of inventories. We used $16.5 million of cash in investing activities, which consisted primarily of a net purchase of short-term investments, cash paid for the acquisition of SAS, other long-term investments and fixed asset purchases. We used $5.7 million of cash in financing activities, primarily as a result of using $14.3 million to repurchase Common Stock offset by the receipt of $8.6 million from the issuance of Common Stock under employee stock plans.

      In 2000, we used $11.1 million of cash in operating activities. This amount resulted primarily from the increase in our inventories of $56.6 million and accounts receivable of $17.5 million, offset by the increase in income tax related liabilities of $15.7 million and the current year net income before non-cash charges (loss from discontinued operations, deprecation and amortization) of $85.4 million. We generated $14.1 million of cash from investing activities, which mainly resulted from our net sales of investments of $17.1 million,

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      In 1999, we generated $61.6 million of cash from operating activities. This amount resulted from current year net income before non-cash charges of $58.8 million, increase in accounts payable and accrued expenses of $13.6 million, offset by an increase of current assets net of liabilities of $2.8 million. We used $85.9 million of cash in investing activities, which resulted primarily from using $62.0 million to purchase shares of Vialta preferred stock, using $11.5 million to buy property, plant and equipment and using $14.6 million for the net purchase of short-term investment. We used $1.0 million of cash for financing activities.

      We believe that our existing cash and cash equivalents as of December 31, 2001 together with short-term investments, the cash generated from operations, available borrowings under our line of credit and other financing options, will be sufficient to fund acquisitions of property and equipment and provide adequate working capital through at least the next twelve months. Capital expenditures for the next twelve months are anticipated to be approximately $1.0 million. We may also use cash to acquire or invest in complementary businesses or products or to obtain the right to use complementary technologies. From time to time, in the ordinary course of business, we may evaluate potential acquisitions of or investment in such businesses, products or technologies owned by third parties.

      On February 1, 2002, we announced that we had commenced a public offering of 4,800,000 shares of our common stock at a price of $19.38 per share. We sold 2,500,000 shares, and 2,300,000 shares were sold by selling shareholders – we did not receive any of the proceeds from the sale of shares by the selling shareholders: Annie M.H. Chan, the Annie M.H. Chan Living Trust and the Shiu Leung Chan & Annie M.H. Chan Gift Trust. We received the net proceeds of $45,550,000 on February 6, 2002, which will be used for general corporate purposes, which may include acquisitions of companies, acquisitions of technology and capital expenditures. Pending such uses, we intend to invest the net proceeds from the offering in short term, interest bearing, investment grade securities.

Recent Accounting Pronouncements

      In July 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 141 Business Combinations, (“SFAS 141”). SFAS 141 requires the purchase method of accounting for business combinations initiated after June 30, 2001 and eliminates the pooling-of-interests method. ESS’s management believes that the adoption of SFAS 141 will not have a significant impact on the Company’s financial statements.

      In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142 “Goodwill and Other Intangible Assets,” (“SFAS 142”), which is effective for fiscal years beginning after December 15, 2001. SFAS 142 requires, among other things, the discontinuance of goodwill amortization. In addition, the standard includes provisions upon adoption for the reclassification of certain existing recognized intangibles as goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of previously reported goodwill and the testing for impairment of existing goodwill and other intangibles. ESS believes that the adoption of SFAS 142 will not have a significant impact on the Company’s financial position and results of operations.

      On October 3, 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”). SFAS 144 supercedes SFAS 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. SFAS 144 applies to all long-lived assets (including discontinued operations) and consequently amends Accounting Principles Board Opinion No. 30. SFAS 144 develops one accounting model for long-lived assets that are to be disposed of by sale. SFAS 144 requires that long-lived assets that are to be disposed of by sale be measured at the lower of book value or fair value less cost to sell. Additionally, SFAS 144 expands the scope of discontinued operations to include all components of an entity with operations that (1) can be distinguished from the rest of the entity and (2) will

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Factors That May Affect Future Results

      We have shifted our primary focus from the PC audio business to developing products primarily for the consumer digital video market. Since the second half of 2000, sales of video system processor chips to the DVD and video CD (including VCD and SVCD) player markets accounted for a majority of our net revenues. We expect that the consumer electronics market will continue to account for a significant portion of our net revenues for the foreseeable future. However, our strategy in this market may not be successful. Given the large installed base of VCRs and other consumer electronics products, coupled with the current economic environment, consumer spending on DVD players and other home electronics may not grow as anticipated.

      Historically, sales of audio and modem chips to the PC market have accounted for a significant portion of our net revenues. However, we are no longer emphasizing this business and expect future sales in the PC market will continue to decline. If the decline in our sales to the PC market is not offset by an increase in sales to the consumer electronics market, our business, financial condition and results of operations would be materially adversely affected.

      In addition, the potential decline in consumer confidence and consumer spending that may be occasioned by terrorist attacks or armed conflict could have a material adverse effect on our business, financial condition and results of operations. We have not yet determined the ultimate effect of the recent terrorist attacks and armed conflict on our results of operations.

      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:

	•	changes in demand for our products;
	•	changes in the mix of products sold and our revenue mix;
	•	charges related to excess inventory;
	•	seasonal customer demand;
	•	increasing pricing pressures;
	•	gain or loss of significant customers;
	•	the cyclical nature of the semiconductor industry;
	•	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;
	•	the timing of significant customer orders;
	•	availability and cost of raw materials;
	•	significant increases in expenses associated with the expansion of operations; and
	•	availability and cost of foundry capacity.

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      We currently place non-cancelable orders to purchase our products from independent foundries on an approximately three-month rolling basis, while our customers generally place purchase orders with us that may be cancelled without significant penalty less than four weeks prior to delivery. If anticipated sales and shipments in any quarter are cancelled or do not occur as quickly as expected, 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. We have experienced significant inventory charges in the past and we may continue to experience these charges in future periods.

      We invest a significant amount of time and resources in our research and development activities to maintain and enhance 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.

      One of our significant projects is the development of a next generation DVD system processor chip that will incorporate three independent processors and allow us to support additional features, including the Linux, PocketPC (formerly WinCE) and VxWorks operating systems. This will require a new architecture and a complete system on a chip design, which is extremely complex and may not be ultimately feasible. If we are unable to successfully develop this next generation DVD system processor chip, or complete other significant research and development projects, our business, financial condition and results of operations could be materially adversely affected.

      We will continue to regularly consider the acquisition of other companies or the products and technologies of other companies to complement our existing product offerings, improve our market coverage and enhance our technological capabilities. There may be technologies that we need to acquire or license in order to remain competitive. However, we may not be able to identify and consummate suitable acquisitions and investments. Acquisitions and investments carry risks that could have a material adverse effect on our business, financial condition and results of operations, including:

	•	the failure to integrate with existing products and corporate culture;
	•	the inability to retain key employees from the acquired company;
	•	diversion of management attention from other business concerns;
	•	the potential for large write-offs;
	•	issuances of equity securities dilutive to our existing shareholders; and
	•	the incurrence of substantial debt and assumption of unknown liabilities.

     Our sales may fluctuate due to seasonality of customer demand.

      Our customers have experienced and may continue to experience significant seasonality in the sales of their products, which affects their orders of our products. A majority of consumer home electronics products are sold during the holiday season. Consequently, as more of our chips are sold into the consumer electronics market, we expect a disproportionate amount of our sales to occur in the third and fourth quarters.

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     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 original equipment manufacturers, or 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 average selling prices of our existing products to decline significantly over the life of each product as the markets for our products mature 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.

     We may lose business to competitors who have significant competitive advantages.

      Our existing and potential competitors consist principally of large domestic and international companies that have substantially greater financial, manufacturing, technical, marketing, distribution and other resources, greater intellectual property rights, broader product lines and longer-standing relationships with customers than we have. 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.

      DVD and video CD players face significant competition from video on demand, VCRs and other video formats. In addition, we expect that the DVD platform for the digital home system 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 supply chips for multiple platforms. A decline in DVD sales may have a disproportionate affect on us as we shift our focus to this market. 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.

     Our business is dependent upon retaining key personnel and attracting new employees.

      Our success depends to a significant degree upon the continued contributions of Fred S.L. Chan, our Chairman of the Board, and Robert L. Blair, our President and CEO. In the past, Mr. Chan has served as our President and Chief Executive Officer besides being our Chairman of the Board and currently he serves as the Chairman of the Board of Vialta, our former subsidiary. Mr. Chan is critical to maintaining many of our key relationships with customers, suppliers and foundries in Asia. The loss of the services of Mr. Chan, Mr. Blair, or any of our other key executives could adversely affect our business. We may not be able to retain these employees and searching for their replacements could divert the attention of other senior management and increase our operating expenses. We currently do not maintain any key person life insurance.

      To manage our future operations effectively, we will need to hire and retain additional management personnel, design personnel and software engineers. We may have difficulty recruiting these employees or integrating them into our business. If we lose the services of a significant number of our management personnel, design personnel or software engineers, the implementation of our business strategy could be disrupted.

      A substantial portion of our net revenues has increasingly been derived from sales to a small number of our customers. During 2001, sales to our top five customers increased to approximately 73% of our net revenues, which includes sales through Dynax Electronics, our largest distributor. 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.

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      During 2001, sales through Dynax Electronics, our largest distributor, increased to approximately 56% of our net revenues. Dynax Electronics is not subject to any minimum purchase requirements and can discontinue marketing any of our products at any time. In addition, Dynax Electronics has rights of return for unsold product and rights to pricing allowances to compensate for rapid, unexpected price changes. Our business would be adversely affected if our relationship with Dynax Electronics deteriorates or their financial condition were to decline. As our business grows, we may increasingly rely on distributors, which may reduce our exposure to future sales opportunities and impede our ability to accurately forecast product orders.

      To protect our intellectual property rights we rely on a combination of patents, trademarks, copyrights and trade secret laws and confidentiality procedures. As of December 31, 2001, we had 15 patents granted in the United States. These patents will expire over time commencing in 2008 and ending in 2019. In addition, as of December 31, 2001, we had 11 corresponding foreign patents, which are going to expire over time commencing in 2002 (the patents expiring in 2002 consist of two audio-related Japanese patents) and ending in 2015. 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 can 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. In particular, if we lose either of the related modem cases, our results of operations could be significantly harmed. 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.

      Substantially all of our sales have been to customers in Hong Kong, Taiwan, China, Korea, Japan, Malaysia, and Singapore. During 2001, sales to customers in Hong Kong, Taiwan and China were in excess of 89% of our net revenues. 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;
	•	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;

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	•	longer payment cycles and greater difficulties in accounts receivable collection;
	•	potentially adverse taxes;
	•	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 Taiwan Semiconductor Manufacturing Company, Ltd., or TSMC, and by United Microelectronics Corporation, or UMC. Our reliance on these or other independent foundries involves a number of risks, including:

	•	the 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 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.

      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 the 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.

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      The greater integration of functions and complexity of our products increases 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. Downturns in the industry have been characterized by abrupt fluctuations in product demand, production over-capacity and accelerated decline of average selling prices. Current trade association data indicate that the semiconductor industry has experienced a severe downturn since the third quarter of 2000 and this downturn may continue for the foreseeable future. This downturn could harm our net revenues and gross margins if average selling prices continue to decline or demand falls. We cannot assure you that the market will stabilize or improve in the near term. A prolonged downturn in the semiconductor industry could materially and adversely impact our business and results of operations.

      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. The success of new products depends on a number of factors, including:

	•	anticipation of market trends;
	•	timely completion of product development, design and testing;
	•	market acceptance of our products and the products of our customers;
	•	offering new products at competitive prices;
	•	meeting performance, quality and functionality requirements of customers and OEMs; and
	•	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 of 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.

      The markets in which we compete are intensely competitive and are characterized by rapid technological changes, price reductions and rapid product obsolescence. Competition typically occurs at the design stage, when customers evaluate alternative design approaches requiring integrated circuits. Because of shortened 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. Advancements in technology can change the competitive environment in ways that may be adverse to us. 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. The announcements and commercial shipments of competitive products could adversely affect sales of our products and may result

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      The following factors may affect our ability to compete in our highly competitive markets:

	•	the price, quality and performance of our products and the products of our competitors;
	•	the timing and success of our new product introductions and those of our customers and competitors;
	•	the emergence of new multimedia standards;
	•	the development of technical innovations;
	•	ability to obtain adequate foundry capacity and sources of raw materials;
	•	the rate at which our customers integrate our products into their products;
	•	the number and nature of our competitors in a given market; and
	•	the protection of our intellectual property rights.

Item 7A.     Quantitative and Qualitative Disclosures about Market Risk

Foreign Exchange Risks

      We fund our operations with cash generated by operations, the sale of marketable securities and short and long-term debt. 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 foundry and test and assembly vendors are denominated in U.S. dollars. 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 rates on these investments. Increases or decreases in interest rates generally translate into decreases and increases in the fair value of these investments. In addition, the credit worthiness of the issuer, relative values of alternative investments, the liquidity of the instrument, and other general market conditions may affect the fair values of interest rate sensitive investments. In order to reduce the risk from fluctuation in rates, we invest in highly liquid governmental notes and bonds with contractual maturities of less than two years. All of the investments have been classified as available for a sale, and at December 31, 2001, the fair market value of our investments approximated their costs.

Risk Associated with Investment

      We are exposed to fluctuations due to changes in the market price of shares of Cisco Systems we hold as marketable securities. Since we do not use hedging instruments, these fluctuations could have an adverse impact on our net income should we decide to sell our remaining Cisco shares for a loss.

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Item 8.     Financial Statements and Supplementary Data

      The following documents are filed as part of this Report:

      Report of Independent Accountants

      Consolidated Balance Sheets as of December 31, 2001 and 2000

      Consolidated Statements of Operations for the years ended December 31, 2001, 2000 and 1999

      Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2001, 2000 and 1999

      Consolidated Statements of Cash Flows for the years ended December 31, 2001, 2000 and 1999

      Notes to Consolidated Financial Statements

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REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Shareholders of ESS Technology, Inc.

      In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of shareholders’ equity and of cash flows present fairly, in all material respects, the financial position of ESS Technology, Inc. and its subsidiaries at December 31, 2001 and 2000, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

	/s/ PRICEWATERHOUSECOOPERS LLP

San Jose, California

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ESS TECHNOLOGY, INC.

CONSOLIDATED BALANCE SHEETS

(1)	Year 2000 amounts have been reclassified to reflect separately the results of Vialta, Inc. as a discontinued operation.

The accompanying notes are an integral part of these consolidated financial statements.

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ESS TECHNOLOGY, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS