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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-K

Commission file number 0-32809

Vialta, Inc.

48461 Fremont Boulevard

(510) 870-3088

     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 registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10-K or any amendments to this Form 10-K.     o

      The aggregate market value of the voting stock held by non-affiliates of the registrant on June 28, 2002 (based on the average bid and ask price on the OTC Bulletin Board as of such date) was approximately $43,886,911.

      The number of outstanding shares of the registrant’s common stock, par value $0.001 per share, on March 7, 2003 was 82,083,640 shares.

DOCUMENTS INCORPORATED BY REFERENCE

      Portions of the registrant’s definitive proxy statement relating to its 2003 annual meeting of stockholders to be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year to which this Report relates, are incorporated by reference into Part III of this Form 10-K Report.

Table of Contents

VIALTA, INC.

FORM 10-K

For the Fiscal Year Ended December 31, 2002

INDEX

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CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

      This report contains forward-looking statements that involve risks and uncertainties. All statements contained in this report that are not purely historical could be deemed 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. When used in this report, words such as “may,” “might,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “intend,” “continue,” and similar expressions, are intended to identify forward-looking statements. These forward-looking statements might include, without limitation, projections of our future financial performance, our anticipated growth and anticipated trends in our businesses; the features, benefits and advantages of our products; the development of new products, enhancements or technologies; business and sales strategies; developments in our target markets; matters relating to distribution channels, proprietary rights, facilities needs, competition and litigation; future gross margins and operating expense levels; and capital needs. These statements reflect the current views of Vialta or its management with respect to future events and are subject to risks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize, or should underlying assumptions proved incorrect, our actual results, performance or achievements in fiscal 2003 and beyond could differ materially from those expressed in, or implied by, these forward-looking statements. Factors that could cause or contribute to material differences include, but are not limited to, those discussed below in Item 7 under the heading “Other Factors That May Affect Our Business and Future Results:” and the risks discussed in our other filings with the Securities and Exchange Commission. We encourage you to read that section carefully. You should not regard the inclusion of forward-looking information as a representation by us or any other person that the future events, plans or expectations contemplated by us will be achieved. Vialta undertakes no obligation to release publicly any updates or revisions to any forward-looking statements to reflect events or circumstances occurring after the date of this report.

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PART I

Item 1:     Business

      Vialta, Inc. (“Vialta” or the “Company”) develops, designs and markets consumer electronics products designed to maximize the benefits of digital technology in a more convenient and easy-to-use manner. Our newest product, Beamer^TM, is a personal videophone. Beamer adds color video to phone calls, enabling Beamer users to see the person they are calling. Beamers are primarily sold in pairs, since the party receiving the video call must also have a Beamer (or compatible videophone). Beamer works with any home phone over any standard (analog) home phone line, at no additional cost to a regular phone call. The first product we developed was ViDVD, a multimedia DVD player that offers enhanced features such as CD, MP3 and karaoke disc playback, Internet connectivity and the ability to view digital photographs.

      We were incorporated in April 1999 in California as a subsidiary of ESS Technology, Inc. (“ESS”). In May 2001, we were reincorporated in Delaware and subsequently spun off by ESS as a distribution to its shareholders in August 2001.

      See Item 8 “Financial Statements and Supplementary Data” for additional financial information regarding our business.

Products and Services

      We have developed and introduced two distinct products: Beamer and ViDVD, both designed to offer greater convenience and ease-of-use to consumers.

      The Beamer is compatible with any home phone and does not require any additional equipment or wiring. Beamer provides the consumer with three viewing options (the calling party, the receiving party, or picture-in-picture) and the ability to adjust the level of movement fluidity in relation to detail. Beamer also has a “snapshot” feature that temporarily pauses any new video transmission, resulting in a higher resolution image on the LCD screen. A “video start” feature gives users full control over initiating the video transmission to another user, for complete video privacy whenever desired. Beamer won a 2003 “Best of Innovations” award in the telephone category from the Consumer Electronics Association based on criteria consisting of value to users, aesthetics, innovativeness, and contributions to quality of life. Beamer also won a 2003 “Good Buy” award from Good Housekeeping magazine based on criteria including ingenuity, value and exceptional performance.

      The ViDVD player is a multimedia DVD player that plays DVD, MP3, CD and karaoke discs, and other audio and video formats. ViDVD also allows users to access the Internet and view Kodak Picture CDs and JPEG format digital photos stored on either CD-R or CD-R/ W discs. We marketed ViDVD in a limited, 18-store commercial launch in late 2001 and had lower than anticipated sales activity. The DVD player market, which was still maturing, was experiencing rapid and substantial changes, including significant downward price pressure for DVD players in the retail market with current pricing approaching commodity levels. This adversely affected our ability to maintain prices and develop the distribution channels necessary to successfully launch ViDVD. As a result, we have chosen not to continue to market ViDVD. We may, at some time in the future, introduce an enhanced DVD player. However, there can be no assurance that we will develop or be able to introduce an enhanced DVD player.

      In addition to these two consumer products, we developed ViMagazine, a proprietary, encrypted, magazine-style DVD–format disc which is capable of delivering a wide variety of entertainment, from feature films to children’s programming, music and other programming content. ViMagazine was developed exclusively for use with our ViDVD to provide consumers with a convenient means of obtaining entertainment content on demand. We have not introduced ViMagazine. We do not presently anticipate introducing

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      In connection with ViDVD’s internet capability, we intended to provide customers with the option of utilizing our Internet Service Provider (ISP), known as ViZip, as an alternative to other commercially available ISPs such as Earthlink or AOL. The ISP market is dominated by a few large companies and can be price sensitive. Based in part on our decision not to continue marketing ViDVD, we discontinued all activities related to ViZip during the fourth quarter of 2002.

Sales and Marketing

      We are currently directing our sales and marketing activities exclusively toward Beamer. This is due to several factors including: a lack of significant competition for Beamer from other companies in the videophone market; the initial positive response and acceptance from retailers and consumers; and the favorable product reviews from industry analysts, trade reporters and the general consumer media.

      We began nationwide retail distribution of Beamer during the third quarter of 2002, and it is currently carried by retailers such as Best Buy, Fry’s Electronics, The Good Guys and The Sharper Image. We market Beamer to retailers and distributors in the U.S. market through a combination of our direct sales force and independent sales representatives. Beamer may also be purchased directly by consumers from our on-line web store. We believe that retail stores will be the primary distribution channel for Beamer in the U.S. market, and we are working to increase the number of retailers carrying Beamer. In 2003 we expect to expand distribution for Beamer in the international consumer market through the use of distributors or strategic partners in specific territories or countries.

      To continue to build consumer demand and acceptance for Beamer, we expect to expand our retail and consumer initiatives, including targeted advertising and consumer awareness programs. Whenever possible, we will combine branding with product promotion opportunities. In addition, we will continue to place an emphasis on generating favorable press from industry analysts, trade reporters and the general consumer media.

Product Development

      Our product development efforts focus on bringing innovative digital consumer electronics products to the retail marketplace. Although much of the core development related to Beamer and ViDVD has already been completed, our ongoing development efforts focus on improvements to the operating system software for Beamer as well as new product offerings to the Beamer videophone product line. Our engineers are also engaged in the development of new products and other improvements and modifications to our existing products.

Intellectual Property

      We rely on a combination of patent, trademark and copyright law, trade secret protection and confidentiality or license agreements with our employees, customers, partners and others to protect proprietary rights. We have filed two patent applications, one to cover ViDVD proprietary functions and digital encoder and decoder solutions and another to cover audio compression technology. In addition, we have filed similar applications in Taiwan and under the Patent Cooperation Treaty. To date, none of the patents have been issued.

      We have filed trademark applications in the U.S., Brazil, Canada, China, the European Union, Hong Kong, Japan, Singapore and Taiwan. The marks for which we have filed applications include the Vialta logo, Beamer, Phone Video Station, PVS, Viewphone, ViDVD, ViMedia, ViMag, ViMagazine, ViAudio, ViOS and ViZip.

      In connection with the spin-off of Vialta by ESS, ESS and Vialta entered into a master technology ownership and license agreement, pursuant to which ESS and Vialta acknowledged the specific technology and trademarks related to Vialta’s business that are owned by Vialta.

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      At the time of our formation, we entered into several intellectual property agreements with ESS. We purchased from ESS all of ESS’ proprietary rights and benefits conferred under U.S. laws with respect to its videophone business and web browser business. We also entered into two research and development agreements, under which Vialta and ESS provide each other with product development services. The master technology ownership and license agreement supercedes prior intellectual property and research and development agreements between ESS and Vialta. In addition, we entered into a purchase agreement under which ESS agreed to provide us with semiconductor products. See “Note 9 — Related Party Transactions” beginning on page 40.

Manufacturing

      We have developed all of our products internally and outsource manufacturing. Beamer is currently manufactured by a contract manufacturer located in China. We believe that this contract manufacturer will provide us with sufficient manufacturing capacity to meet our current product demand. Our quality assurance engineers are located in China to oversee the contract manufacturer. We outsource import and export logistics, including clearance of Chinese and U.S. customs and ocean freight. We currently handle warehousing and all shipments to retail distribution centers, individual retailers and individual customers purchasing Beamer online.

Seasonality

      We expect that our operating results will be subject to seasonality and to quarterly and annual fluctuations. Domestic consumer electronic product sales have traditionally been much higher during the holiday shopping season than during other times of the year. As a result, we anticipate that our sales will be significantly higher in the third and fourth quarters than in the first and second quarters of each year.

Competition

      Beamer competes directly with several other companies in the videophone market which offer products delivering features similar to Beamer. We believe none of these companies has secured nationwide retail distribution relationships. The majority are available primarily through specialized retailers and websites. Furthermore, other videophone models have been integrated with handsets and have a significantly higher per unit retail price than Beamer. We believe the key competitive factors for videophone products are price, cost to use, quality of the video (especially moving images), retail distribution, brand awareness and ease of installation and use. We believe that among manufacturers of videophones that use analog phone lines, we compete favorably on the basis of price, video quality, product availability and ease of installation and use. In addition, we face competition from other video communication products utilizing Internet and broadband connections and digital camera cellular telephones. Internet and broadband products, which frequently are priced less than Beamer, utilize a personal computer or television, currently require subscription to an ISP and may require additional subscription services. These products may also be interoperable with users of competitive products, provide multiple transmission and storage options, and act as a digital camera. Digital camera cellular telephones are relatively new and most only offer still picture transmission or reception and require a digital cellular connection. Many of the current and prospective competitors in this market are larger, better known and have greater resources and experience than us.

      If we were to introduce an enhanced DVD player, we would still compete with established DVD player manufacturers who have substantially greater brand recognition, market presence, distribution channels, financial resources and promotional and strategic partners than us.

Employees

      As of February 28, 2003, we had 71 employees, including 23 in research and development, 14 in marketing, sales and support, 19 in manufacturing and operations and 15 in finance and administration.

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Item 2:     Properties

      As of February 28, 2003, our corporate headquarters and one of our research and development centers occupy a 78,000 square foot facility located in Fremont, California, under a lease from ESS that expires in December 2003. We also lease office space in Los Angeles, California and a research and development center in Hong Kong. We still have leased space in Toronto, Canada for our ViZip ISP which is currently vacant. We believe that our existing facilities are adequate for our current needs.

Item 3:     Legal Proceedings

      In August 2001, Professional Staffing Corporation (“PSC”) filed a lawsuit against the Company in The Superior Court of California, County of Alameda, Case No. 2001-22331, alleging causes of action for breach of contract and fraud. In December 2001, we answered and filed a cross-complaint alleging cause of action for breach of contract, breach of the covenant of good faith and fair dealing, fraud, unfair competition, and abuse of process. In the past, PSC had provided temporary information technology workers to the Company on an ongoing basis, and prior to the suit being filed, in July of 2001 we withheld payment to PSC on $92,095 of invoices pending the results of an in-house audit. In October of 2002, the parties negotiated and signed a comprehensive settlement agreement and mutual release of all claims with prejudice. Performance of the settlement agreement has been completed by all parties, and dismissals to the complaint and cross-complaint were filed on November 1, 2002.

      We are not a party to any other litigation at the present time.

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

      There were no matters submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 2002.

PART II

Item 5:     Market for the Registrant’s Common Equity and Related Shareholder Matters

      Our common stock has been quoted on the OTC Bulletin Board under the symbol “VLTA” since August 21, 2001. The following table sets forth the high and low bid prices for the common stock as reported by the OTC Bulletin Board during the periods indicated. Such prices reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.

      As of March 7, 2003, there were approximately 430 record holders of the Company’s common stock.

      We have never declared or paid any cash dividends on our common stock. We currently anticipate that we will retain any earnings for use in our business, and we do not anticipate paying any cash dividends in the foreseeable future.

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Item 6:     Selected Consolidated Financial Data

      You should read the selected consolidated financial data set forth below in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this report. The selected consolidated statement of operations data set forth below for the years ended December 31, 2002, 2001 and 2000, and for the period from April 20, 1999 (date of inception) through December 31, 1999 and for the period from April 20, 1999 (date of inception) through December 31, 2002 and the selected consolidated balance sheet data as of December 31, 2002, 2001, 2000 and 1999 are derived from, our audited consolidated financial statements. The information below is not necessarily indicative of the results of operation to be expected for any future period.

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Item 7:     Management’s Discussion and Analysis of Financial Condition and Results of Operations

      The following discussion includes forward-looking statements with respect to our future financial performance. Actual results may differ materially from those currently anticipated depending on a variety of factors, including those described below under the sub-heading, “Cautionary Statement Regarding Forward-Looking Statements” as well as “Other Factors That May Affect Our Business and Future Results” and the risks discussed in our most recent filing with the Securities and Exchange Commission. This following discussion should be read in conjunction with the Selected Consolidated Financial Data and the Consolidated Financial Statements and notes thereto that appear elsewhere in this report.

Overview

      We were incorporated on April 20, 1999 as a wholly owned subsidiary of ESS Technology, Inc. On August 21, 2001, we spun off from ESS Technology, Inc. and operate as a stand-alone entity. We develop, design and market consumer electronics products designed to maximize the advantages of digital technology in a convenient and easy-to-use manner. Our newest product, Beamer^TM, is a personal videophone. Beamer adds color video to phone calls, enabling Beamer users to see the person they are calling. Beamers are primarily sold in pairs, since the party receiving the video call must also have a Beamer (or compatible videophone). Beamer works with any home phone over any standard (analog) home phone line, at no additional cost to a regular phone call. We began nationwide retailer distribution of Beamer during the third quarter of 2002, and it is currently carried by retailers such as Best Buy, Fry’s Electronics, The Good Guys and The Sharper Image. The first product we developed was ViDVD, a multimedia DVD player that offers enhanced features such as CD, MP3 and karaoke disc playback, Internet connectivity and the ability to view digital photographs. We are currently not marketing the ViDVD. We also developed ViMagazine, a proprietary, encrypted, magazine-style DVD-format disc, which is capable of delivering a wide variety of entertainment, from feature films to children’s programming, music and other programming content to be used exclusively in conjunction with our ViDVD. As a result of our decision not to continue marketing ViDVD, we have not introduced ViMagazine.

      We have financed our development stage activities to date primarily from funds raised in private offerings of convertible preferred stock and common stock and through vendor credit. For the fiscal years ended December 31, 2002, 2001 and 2000, we had net losses of $42.6 million, $35.9 million and $22.9 million, respectively, and expect to continue to incur losses in 2003. From our inception through December 31, 2002, we had an accumulated deficit of $102.7 million.

      Through December 31, 2002, we have recognized no revenues. We began shipments of Beamer during the third quarter of 2002 and these shipments became more significant in the fourth quarter of 2002. As a result, we experienced a significant increase in working capital requirements due to channel inventory requirements, which were partially offset by cash receipts from our customers. For most of the shipments, the standard warranty period had not been completed as of December 31, 2002. Due to a limited history of warranty and sales returns for Beamer, we did not recognize revenues through December 31, 2002. We deferred revenue on Beamer of $3.2 million (the costs for which were expensed in prior periods) as of December 31, 2002, the majority of which is expected to be recognized during the quarter ending March 31, 2003. We anticipate that we will begin recognizing revenues, net of estimated warranty claims and returns, during the first quarter of 2003. We expect the company to come out of development stage in 2003.

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Results of Operations

      The following table discloses key elements of the statements of operations, expressed as a percentage of total operating expenses.

      Product Costs. Product costs were $10.4 million or 23.8% of operating expenses for the year ended December 31, 2002. Product costs represent inventory expenditures for raw materials and finished goods related to Beamer. Because Beamer is a new product that was only recently introduced, we expensed inventory costs as incurred through the third quarter of 2002. Following the nationwide commercial launch of Beamer, we began to capitalize the additional value of inventory costs associated with Beamer in the fourth quarter of 2002. We believe our inventory levels as of December 31, 2002 will be sufficient to meet our anticipated Beamer distribution commitments at least through June 30, 2003. All costs related to ViDVD products during the year ended December 31, 2001 were included in research and development; there were no similar ViDVD costs in 2002.

      Research and Development. Research and development expenses were $13.3 million for the year ended December 31, 2002, or 30.3% of operating expenses, compared to $25.3 million, or 65.9% of operating expenses for the year ended December 31, 2001. The decrease in research and development expenses was due to significant reductions in personnel expenses as we shifted our focus to sales and marketing efforts from core development activities and the fact that product costs for Beamer were presented as a separate category in 2002. All costs related to ViDVD products in development during the year ended December 31, 2001 were included in research and development. During the fourth quarter of 2002, we discontinued our Internet Service Provider (ISP) business, ViZip, and recorded a charge of $0.9 million related to the exit of this business. As a result of the decision to stop marketing ViDVD, we also reduced our research and development expense relating to both ViDVD and ViMagazine. We expect research and development expenses will continue at current dollar levels.

      Amortization and Impairment of Content Licenses. Amortization and impairment of content licenses for ViMagazine was $11.4 million in the year ended December 31, 2002, or 26% of operating expenses. During January 2002, we licensed feature film content from Artisan Entertainment for $10.0 million to use as part of our ViMagazine. Starting in the first quarter of 2002, we began to expense our content licenses, based on the greater of the royalty amounts due or amortization on a straight-line basis over an estimated life of three years. During the fourth quarter of 2002, we concluded that the content licenses had suffered a permanent decline in value, as a result of our decision not to market ViMagazine, and the remaining unamortized balance of $8.3 million was written down to zero. The $10.0 million license fee to Artisan Entertainment included a $5.0 million note that matures in January 2005 and would convert to a license fee if certain events occurred. We continue to receive current interest payments on the note and, since conversion is unlikely, we may receive the principal at maturity. If we were to be paid at maturity we would recognize a gain at that time.

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      Sales and Marketing. Sales and marketing expenses were $3.1 million for the year ended December 31, 2002, or 7.1% of operating expenses, compared to $3.7 million, or 9.8% of operating expenses, for the year ended December 31, 2001. The decrease in sales and marketing expenses was primarily due to reductions in personnel expenses as a result of the suspension of ViDVD sales and marketing activities and improved organizational efficiencies. We expect sales and marketing spending to increase in future periods to support expansion of retail and consumer marketing initiatives, including advertising and consumer awareness programs, for Beamer and other new product introductions.

      General and Administrative. General and administrative expenses were $5.6 million for the year ended December 31, 2002, or 12.8% of operating expenses, compared to $9.3 million, or 24.3% of operating expenses, for the year ended December 31, 2001. The decrease in general and administrative expenses was primarily due to significant reductions in personnel and other corporate expenses and lower reimbursements to ESS for administrative and management services. We expect general and administrative expenses to be relatively constant as a percentage of total operating expenses in future periods.

      Other Income, Net. Interest income was $1.2 million for the year ended December 31, 2002 compared to $3.6 million for the year ended December 31, 2001. The decrease in interest income was primarily due to lower cash balances and lower yields on available-for-sale securities during the year ended December 31, 2002 as compared to the year ended December 31, 2001. During the year ended December 31, 2001, we recorded other expenses of $1.3 million related to investment write-offs. The investments were written off because we concluded that the investments had suffered a permanent decline in value based on our assessment of the financial condition of the companies in which we had invested and the markets that they serve. There were no investment write-offs for the year ended December 31, 2002.

      Net Loss. We incurred a net loss of $42.6 million for the year ended December 31, 2002 compared to $35.9 million for the year ended December 31, 2001. The increase in net loss was primarily due to increased amortization and write-downs associated with content licenses of $11.4 million, net inventory expenditures of $5.1 million and lower interest income of $2.4 million. These increases were partially offset by lower operating expenditures of $10.6 million for research and development, sales and marketing and general and administrative expenses, and the absence of investment write-offs in fiscal year 2002.

      The following table discloses key elements of the statements of operations, expressed as a percentage of total operating expenses.

      Research and Development. Research and development expenses were $25.3 million for the year ended December 31, 2001, or 65.9% of operating expenses, compared to $19.6 million, or 67.0% of operating expenses for the year ended December 31, 2000. The increase was primarily due to increases in payroll and payroll related expenses due to increased headcount and operating supplies necessitated by our expanded

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      Sales and Marketing. Sales and marketing expenses were $3.7 million for the year ended December 31, 2001, or 9.8% of operating expenses, compared to $2.9 million, or 10.0% of operating expenses, for the year ended December 31, 2000. The increase was primarily due to increases in payroll and marketing expenses due to increased headcount and introduction of ViDVD.

      General and Administrative. General and administrative expenses were $9.3 million for the year ended December 31, 2001, or 24.3% of operating expenses, compared to $6.7 million, or 23.0% of operating expenses, for the year ended December 31, 2000. The increase was primarily due to increases in payroll and other expenses due to increased headcount, as we expanded development efforts and infrastructure and fees in connection with the spinoff and being a public company.

      Other Income, Net. Net other income was $2.3 million for the year ended December 31, 2001 compared to $6.0 million for the year ended December 31, 2000. Net other income consists primarily of net interest income. Net interest income fell to $3.6 million for the year ended December 31, 2001 from $7.7 million for the year ended December 31, 2000. The decrease in net interest income was primarily due to lower cash balances during 2001. Partially offsetting interest income were equity investment write offs in an amount of $1.1 million for the year ended December 31, 2001 and $1.7 million for the year ended December 31, 2000. We wrote these equity investments off because we concluded that the equity investments had suffered a permanent decline in value, based on the financial condition of the companies in which we had invested.

      Income Tax Benefit. We did not make a provision for income taxes for the year ended December 31, 2001 compared to recording an income tax benefit of $260,000 for the year ended December 31, 2000. The income tax benefit for the year ended December 31, 2000 was a reimbursement of $260,000 from ESS pursuant to tax arrangements between ESS and us as a result of ESS realizing a tax benefit for utilizing our net operating losses for 2000. No tax benefit was recognized during the year ended December 31, 2001 since ESS did not expect to benefit during 2001 from our net operating losses as a result of the spin-off.

      Net Loss. We incurred a net loss of $35.9 million for the year ended December 31, 2001, compared to $22.9 million for the year ended December 31, 2000. The $13.0 million increase in net loss was due to increased operating expenses associated with our anticipated growth and development coupled with lower net interest income resulting from lower cash balances during 2001.

Liquidity and Capital Resources

      As of December 31, 2002, we had $32.7 million in cash, cash equivalents and short-term investments compared to $67.4 million as of December 31, 2001, representing a decrease of $34.7 million. As of December 31, 2002, we had no long-term investments compared to $4.1 million as of December 31, 2001.

      Our principal sources of liquidity are cash, cash equivalents and short-term investments. Net cash used in operating activities was approximately $23.3 million and $25.0 million for the years 2002 and 2001, respectively, representing a decrease of approximately $1.7 million. Our cash used in operating activities during the year ended December 31, 2002 was primarily attributable to product costs and normal operating expenses. Accounts receivable increased $1.4 million as a result of Beamer product shipments, primarily in the fourth quarter of 2002. We believe our inventory levels as of December 31, 2002 will be sufficient to meet our anticipated Beamer distribution commitments through June 30, 2003. The decrease in cash used in operating activities for 2002 compared to 2001 was primarily due to decreased operating expenses incurred by us as a result of the completion of our core development activities and significant reductions in personnel, partially offset by higher product costs. For the years ended December 31, 2002 and December 31, 2001, we had a net loss of $42.6 million and $35.9 million, respectively, and we expect to continue to incur losses in the fiscal year 2003.

      Net cash used in investing activities for the year ended December 31, 2002 was $11.6 million compared to $11.5 million of cash provided by investing activities for the year ended December 31, 2001. Net cash used in investing activities for the year ended December 31, 2002 was primarily related to purchases of content licenses of

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      Net cash used by financing activities was $5.1 million for the year ended December 31, 2002 and $34.0 million for the year ended December 31, 2001. Net cash used in financing activities for the year ended December 31, 2002 was primarily related to repurchases of our common stock in the open market. Net cash used in financing activities for the year ended December 31, 2001 was for the repayment of a $30.0 million loan from a party controlled by Annie M.H. Chan, the spouse of Fred S.L. Chan, our Chairman, and repurchases of our common stock in the open market.

      Capital expenditures for the 12-month period ending December 31, 2003 are anticipated to be approximately $0.3 million, primarily budgeted to acquire capital equipment. Net inventory build requirements are expected to be approximately $5.3 million during the 12-month period ending December 31, 2003, primarily in the second half of 2003. We may also utilize cash to acquire or invest in complementary businesses or products or to obtain the right to use complementary technologies. Such acquisition or investment may significantly increase our planned requirements for capital. From time to time, in the ordinary course of our business, we may evaluate potential acquisitions of or investments in such businesses, products or technologies owned by third parties.

      In September 2001, the Board of Directors authorized the repurchase of up to 10,000,000 shares of its common stock in the open market over a 12-month period. In June 2002, the Board of Directors authorized the existing stock repurchase program be extended to include the repurchase of up to an additional 10,000,000 shares of common stock. For the year ended December 31, 2001 we repurchased approximately 6,236,000 shares of common stock at an aggregate cost of $4.0 million. For the year ended December 31, 2002, we repurchased approximately 4,969,000 shares of common stock at an aggregate cost of $5.1 million. From January 1, 2003 through February 21, 2003, we repurchased approximately 716,000 shares at an aggregate cost of approximately $278,000. As of February 21, 2003 approximately 8,079,000 shares remain authorized for repurchase.

      In January 2000, we entered into a non-cancelable lease agreement for our headquarters that will expire in 2003. Under the terms of this and other leases, with various expiration dates through 2006, our future minimum rental payments are as follows (in thousands):

      We believe that our existing cash and cash equivalents, and short-term investments will be sufficient to fund our operations through December 31, 2003. However, to continue our operations beyond 2003 or to achieve our longer-term goals of introducing additional products to consumers, we believe we will need to raise additional capital, which may not be available on acceptable terms, if at all. We have historically used vendor credit as well as private offerings of convertible preferred stock and common stock to fund operations and provide for capital requirements. However, the price per share of any future equity-related financing will be determined at the time the offering is made and cannot be anticipated at this time. If additional funds are raised through the issuance of equity securities, the percentage ownership of current stockholders are likely to or will be reduced and such equity securities may have rights, preferences or privileges better than those of current stockholders. We cannot assure you that any additional financing will be available or that, if available, it will be sufficient or it can be obtained on terms favorable to us or our stockholders. If adequate funds are not

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Critical Accounting Policies

      The preparation of financial statements and the related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. On an ongoing basis, we evaluate our estimates to ensure that our estimates remain reasonable under current conditions. Actual results may differ from these estimates, which may have a material impact on our results of operations and financial condition.

      Critical accounting policies that require significant judgments and estimates for the preparation of our consolidated financial statements are as follows:

      We generally recognize revenue on products sold to end customers upon shipment provided that we have no post-sale obligations, can reliably estimate and accrue warranty and sales returns, the price is fixed or determinable and collection of the resulting receivable is reasonably assured. For sales to end customers that do not meet the above criteria, revenue is deferred until such criteria are met. Due to our limited history of warranty and sales returns, we have not recognized revenues on sales of Beamer pending the expiration of the warranty period.

      Products sold to retailers and distributors are subject to rights of return. Subject to our warranty reserves, we defer recognition of revenue on products sold to retailers and distributors until the retailers and distributors sell the products to their customers. We recognize revenues from retailers and distributors according to information on shipments to their customers as provided by those retailers and distributors. If information on shipments to their customers is not provided to us on a timely and accurate manner, there may be a material impact on our reported results of operations and financial condition.

      Allowances are provided for estimated returns. Provision for return allowances will be recorded at the time when revenue is recognized based on our historical returns, current economic trends and changes in customer demand. Such allowances will be adjusted periodically to reflect actual and anticipated experience. Material differences may result in the amount and timing of our revenue for any period if management were to make different judgments or utilize different estimates. As of December 31, 2002, we did not have sufficient history and experience with respect to sales returns. As a result, we did not recognize any revenues on sales of Beamer pending the expiration of the warranty period.

      We provide a limited warranty on our products for periods ranging from 90 days to 12 months from the date of sale to the end customers. Through December 31, 2002, we did not recognize any revenue. A key factor in the decision not to recognize revenue is that as of December 31, 2002, we did not have sufficient history to reasonably estimate warranty costs, and the warranty period had not lapsed from our first significant shipments. We will estimate warranty costs based on historical experience and will accrue for estimated costs as a charge to cost of sales when revenue is recognized. In the future, actual warranty costs may be higher than our estimates.

      Inventories are stated at the lower of cost or market, with cost being determined by the first-in, first-out method. We record our inventory reserve for estimated losses based on assumptions about future demand and

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      Since our inception through December 31, 2001, we expensed inventory costs related to ViDVD of $9.0 million, as commercial shipments of ViDVD were limited. No additional ViDVD inventories were purchased during the year ended December 31, 2002, and we had discontinued marketing ViDVD.

      We expensed $10.4 million inventory costs on our new product Beamer through September 30, 2002. We began capitalizing our inventory costs in the fourth quarter of 2002 because we experienced an increase in shipments since Beamer was commercially introduced nationwide in the third quarter of 2002. Additional inventory reserves may be needed if actual demand or market conditions are less favorable than management’s projection.

      We review long-lived assets based upon an undiscounted cash flow basis and will record an impairment whenever events or changes in circumstances indicate the carrying amount of the assets may not be fully recoverable. If an asset is considered impaired, the asset is written down to carrying value based on undiscounted cash flows. During the fourth quarter of 2002, we wrote the remaining unamortized balance of $8.3 million of content licenses down to zero. Future cash flows could be different from those estimated by our management.

Recent Accounting Pronouncements

      In June 2002, the Financial Accounting Standards Board, or FASB, issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” This Statement requires that a liability for costs associated with an exit or disposal activity be recognized and measured initially at fair value only when the liability is incurred. SFAS No. 146 is effective for exit or disposal activities initiated after December 31, 2002. Our adoption of FAS 146 did not have a material effect on our consolidated financial statements.

      In November 2002, the FASB issued Interpretation No. 45 (FIN No.45), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN No. 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN No. 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The initial recognition and initial measurement provisions of FIN No. 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. The disclosure requirements of FIN No. 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. We do not expect our adoption of FIN No. 45 to have a material impact on our consolidated financial statements.

      In January 2003, the FASB issued Interpretation No. 46 (“FIN No. 46”) “Consolidation of Variable Interest Entities.” Until this interpretation, a company generally included another entity in its consolidated financial statements only if it controlled the entity through voting interests. FIN No. 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns. We do not expect our adoption of FIN No. 46 to have material impact on our consolidated financial statements.

Other Factors That May Affect Our Business and Future Results

      Our future business, operating results and financial condition are subject to various risks and uncertainties, including those described below.

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      We are currently marketing only one product. As a result, our success is highly dependent upon consumer acceptance of Beamer, which began shipping in the third quarter of 2002. Consumer acceptance requires, among other things, that we:

	•	educate consumers on the advantages of Beamer;
	•	commit a substantial amount of human and financial resources to support the retail distribution of Beamer;
	•	continue to develop our sales, marketing and support activities to consumers and retailers; and
	•	expand the number and location of retailers carrying Beamer.

      We may not achieve any or all of these objectives. As a result, despite our initial national retail launch, consumers may not be aware of Beamer. This could delay or prevent our ability to achieve broad market acceptance of Beamer. The failure of Beamer to achieve sufficient consumer and retailer acceptance would impair our ability to continue operating our business.

      We are a development stage company with a limited commercial operating history. We have not recognized any revenue, have incurred significant losses and have had substantial negative cash flow. As of December 31, 2002, we had $32.7 million in cash, cash equivalents and short-term investments. For the fiscal year ended December 31, 2002, we had a net loss of $42.6 million. We expect to continue to incur significant operating and non-operating expenses over the next several years as part of the continued development and potential expansion of our business. As a result, we expect to continue to lose money for the foreseeable future. The size of these net losses will depend in part on our recent and any future product launches, any growth in sales of our products and the rate of increase in our expenses. As a result, we will need to generate significant revenues to achieve profitability. Several factors, including consumer acceptance, retailer arrangements and competitive factors make it impossible to predict when or whether we will generate significant revenues or attain profitability. Consequently, we may never achieve significant revenues or profitability, and even if we do, we may not sustain or increase profitability on a quarterly or annual basis in the future.

      The current videophone end-user market is relatively small and primarily focused on business-to-business video conferencing applications. Although videophones have been commercially available for many years, previous videophone models have had high retail prices, limited retail distribution, limited functionality, poor video quality and have been integrated with a handset. Even though we believe Beamer has addressed many of the limitations associated with videophones and videophone technology, consumer demand remains low and may not increase. Even after educating consumers on the features of Beamer, consumers may still perceive little or no benefit from Beamer or may already own other products that provide similar benefits or functionality, such as PC-based Internet video or digital camera cellular telephones. As a result, consumers may not value, or be unwilling to purchase Beamer at profitable prices. We also do not have an established brand image, and the expense of a national advertising campaign to build and sustain brand awareness is not within our reach. Accordingly, to develop market acceptance of Beamer and any future products, we will need to devote a substantial amount of resources to educate consumers about the features and benefits of Beamer via alternative means including targeted public relations and extensive retail distribution. However, we cannot assure you that this commitment of resources will be successful in generating the revenues required to sustain our business. If we are unsuccessful, the future of our Company will be in doubt.

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      To emerge from the development stage, introduce follow-on products and sustain and grow our business, we must continue to make significant investments to develop, enhance and market our products. We will also need significant working capital to take advantage of future opportunities and to respond to competitive pressures or unanticipated requirements. We expect that our existing capital resources will be sufficient to meet our cash requirements through December 31, 2003, although our current resources could be exhausted more quickly depending on the payment terms that we are able to negotiate with our vendors and suppliers and our success in generating and collecting on accounts receivable. The magnitude of our future capital requirements will depend on many factors, including, among others, product development expense levels, investments in working capital, and the amount of income, if any, generated by operations.

      When we do need to raise additional capital, that capital may not be available on acceptable terms, or at all. If we cannot raise necessary additional capital on acceptable terms, we may not be able to develop or enhance our products, take advantage of future opportunities, respond to competitive pressures or unanticipated requirements or even continue operating our business.

      If additional capital is raised through the issuance of equity securities, the percentage ownership of our existing stockholders will decline. Also, if any securities are issued, our stockholders may experience dilution in net book value per share, and these securities may have rights, preferences or privileges superior to those of the holders of our common stock. Any debt financing, if available, may also require limitations or restrictions on our operations or future opportunities.

      We were incorporated in April 1999 and have a limited operating history. As a result of our limited operations, our historical financial and operating information is of limited value in evaluating our future potential operating results. In addition, any evaluation of our business and prospects must be made in light of the risks and difficulties encountered by start-up companies developing products in new and rapidly evolving markets. For example, it may be difficult to accurately predict our future revenues, costs of revenues, expenses or results of operations. Beamer and any other future products represent new products for most consumers. It may be difficult to predict the creation of any market or the growth rate, if any, or size of the market for Beamer or other new products we may develop. We may be unable to accurately forecast customer needs or behavior or recognize or respond to emerging trends, changing preferences or competitive factors facing us. As a result, we may be unable to make accurate financial forecasts or adjust our spending in a timely manner to compensate for any unexpected changes or revenue shortfall. This inability could cause our results of operations in a given quarter to be worse than expected, and could cause the price of our stock to decline.

      The consumer electronics market is intensely competitive and rapidly evolving. Existing participants and new entrants in this market currently offer and may develop and offer additional products that will compete directly with Beamer or future products that we may develop.

      The consumer electronics industry in particular is characterized by rapid technological innovation and intense price competition. The competition for consumer spending and acceptance is also intense. Beamer competes directly with several other companies in the videophone market. All of these companies currently offer videophone products to consumers that operate over standard (analog) phone lines with no additional cost to the user, similar to Beamer. In addition to these companies we face competition from a competitively priced videophone product that utilizes a consumers broadband connection (as opposed to a standard phone line) to deliver a video image over a consumer’s television during a phone call. Beamer also faces competition from PC-based Internet video and from digital camera cellular telephones manufacturers and potential future offerings from current telephone manufacturers.

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      If we choose to market the ViDVD or another enhanced DVD player, we would compete directly with several other currently available or soon to be introduced DVD players from major consumer electronics manufacturers, specialized manufacturers, and with products developed by smaller companies. Like the ViDVD, nearly all of these products accommodate media in DVD, CD, MP3 and JPEG formats, many offer Internet connectivity, and some include karaoke playback.

      In addition, many of the manufacturers and distributors of these competing products have substantially greater brand recognition, market presence, distribution channels, financial resources and promotional and other strategic partners than us.

      The success of Beamer, as well as product line extensions to develop and define an entire videophone product category depends on a number of factors, including, but not limited to, strategic allocation of our limited financial and technical resources, accurate forecasting of consumer demand, timely completion of product development and introduction to market, and market and industry acceptance of our future and existing products. Most of our planned product and feature introductions are still in various stages of development and will require engineering and technical resources to bring to market. The success of some of our planned products may also require industry acceptance of new proprietary technologies or the adaptation of our products and technologies to accommodate the use of existing industry-accepted technologies. If we fail to develop and market new products and features, we may not be able to sustain our business.

      We rely on a single contract manufacturer located in China to meet our current product demand. We also rely on ESS and a limited number of other third party suppliers for a number of key components for Beamer, including modem chips, video chips and LCD screens. We do not have long-term agreements in place with our suppliers. We do not control the time and resources that these suppliers devote to our business. We cannot be sure that these suppliers will perform their obligations as expected or that any revenue, cost savings or other benefits will be derived from the efforts of these parties. Our need for semiconductors as a key component of Beamer indirectly subjects us to a number of risks relating to ESS’ and any other future semiconductor suppliers’ reliance on independent foundries to produce those semiconductors, including the absence of adequate capacity, the unavailability of, or interruption in access to, certain process technologies and reduced control over delivery schedules, manufacturing yields and costs, and risks related to the international location of most major foundries. If any of our third party suppliers breaches or terminates its agreement with us or otherwise fails to perform its obligations in a timely manner, we may be delayed or prevented from launching or marketing our products. Because our relationships with these parties are non-exclusive, they may also support products that compete directly with ours, or offer similar or greater support to our competitors. Any of these events could require us to undertake unforeseen additional responsibilities or devote additional resources to commercialize our products. This outcome would harm our ability to compete effectively and quickly achieve market acceptance and brand recognition.

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      Conflicts of interest may arise between ESS and us in a number of areas relating to ongoing relationships between the companies, including:

	•	Although we entered into agreements with ESS that govern our business relationship after the distribution of our stock to ESS shareholders, ESS has no obligation to extend the terms of those agreements to us beyond the stated duration of those agreements;
	•	ESS may supply semiconductors to competitors, which may affect ESS’ capacity to supply semiconductors to us;
	•	We may compete with ESS with respect to business opportunities that are attractive to both companies, and ESS is not restricted from competing with our business.

      In order to maintain our relationships with retailers and distributors we may be required to accept arrangements and terms, which may not be favorable to us. Such terms may include consignment arrangements, pricing concessions, marketing incentives, aggressive return allowances, commissions and other requirements, which could adversely affect the profitability of our products. In addition, we expect that our retailers and distributors will sell products offered by our competitors. If our competitors offer retailers and distributors more favorable terms or have more products available to meet their needs, those retailers and distributors may decline to carry or may not adequately promote our products. Although we are aggressively attempting to increase the number of retailers that market Beamer to consumers, there can be no assurance that we will be able to do so. If we are unable to maintain successful relationships with distributors and retailers or to expand our distribution channels, our business may fail.

      We may need to expand our headcount, facilities and infrastructure to support potential sales growth and to allow us to pursue market opportunities. This potential expansion could place a significant strain on our management, operational and financial resources and systems. Specific risks we face as our business expands include:

	•	We may need to attract and retain qualified personnel, and any failure to do so may impair our ability to offer new products or grow our business. We may be unable to successfully attract, integrate or retain sufficiently qualified personnel. If we are unable to hire, train, retain or manage the necessary personnel, we may be unable to successfully introduce new products or otherwise implement our business strategy.
	•	We may need to provide acceptable customer support, and any inability to do so will impair our ability to develop consumer acceptance of our products. We expect that some of our customers will require support when using Beamer. We also anticipate that purchasers of any future products will require support in their use of such products. We do not have experience with widespread deployment of Beamer to a diverse customer base, and we may not have adequate personnel to provide the levels of support that our customers will require. Our failure to provide adequate customer support for our products will damage our reputation in the consumer electronics marketplace and strain our relationships with customers and strategic partners. This could prevent us from gaining new or retaining existing customers and could harm our reputation and brand.
	•	We may need to improve our operational and financial systems, procedures and controls to support our expected growth, and any inability to do so will adversely impact our ability to grow our business. Our current and planned systems, procedures and controls may not be adequate to support our future

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		operations and expected growth. Delays or problems associated with any improvement or expansion of our operational systems and controls could adversely impact our relationships with customers and harm our reputation and brand.

      Errors and product defects can result in significant warranty and repair problems, which could cause customer relations problems. Correcting product defects requires significant time and resources, which could delay product releases and affect market acceptance of our products. Any delivery by us of products with undetected material product defects could harm our credibility and market acceptance of our products.

      Beamer is currently manufactured, assembled and tested by a single contract manufacturer located in China. In addition, most of our suppliers are located in China, Hong Kong and Taiwan. We also anticipate that, starting in 2003, revenue from international sales could represent a significant portion of our total revenue. Because of our international operations and relationships, and our reliance on foreign third-party manufacturing, assembly and testing operations, we are subject to the risks of conducting business outside of the United States, including:

	•	changes in political and strategic relations between China, Taiwan and the U.S.;
	•	changes in foreign currency exchange rates;
	•	changes in a specific country’s or region’s political or economic conditions, particularly in China, Taiwan and other emerging Asian markets;
	•	trade protection measures and import or export licensing requirements;
	•	potentially negative consequences from changes in tax laws;
	•	difficulty in managing widespread sales and manufacturing operations; and
	•	less effective protection of intellectual property.

      Our success and ability to compete are partly dependent upon our internally developed technology. We rely on patent, trademark and copyright law, trade secret protection and confidentiality or license agreements with our employees, customers, partners and others to protect our proprietary rights. However, the steps we take to protect our proprietary rights may be inadequate. We have filed two U.S. patent applications, one to cover ViDVD proprietary functions and digital encoder and decoder solutions and another to cover digital audio signal compression and processing. In addition, we have filed corresponding applications in Taiwan and with the patent cooperation treaty, which reserves the right to file in foreign countries. To date, no patents have been issued, and we cannot assure you that any patents will ever be issued, that any issued patents will protect our intellectual property or that third parties will not challenge any issued patents. Moreover, other parties may independently develop similar or competing technologies designed around any patents that may be issued to us.

      The laws of certain foreign countries in which our products are or may be designed, manufactured or sold, including various countries in Asia, may not protect our products or intellectual property rights to the same extent as do the laws of the U.S., and thus make the possibility of piracy of our technology more likely. We cannot assure you that the steps taken by us to protect our proprietary information will be adequate to prevent misappropriation of our technology or that our competitors will not independently develop technologies that are substantially equivalent or superior to our technology. Our failure to protect our proprietary rights could harm our business.

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      If other parties claim that our products infringe upon their intellectual property, we could be forced to defend ourselves or our customers, manufacturers or suppliers against those claims. We could incur substantial costs to prosecute or defend those claims. A successful claim of infringement against us, or any failure or inability of us to develop non-infringing technology or license the infringed technology on acceptable terms and on a timely basis, could harm our business, financial condition and results of operations.

      Our future performance will be substantially dependent on the continued services of our senior management, especially our Chairman, Fred S.L. Chan, our President and Chief Executive Officer, Didier Pietri, and other key personnel. The loss of any members of our executive management team and our inability to hire additional executive management could harm our business and results of operations. We employ our key personnel on an at-will basis. We have obtained key person insurance for Mr. Chan, but we do not maintain key person insurance policies on any of the other members of our executive management team.

      As part of our ongoing business strategy, we may consider acquisitions of, or significant investments in, additional businesses that offer or develop products and technologies complementary to our own. Such acquisitions could materially adversely affect our operating results and/or the price of our stock. Acquisitions also entail numerous risks, including:

	•	difficulty of integrating the operations, products and personnel of the acquired businesses;
	•	potential disruption of our ongoing business;
	•	unanticipated costs associated with the acquisition;
	•	inability of management to manage the financial and strategic position of acquired or developed products and technologies;
	•	inability to maintain uniform standards, controls, policies and procedures; and
	•	impairment of relationships with employees and customers that may occur as a result of integration of the acquired business.

      To the extent that shares of our stock or other rights to purchase stock are issued in connection with any future acquisitions, dilution to our existing stockholders may result and our earnings per share may suffer. Any future acquisitions or strategic investments may not generate additional revenue or provide any benefit to our business, and we may not achieve a satisfactory return on our investment in any acquired businesses.

      Because our products are expected to provide our customers with access to a variety of methods of electronic communication, it is difficult to predict what laws or regulations will be applicable to our business. Therefore, it is difficult to anticipate the impact of current or future laws and regulations on our business. Among the many regulations that may be applicable to our business are the following:

	•	Federal Communications Commission regulations relating to the electronic emissions of consumer products;
	•	Federal Communications Commission regulations relating to consumer products that connect to the public telephone network;

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	•	federal export regulations relating to the export of sensitive computer technologies such as encryption and authentication software.

      Changes in the regulatory climate or the enforcement or interpretation of existing laws could expose us to legal action if we fail to comply. In addition, any of these regulatory bodies could promulgate new regulations or interpret existing regulations in a manner that would cause us to incur significant compliance costs or force us to alter the features or functionality of our products.

      Our stock may fit the definition of a penny stock. The Securities and Exchange Act of 1934 defines a penny stock as any equity security that is not traded on a national securities exchange or authorized for quotation on The NASDAQ National Market and that has a market price of less than $5.00 per share, with certain exceptions. Penny stocks are subject to Rule 15g under the Securities and Exchange Act of 1934, which imposes additional sales practice requirements on broker-dealers who sell such securities. In general, a broker-dealer, prior to a transaction in a penny stock, must deliver a standardized risk disclosure document that provides information about penny stocks and the risks in the penny stock market. The broker-dealer must provide the customer with current bid and offer quotations for the penny stock, information about the commission payable to the broker-dealer and its salesperson in the transaction and monthly statements that disclose recent price information for each penny stock in the customer’s account. Finally, prior to any transaction in a penny stock, the broker-dealer must make a special written suitability determination for the purchaser and receive the purchaser’s written consent to the transaction prior to sale. All of these requirements may restrict your ability to sell our stock and could limit the trading volume of our stock and adversely affect the price investors are willing to pay for our stock.

      We expect our operating results, including any revenues we may generate, to fluctuate significantly due to a number of factors, many of which are outside of our control. Therefore, you should not rely on period-to-period comparisons of results of operations as an indication of our future performance. It is possible that in some future periods our operating results may fall below the expectations of market analysts and investors. In this event, the market prices of our stock would likely fall. Factors that may affect our quarterly operating results include:

	•	consumer awareness and demand for Beamer;
	•	ongoing demand and supply for Beamer;
	•	seasonality and other consumer and advertising trends;
	•	changes in the economic terms of our relationships with our strategic partners;
	•	shortfalls in the supply of components necessary for the manufacture of our products;
	•	changes in our pricing policies, the pricing policies of our competitors and general pricing trends in the consumer electronics market;
	•	unanticipated shortfalls in revenue due to the fact that our expenses precede associated revenues;
	•	changes in estimates of our financial performance or changes in recommendations by securities analysts;
	•	release of new or enhanced products or services or introduction of new marketing initiatives by us or our competitors;
	•	announcements by us or our competitors of the creation or termination of significant strategic partnerships, joint ventures, significant contracts, or acquisitions;

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	•	the market price generally for consumer electronics and retail industry stocks;
	•	market conditions affecting the consumer electronics industry;
	•	additions or departures of key personnel;
	•	demand for and consumer acceptance of other anticipated future products offerings; and
	•	general economic conditions.

      In the past, securities class action litigation has often been brought against a company following stock price declines. We may be the target of similar litigation in the future if the price of our common stock declines. Securities litigation could result in substantial costs and diversion of management attention and resources, all of which could materially harm our business, financial condition and results of operations.

      Domestic consumer electronic product sales have traditionally been much higher during the holiday shopping season than during other times of the year. Although predicting consumer demand for Beamer and any future products will be very difficult, we believe that sales of Beamer will be higher during the holiday shopping season when compared to other times of the year. We believe we have adequate capital to continue to operate for the 12-month period ending December 31, 2003. However, if we are unable to generate sufficient revenues during the 2003 holiday shopping season, or any future season, we may not be able to continue our business

      Our historical financial information does not necessarily reflect what our financial position, operating results and cash flows would have been had we been a stand-alone entity during the periods presented. In addition, our historical information is not necessarily indicative of what our operating results, financial position and cash flows will be in the future.

      Fred S.L. Chan, our Chairman, owns a significant amount of ESS stock and our stock and options to purchase ESS stock and our stock. In addition, Matthew K. Fong, a member of our board of directors, owns ESS stock and options to purchase ESS stock. Mr. Chan is the Chairman ESS. These factors could create, or appear to create, potential conflicts of interest when these directors are faced with decisions that could have different implications for ESS and us.

      Even if ESS’ distribution of our stock to its shareholders is otherwise a tax-free distribution, ESS may, under certain circumstances, recognize gain for U.S. federal and state income tax purposes with respect to the distribution if a 50% or greater interest in us is acquired during the two-year period following the distribution. Certain sales of shares by us that occurred during the two years immediately prior to the distribution may be counted towards the 50% threshold. The amount of such gain would be the difference between the fair market value of the stock distributed, on the date of distribution, and ESS’ adjusted tax basis in the stock. Under a tax sharing and indemnity agreement, we have agreed in certain circumstances to indemnify ESS for ESS’ U.S. federal and state income tax liability which results as a direct consequence of any acquisition of a 50% or greater interest in us after the distribution. This indemnity obligation, if triggered, could have a substantial effect on our available cash. In addition, the existence of the indemnity obligation may discourage potential

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      The IRS decision not to provide a ruling on the distribution does not mean that the distribution is taxable. We believe that the distribution is tax-free. ESS has advised us that they intend to report the distribution as tax-free in its federal income tax filings. ESS has also advised us that it is seeking an opinion from its tax advisors that the distribution is tax-free. No assurance can be given that such an opinion will be obtained or the level of assurance such opinion will provide.

      Even if such an opinion is obtained, no assurance can be given that the IRS will not determine at a later date that the distribution is taxable. If the IRS determines that the distribution is taxable, recipients of our stock in distribution may be required to pay income taxes as a result of the distribution, with the amount of ordinary income and gain dependent upon the value of the stock they received and their share of ESS’ earnings and profits. Determining whether or not the distribution will qualify for tax-free status requires a complex analysis of many factors, including, among others, the business purpose for the distribution, the nature of the business to be engaged in by ESS and us following the distribution, and the extent to which ESS remains in control of us following the distribution. Because of the fact-intensive nature of this analysis, there will be substantial uncertainty as to whether the distribution will qualify for tax-free treatment.

      ACCORDINGLY, WE CANNOT ASSURE RECIPIENTS OF OUR STOCK IN THE DISTRIBUTION THAT THE IRS WILL NOT SUCCESSFULLY ASSERT THAT THE DISTRIBUTION IS TAXABLE. IN ADDITION, SUCH RECIPIENTS MAY BE TAXED BY THE STATE, LOCAL OR FOREIGN JURISDICTION IN WHICH THEY RESIDE. ACCORDINGLY, ALL RECIPIENTS OF OUR STOCK IN THE DISTRIBUTION ARE STRONGLY URGED TO CONSULT WITH THEIR OWN FINANCIAL ADVISORS REGARDING THE POTENTIAL TAX IMPACT TO THEM OF THE DISTRIBUTION AND TO PREPARE FOR THE SIGNIFICANT POSSIBILITY THAT THE TRANSACTION WILL BE TAXABLE TO THEM.

      If the distribution is taxable to them, the value of the shares they received will be treated as taxable ordinary income, return of cost or as taxable capital gain up to the value of the stock distributed. If the distribution is taxable, they will incur this tax whether or not they decide to sell the shares they receive in the distribution. Unless a recipient of shares in the distribution is required to make quarterly estimated tax payments to the IRS, this tax would generally have to be paid on or before the April 15, 2002 due date for the 2001 tax return. If such recipients do not have the cash available to pay the tax at or before the time it is due, they may have to sell all or a portion of their shares of our stock to pay the tax or risk incurring interest and penalties imposed by the IRS. If holders of a significant percentage our stock are also forced to sell in order to pay their taxes, or if there is for any other reason, a decline in the trading price of our shares following the distribution, recipients of our stock in the distribution may have to sell their shares of our stock at a lower price than they might otherwise have obtained.

      Our amended and restated certificate of incorporation, amended and restated bylaws and Delaware law contain provisions that could make it more difficult for a third party to acquire us without the consent of our board of directors. Delaware law also imposes some restrictions on mergers and other business combinations between us and any holder of 15% or more of our outstanding shares. Although we believe these provisions provide for an opportunity to receive a higher bid by requiring potential acquirers to negotiate with our board of directors, these provisions apply even if the offer may be considered beneficial by some stockholders.

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Item 7a:     Quantitative and Qualitative Disclosure About Market Risk

      Interest Rate Risks. We 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. 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 sale, and at December 31, 2002, are recorded at market values.

      Foreign Exchange Risks. Because our products are manufactured 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 third party manufacturers and component vendors are denominated in U.S. dollars. We do not engage in any currency hedging activities.

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Item 8:     Financial Statements and Supplementary Data

      The following documents are filed as part of this Report:

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REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Stockholders of Vialta, Inc.:

      In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of redeemable convertible preferred stock and stockholders’ equity and of cash flows present fairly, in all material respects, the financial position of Vialta, Inc. (a development stage company) and its subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002 and for the period from April 20, 1999 (date of inception) through December 31, 2002, 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.

PricewaterhouseCoopers LLP

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VIALTA, INC.

CONSOLIDATED BALANCE SHEETS

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

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VIALTA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

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

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VIALTA, INC.

CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY