ESS TECHNOLOGY INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)


[X]		Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

For the quarterly period ended June 30, 2003.


[ ]		Transitional Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

For the transition period from: to:

Commission File Number: 0-26660

ESS TECHNOLOGY, INC.

(Exact name of registrant as specified in its charter)


CALIFORNIA (State or other jurisdiction of incorporation or organization)		94-2928582 (I.R.S. Employer Identification No.)

48401 FREMONT BOULEVARD
FREMONT, CALIFORNIA 94538

(Address of principal executive offices, including zip code)

(510) 492-1088

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.

Yes [X] No [ ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes [X] No [ ]

As of August 1, 2003 the registrant had 38,667,743 shares of common stock outstanding.

TABLE OF CONTENTS


PART I. FINANCIAL INFORMATION
	Item 1. Financial Statements
		CONDENSED CONSOLIDATED BALANCE SHEETS
		CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
		CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
		NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosures About Market Risk
	Item 4. Disclosure Controls and Procedures
PART II. OTHER INFORMATION
	Item 1. Legal Proceedings
	Item 4. Submission of Matters to a Vote of Security Holders.
	Item 6. Exhibits and Reports on Form 8-K
SIGNATURES
INDEX TO EXHIBITS
EXHIBIT 10.49
EXHIBIT 10.50
EXHIBIT 10.51
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32

ESS TECHNOLOGY, INC.
TABLE OF CONTENTS


		Page

PART I	FINANCIAL INFORMATION		3
Item 1.	Financial Statements (unaudited):		3
	Condensed Consolidated Balance Sheets as of June 30, 2003 and December 31, 2002		3
	Condensed Consolidated Statements of Operations for the three months ended and six months ended June 30, 2003 and 2002		4
	Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2003 and 2002		5
	Notes to Condensed Consolidated Financial Statements		6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		19
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		38
Item 4.	Disclosure Controls and Procedures		39
PART II	OTHER INFORMATION		39
Item 1.	Legal Proceedings		39
Item 4.	Submission of Matters to a Vote of Security Holders.		40
Item 6.	Exhibits and Reports on Form 8-K		42
SIGNATURES			43
INDEX TO EXHIBITS			44

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (unaudited)

ESS TECHNOLOGY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)


		June 30,		December 31,
		2003		2002

		(In thousands)
ASSETS
Cash and cash equivalents		$	74,544	$	138,072
Short-term investments			61,377		61,030
Accounts receivable, net			30,383		28,435
Related party receivable — Vialta			476		33
Receivable — MediaTek			45,000		—
Inventories, net			23,867		24,155
Prepaid expenses and other assets			4,314		2,834

	Total current assets		239,961		254,559
Property, plant and equipment, net			20,763		18,985
Goodwill			20,218		2,074
Other intangible assets			7,803		249
Other assets			8,981		5,735

	Total assets	$	297,726	$	281,602

LIABILITIES AND SHAREHOLDERS’ EQUITY
Accounts payable and accrued expenses		$	39,265	$	35,084
Income tax payable and deferred income taxes			36,576		9,474

	Total current liabilities		75,841		44,558
Non-current deferred tax liability			10,813		7,676

	Total liabilities		86,654		52,234
Commitments and contingencies (Note 10)
Shareholders’ equity:
Common stock			171,529		196,344
Accumulated other comprehensive income (Note 8)			440		504
Retained earnings			39,103		32,520

	Total shareholders’ equity		211,072		229,368

	Total liabilities and shareholders’ equity	$	297,726	$	281,602

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

ESS TECHNOLOGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)


		Three Months Ended June 30,					Six Months Ended June 30,

		2003			2002		2003			2002

					(In thousands, except per share data)
Net revenues		$	30,996		$	85,984	$	64,143		$	165,083
Net revenues from related party — Vialta			15			53		19			69

	Total net revenues		31,011			86,037		64,162			165,152
Cost of revenues			20,982			50,817		44,358			95,656

	Gross profit		10,029			35,220		19,804			69,496
Operating expenses:
	Research and development		7,330			7,043		13,586			13,424
	In-process research and development		1,420			—		1,420			—
	Selling, general and administrative		6,660			11,051		13,334			21,407

Operating income (loss)			(5,381	)		17,126		(8,536	)		34,665
Non-operating income (loss), net			44,187			1,085		45,131			(182	)

Income before provision for income taxes			38,806			18,211		36,595			34,483
Provision for income taxes			22,905			889		22,807			775

Net income		$	15,901		$	17,322	$	13,788		$	33,708

Net income per share:
	Basic	$	0.41		$	0.38	$	0.34		$	0.75

	Diluted	$	0.40		$	0.36	$	0.34		$	0.70

Shares used in calculating net income per share:
	Basic		38,683			45,147		40,164			44,692

	Diluted		39,842			48,446		41,129			48,447

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

ESS TECHNOLOGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)


					Six Months Ended June 30,

					2003			2002

						(In thousands)
Cash flows from operating activities:
Net income					$	13,788		$	33,708
	Adjustments to reconcile net income to net cash provided by operating activities:
		Depreciation and amortization				2,277			3,549
		(Gain) loss on sale of property, plant and equipment				1			(85	)
		(Gain) loss from sale of investments				(32	)		189
		Acquired in-process research and development				1,420			—
		Write-down of investments				1,986			2,912
		Gain on MediaTek settlement				(45,000	)		—
		Changes in assets and liabilities, net of acquisition related amounts:
			Accounts receivable, net			(764	)		8,051
			Related party receivable — Vialta			(443	)		(1	)
			Inventories, net			2,248			(11,737	)
			Prepaid expenses and other assets			(696	)		409
			Accounts payable and accrued expenses			(1,064	)		2,523
			Related party payable — Vialta			—			(111	)
			Income tax payable and deferred income taxes			23,250			3,774

				Net cash provided (used in) by operating activities		(3,029	)		43,181

Cash flows from investing activities:
	Cash paid for acquisition, net of cash acquired					(23,958	)		—
	Purchase of property, plant and equipment					(2,660	)		(436	)
	Sale of property, plant and equipment					3			85
	Purchase of short-term investments					(18,267	)		(45,597	)
	Sale of short-term investments					17,749			15,159
	Purchase of long-term investments					(5,000	)		(5,212	)
	Sale of long-term investments					—			440
	Proceeds from sales of Cisco stock					—			1,009

				Net cash used in investing activities		(32,133	)		(34,552	)

Cash flows from financing activities:
	Repurchase of common stock					(29,301	)		(38,829	)
	Issuance of common stock from public offering					—			45,181
	Issuance of common stock under employee stock purchase plan and stock option plans					935			7,745

				Net cash provided by (used in) financing activities		(28,366	)		14,097

Net increase (decrease) in cash and cash equivalents						(63,528	)		22,726
Cash and cash equivalents at beginning of period						138,072			96,995

Cash and cash equivalents at end of period					$	74,544		$	119,721

Supplemental disclosure of cash flow information
	Cash paid for income taxes				$	(61	)	$	(237	)
	Cash refund for income taxes				$	4		$	3,340

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

ESS TECHNOLOGY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 1. NATURE OF BUSINESS

We are a leading designer, developer and marketer of highly integrated digital processor chips and imaging sensor chips. Our digital processor chips are the primary processors driving digital video and audio players, including DVD, Video CD (“VCD”) and digital media players. Our imaging sensor chips offer advanced CMOS sensor and image processor solutions for digital still cameras and cellular camera phones. Our chips use multiple processors and a programmable architecture that enable us to offer a broad array of features and functionality. We have also developed an encoding processor to address the growing demand for the digital video recorder (“DVR”) and recordable DVD players. We believe that multi-featured DVD, DVR and recordable DVD players will serve as a platform for the digital home system (“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, consumer digital audio, PC Audio and digital imaging semiconductor products. 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.

We market our products worldwide through our direct sales force, distributors and sales representatives. Substantially all of our sales are to customers in China, Hong Kong, Japan, Taiwan, Korea, Singapore and Brazil. We employ sales and support personnel located outside of the United States in China, Hong Kong, Taiwan, Japan and Korea to support these international sales efforts. We expect that international sales will continue to represent a significant portion of our net revenues. In addition, substantially all of our products are manufactured, assembled and tested by independent third parties in Asia. We also have a limited number of employees engaged in research and development efforts outside of the United States. There are special risks associated with conducting business outside of the United States.

ESS was incorporated in California in 1984 and became a public company in 1995. In April 1999, we expanded our business beyond the semiconductor segment by establishing Vialta, Inc. (“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 in Vialta. The Vialta spin-off was completed on August 21, 2001. See Note 11, “Related Party Transactions.” On June 9, 2003, we acquired 100% of the outstanding shares of Pictos Technologies, Inc., a Delaware corporation (“Pictos”). See Note 13, “Acquisition and Related Charges.”

NOTE 2. BASIS OF PRESENTATION

Our interim condensed consolidated financial statements included herein have been prepared by us, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the interim condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary for a fair statement of the results for the interim periods presented. These interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto, as well as the accompanying Management’s Discussion and Analysis of Financial Condition and Results of Operations, for the year ended December 31, 2002 included in our annual reports on Form 10-K. Interim financial results are not necessarily indicative of the results that may be expected for a full year.

Reclassification

Certain reclassifications are made to prior period financial data to conform with current period presentations.

Use of estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates.

Stock-based compensation

We account for stock-based compensation, including stock options granted under our various stock option plans and shares issued under the 1995 Employee Stock Purchase Plan (“Purchase Plan”), using the intrinsic value method prescribed in APB No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Compensation cost for stock options, if any, is recognized ratably over the vesting periods. Our policy is to grant options under our stock option plans with an exercise price equal to the Fair Market Value of our common stock based on the closing price on the grant date. Our policy is to grant purchase options under the Purchase Plan with a purchase price equal to 85% of the lesser of the fair market value of the common stock on the enrollment date or on the purchase date. Unless otherwise specified, the purchase dates under the Purchase Plan are on the last business day of each April and October. There were no purchases under the Purchase Plan during this quarter. We provide additional pro forma disclosures as required under SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) and SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure — an Amendment of SFAS No. 123.”

Our reported net income and pro forma net income per share would have been as follows had compensation costs for options granted under our stock option plans and shares purchased under our Purchase Plan been determined based on the fair value method prescribed in SFAS 123.


		Three Months Ended June 30,						Six Months Ended June 30,

		2003			2002			2003			2002

		(In thousands, except per share data)
Net income
	As reported	$	15,901		$	17,322		$	13,788		$	33,708
	Amortization of stock compensation expense		(2,292	)		(2,884	)		(4,636	)		(5,318	)

	Pro forma	$	13,609		$	14,438		$	9,152		$	28,390

Net income per share — basic:
	As reported	$	0.41		$	0.38		$	0.34		$	0.75
	Pro forma	$	0.35		$	0.32		$	0.23		$	0.64
Net income per share — diluted:
	As reported	$	0.40		$	0.36		$	0.34		$	0.70
	Pro forma	$	0.34		$	0.30		$	0.22		$	0.59

The fair value of each option granted under our stock option plans is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:


	Employee Stock Option plans

	Three Months Ended June 30,						Six Months Ended June 30,

	2003			2002			2003			2002

Expected dividend yield		0.0	%		0.0	%		0.0	%		0.0	%
Weighted average risk-free interest rate		1.70	%		2.94	%		1.71	%		2.96	%
Expected volatility		94	%		99	%		94	%		99	%
Weighted average expected life (in years)		3.20			4.20			3.18			4.13

Pro forma compensation expense for the purchase rights granted under the Purchase Plan was calculated using the Black-Scholes model with the following assumptions for three months and six months ended June 30, 2003 and 2002:


	1995 Employee Stock Purchase plan

	Three Months Ended June 30,						Six Months Ended June 30,

	2003			2002			2003			2002

Expected dividend yield		0.0	%		0.0	%		0.0	%		0.0	%
Risk-free interest rate		0.97	%		1.21	%		0.97	%		1.21	%
Expected volatility		70	%		91	%		70	%		91	%
Expected life (in months)		6			6			6			6
Weighted average grant date fair value	$	2.04		$	3.19		$	2.04		$	3.19

Because additional option grants are expected to be made from our stock option plans and additional shares are expected to be purchased under the Purchase Plan in the future, the above pro forma disclosures are not representative of pro forma effects on reported net income (loss) for future periods.

NOTE 3. BALANCE SHEET COMPONENTS


		June 30,			December 31,
		2003			2002

		(In thousands)
Cash and cash equivalents:
	Cash and money market accounts	$	13,611		$	14,121
	U.S. government notes and bonds		60,933			123,951

		$	74,544		$	138,072

Short-term investments:
	U.S. government notes and bonds	$	61,027		$	60,426
	Marketable equity securities		—			46
	Unrealized gain on short-term investment		350			558

		$	61,377		$	61,030

Accounts receivable, net:
	Accounts receivable	$	31,380		$	29,384
	Less: allowance for doubtful accounts		(997	)		(949	)

		$	30,383		$	28,435

Inventories, net:
	Raw materials	$	2,838		$	12,569
	Work-in-process		4,355			7,138
	Finished goods		16,674			4,448

		$	23,867		$	24,155

Property, plant and equipment, net:
	Land	$	2,860		$	2,860
	Building and building improvements		23,912			23,339
	Machinery and equipment		34,232			31,905
	Furniture and fixtures		14,192			13,482

			75,196			71,586
	Less: accumulated depreciation		(54,433	)		(52,601	)

		$	20,763		$	18,985

Other assets:
	Investments	$	7,476		$	4,266
	Other		1,505			1,469

		$	8,981		$	5,735

Accounts payable and accrued expenses:
	Accounts payable	$	16,928		$	10,045
	Accrued compensation costs		5,037			4,033
	Accrued commission and royalties		9,859			10,842
	Marketing and advertising related accruals		—			1,876
	Deferred revenue related to distributor sales, net of deferred cost of goods sold		2,386			818
	Other accrued liabilities		5,055			7,470

		$	39,265		$	35,084

NOTE 4. MARKETABLE SECURITIES

The amortized costs and estimated fair value of securities available-for-sale as of June 30, 2003 and December 31, 2002 are as follows:


				Gross		Gross
		Amortized		Unrealized		Unrealized			Fair
June 30, 2003		Cost		Gains		Loss			Value

		(In thousands)
Money market accounts & currencies		$	5,006	$	—	$	—		$	5,006
Municipal bonds			89,611		63		—			89,674
Corporate debt securities			28,244		229		(4	)		28,469
Corporate equity securities			1,012		359		—			1,371
Government agency bonds			4,104		62		—			4,166

	Total available-for-sale		127,977		713		(4	)		128,686
Less: Cash equivalents			65,938		—		—			65,938
	Short-term marketable securities		61,027		354		(4	)		61,377

Long-term marketable securities		$	1,012	$	359	$	—		$	1,371


				Gross		Gross
		Amortized		Unrealized		Unrealized			Fair
December 31, 2002		Cost		Gains		Loss			Value

		(In thousands)
Money market accounts		$	129	$	—	$	—		$	129
Municipal bonds			142,341		61		—			142,402
Corporate debt securities			36,108		374		(5	)		36,477
Corporate equity securities			1,058		139		—			1,197
Government agency bonds			5,928		93		—			6,021

	Total available-for-sale	$	185,564	$	667	$	(5	)	$	186,226
Less: Cash equivalents			124,080		—		—			124,080
	Short-term marketable securities		60,472		563		(5	)		61,030

Long-term marketable securities		$	1,012	$	104	$	—		$	1,116

The contractual maturities of debt securities classified as available-for-sale as of June 30, 2003 regardless of the consolidated balance sheet classification are as follows:


June 30, 2003	Estimated Fair Value

	(In thousands)
Maturing 90 days or less from purchase	$	60,933
Maturing between 90 days and one year from purchase		21,100
Maturing more than one year from purchase		40,276

Total available-for-sale	$	122,309

Actual maturities differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties, and we may need to sell the investment to meet our cash needs. Net realized gains and losses for the six months ended June 30, 2003 and 2002 were not material to our financial position or results of operations.

NOTE 5. DEBT

We have a $10.0 million unsecured line of credit with U.S. Bank National Association, which will expire on June 5, 2006. Under

the terms of the agreement, we may borrow at a fixed rate of LIBOR plus 1.5% or prime rate. The prime rate was 4% on June 30, 2003. The line of credit requires us to achieve certain financial ratios and operating results. As of June 30, 2003, we were in compliance with the borrowing criteria. As of June 30, 2003, we had $10.0 million of borrowing capability under this line of credit.

NOTE 6. EARNINGS PER SHARE

EPS is calculated in accordance with the provisions of SFAS No. 128, “Earnings Per Share” (“SFAS 128”). SFAS 128 requires us to report both basic EPS, which is based on the weighted average number of common stock outstanding, and diluted ESP, which is based on the weighted average number of common stock outstanding and all dilutive potential common stock outstanding. A reconciliation of basic and diluted income per share is presented below:


		Three Months Ended June 30,

		2003						2002

		Net				Per Share		Net				Per Share
		Income		Shares		Amount		Income		Shares		Amount

				(In thousands, except per share amounts)
Basic EPS		$	15,901		38,683	$	0.41	$	17,322		45,147	$	0.38

Effects of dilutive securities:
	Stock options		—		1,159		—		—		3,299		—

Diluted EPS		$	15,901		39,842	$	0.40	$	17,322		48,446	$	0.36


		Six Months Ended June 30,

		2003						2002

		Net				Per Share		Net				Per Share
		Income		Shares		Amount		Income		Shares		Amount

		(In thousands, except per share amounts)
Basic EPS		$	13,788		40,164	$	0.34	$	33,708		44,692	$	0.75

Effects of dilutive securities:
	Stock options		—		965		—		—		3,755		—

Diluted EPS		$	13,788		41,129	$	0.34	$	33,708		48,447	$	0.70

For the three months ended June 30, 2003 and 2002, there were options to purchase approximately 3,824,896 and 697,088 shares, respectively, of common stock with exercise prices greater than the average market value of such common stock during the period. For the six months ended June 30, 2003 and 2002, there were options to purchase approximately 4,185,806 and 49,265 shares, respectively, of common stock with exercise prices greater than the average market value of such common stock during the period. These options were excluded from the calculation of diluted earnings per share.

NOTE 7. NON-OPERATING INCOME (LOSS), NET

The following table lists the major components of non-operating income (loss) for the three months and six months ended June 30, 2003 and 2002:


	Three Months Ended June 30,						Six Months Ended June 30,

	2003			2002			2003			2002

	(In thousands)
Licensing fee from MediaTek settlement	$	45,000		$	—		$	45,000		$	—
Legal fee related to MediaTek settlement		(515	)		—			(515	)		—
Interest income		641			1,024			1,422			1,880
Loss on sale of Cisco stock		—			(61	)		—			(61	)
Loss on sale of other investments		—			—			—			(128	)
Write-down of investments		(1,636	)		(367	)		(1,986	)		(2,912	)
Vialta rental income		463			463			926			926
Other		234			26			284			113

Total non-operating income (loss)	$	44,187		$	1,085		$	45,131		$	(182	)

MediaTek Settlement

On June 11, 2003, we entered into a License Agreement and Mutual Release (“Agreement”) with MediaTek Incorporation (“ MediaTek”) relating to a patent infringement lawsuit. Under the terms of the Agreement, both sides will terminate all claims against each other and MediaTek will receive a non-exclusive worldwide license to ESS’s proprietary DVD user interface and other key DVD software. The agreement requires MediaTek to pay us a one-time license fee of $45.0 million for past damages related to sales of certain DVD products, plus ongoing royalties with a quarterly cap of $5.0 million and lifetime cap of $45.0 million. The maximum total payments under this agreement are $90.0 million. Income from MediaTek royalty for future sales of products utilizing the licensed technology will be reported as revenues based on the number of units sold. In connection with the Agreement, we recorded a one-time, pretax gain of $45.0 million in other non-operating income during the three months ended June 30, 2003. Taxes on the proceeds of the one-time license fee of $45.0 million were accrued at 53% to provide for potential US income tax and Taiwanese withholding tax associated with this payment. MediaTek has already deposited principal of $36.0 million to escrow account. ESS and MediaTek are working with the Taiwanese tax authority to determine our tax withholding obligations in Taiwan related to this payment. Tax expenses may be adjusted in accordance with the future resolution of this issue.

NOTE 8. COMPREHENSIVE INCOME

Comprehensive income is comprised of net income and the change in unrealized gain (loss) on marketable securities. Comprehensive income was $16.0 million for the three month ended June 30, 2003 and comprehensive income was $17.7 million for the three month ended June 30, 2002. The following table reconciles net income to comprehensive income for the three months and six months ended June 30, 2003 and 2002:


	Three Months Ended June 30,				Six Months Ended June 30,

	2003		2002		2003			2002

	(In thousands)
Net income	$	15,901	$	17,322	$	13,788		$	33,708
Change in unrealized gain (loss) on marketable equity securities		146		357		(64	)		1,531

Total comprehensive income	$	16,047	$	17,679	$	13,724		$	35,239

The following table shows the individual components of accumulated other comprehensive income as of June 30, 2003 and December 31, 2002:


	June 30,		December 31,
	2003		2002

	(In thousands)
Unrealized gain on MosChip shares	$	223	$	180
Unrealized gain on marketable equity securities		217		324

Accumulated other comprehensive income	$	440	$	504

NOTE 9. SEGMENT INFORMATION

We operate in one reportable business segment: the semiconductor segment. We design, develop, support, manufacture and market highly integrated mixed-signal semiconductor, hardware, software and system solutions for DVD, VCD, Communication and Other, PC Audio, Consumer Digital Audio (“CDA”) and Digital Imaging products.

The following table summarizes revenues for the three months and six months ended June 30, 2003 and 2002 by major product category:


	Three Months Ended				Six Months Ended
	June 30,				June 30,

	2003		2002		2003		2002

			(In thousands)
DVD	$	14,030	$	52,866	$	27,955	$	98,528
VCD		14,313		25,979		30,850		50,289
CDA		1,272		—		1,824		—
Communication and Other		791		4,411		2,116		7,951
PC Audio		439		2,781		1,251		8,384
Digital Imaging		166		—		166		—

Total	$	31,011	$	86,037	$	64,162	$	165,152

NOTE 10. COMMITMENTS AND CONTINGENCIES

We maintain leased office space in various locations, in addition to certain testing equipment leased from third parties. Future minimum rental payments under these operating leases are as follows:


Year Ending December 31,	Amounts

	(In thousands)
2003	$	1,594
2004		444
2005		78
2006		16

Total	$	2,132

As of June 30, 2003, our commitments to purchase inventory from the third-party contractors aggregated approximately $18.8 million. Under these contractual agreements, we may order inventory from time to time depending on our needs. There is no termination date to these agreements. Additionally, in the ordinary course of business, we enter into various arrangements with vendors and other business partners, principally for service, license and other operating supplies arrangements. As of June 30, 2003, commitments under these arrangements totaled $1.5 million. There are no material commitments for these arrangements extending beyond 2006.

From time to time, we are subject to legal proceedings and claims, including claims of alleged infringement of trademarks, copyrights and other intellectual property rights and other claims arising out of the ordinary course of business. Further, we are currently engaged in certain shareholder class action and derivative lawsuits. We intend to defend these suits vigorously. We may incur substantial expenses in litigating claims against third parties and defending against existing and future third-party claims that may arise. In the event of a determination adverse to us, we may incur substantial monetary liability and be required to change our business practices. Either of these results could have a material adverse effect on our financial position, results of operations and cash flows.

As permitted under California law, we have agreements whereby we indemnify our officers and directors for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have a director and officer insurance policy that reduces our exposure and enables us to recover a portion of any future amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements is minimal.

We are a party to a variety of agreements pursuant to which we may be obligated to indemnify the other party with respect to certain matters. Typically, these obligations arise in the context of contracts entered into by us, under which we may agree to hold the other party harmless against losses arising from a breach of representations or under which we may have an indemnity obligation to the counterparty with respect to certain intellectual property matters or certain tax related matters. Customarily, payment by us with respect to such matters is conditioned on the other party making a claim pursuant to the procedures specified in the particular contract, which procedures typically allow us to challenge the other party’s claims. Further, our obligations under these agreements may be limited in terms of time and/or amount, and in some instances, we may have recourse against third parties for certain payments made by us. It is not possible to predict the maximum potential amount of future payments under these or similar agreements due to the conditional nature of our obligations and the unique facts and circumstances involved in each particular agreement. Historically, payments made by us under these agreements have not had a material effect on our financial position or results of operations. We believe if we were to incur a loss in any of these matters, such loss should not have a material effect on our financial position or results of operations.

NOTE 11. RELATED PARTY TRANSACTIONS

Fred S.L. Chan, our Chairman of Board of Directors, also serves as the Chairman of the Board for Vialta; each company pays Fred S.L. Chan a base salary separately.

In connection with the spin-off of Vialta in August 2001, we entered into a Master Distribution Agreement that outlines the general terms and conditions of the distribution and a number of ancillary agreements that govern the various relationships between ESS and Vialta following the spin-off. The spin-off agreements, which include the Master Distribution Agreement and its ancillary agreements, consisting of the Master Technology Ownership and License Agreement, the Employee Matters Agreement, the Tax Sharing and Indemnity Agreement, the Real Estate Matters Agreement, the Master Confidential Disclosure Agreement, and the Master Transitional Services Agreement, provide for contractual obligations between the parties that are not expected to have any material impact on our revenues, operating results or cash flows.

The Master Technology Ownership and License Agreement supercedes the prior Intellectual Property and Research and Development Agreements between ESS and Vialta and allocates ownership rights generally along the product lines of each of ESS and Vialta. In the Master Technology Ownership and License Agreement, we acknowledge Vialta’s exclusive ownership of specific technology and trademarks related to Vialta’s products. Vialta has unrestricted rights to use the assigned technology and related trademarks that Vialta alone owns. The Master Technology Ownership and License Agreement does not obligate either Vialta or ESS to provide to the other improvements that it makes to its own technology.

The Employee Matters Agreement allocates responsibilities relating to current and former employees of Vialta and their participation in any benefits plans that ESS has sponsored and maintained. Prior to the distribution, ESS transferred to Vialta approximately 9,839,672 shares of Vialta Class A common stock. This same number of shares of Vialta Class A common stock has been authorized and reserved for issuance under the Vialta 2001 Non-Statutory Stock Option Plan. Immediately prior to the distribution, Vialta granted options to all ESS employees who held ESS options, based on ESS options outstanding as of the record date for the spin-off distribution. As a result, on the date of the distribution, approximately 9,839,672 of the total shares authorized under the 2001 Non-Statutory Stock Options Plan became subject to outstanding options. The resulting Vialta options vest, become exercisable, expire and otherwise be treated under terms that essentially mirror the provisions of the corresponding ESS option held by the ESS employee.

The Tax Sharing and Indemnity Agreement allocate responsibilities for tax matters between ESS and Vialta. Vialta will indemnify ESS in the event the distribution initially qualifies for tax-free treatment and later becomes disqualified as a result of actions taken by Vialta or within Vialta’s control. The Tax Sharing and Indemnity Agreement also assigns responsibilities for administrative matters such as the filing of returns, payment of taxes due, retention of records and conduct of audits, examinations and similar proceedings.

The Real Estate Matters Agreement addresses real estate matters relating to property owned by ESS that ESS leases to Vialta, as well as other properties already leased by Vialta. The Real Estate Matters Agreement also amends and restates the terms of the lease from ESS to Vialta for the Fremont facility that currently serves as Vialta’s corporate headquarters. The Real Estate Matters Agreement will terminate initially on December 31, 2003 and may be renewed for up to three years. Under this agreement, Vialta pays us approximately $1.85 million per year, receivable in installments of $154,498 per month, to lease office space for its corporate headquarters.

The Master Confidential Disclosure Agreement provides that Vialta and ESS agree not to disclose confidential information of the other except in specific circumstances or as may be permitted in an ancillary agreement.

The Master Transitional Services Agreement governs corporate support services that ESS has agreed to provide to Vialta, including, without limitation, information technology systems, human resources administration, product order administration, customer service, buildings and facilities and finance and accounting services, each as specified and on the terms set forth in the Master Transitional Services Agreement and in the schedules to the Master Transitional Services Agreement. The Master Transitional Services Agreement also provides for the provision of additional services identified from time to time after the distribution date that Vialta reasonably believes were inadvertently or unintentionally omitted from the specified services, or that are essential to effectuate an orderly transition under the Master Distribution Agreement, so long as the provision of such services would not significantly disrupt our operations or significantly increase the scope of our obligations under the agreement. The Master Transitional Services Agreement expired on August 21, 2002, although we intend to continue to charge Vialta on a per usage basis for IT hardware support, the cafeteria and the corporate dormitory.

The only other agreement between Vialta and us is a supply agreement under which ESS agrees to give Vialta the best price available to any other customers. ESS supplies chips to Vialta from time to time pursuant to standard purchase orders issued under this supply agreement. We anticipate that we will continue to provide products and services to Vialta under the terms of this supply agreement.

The following is a summary of major transactions between ESS and Vialta for the periods presented:


	TRANSACTION BETWEEN ESS AND VIALTA

	Three Months Ended					Six Months Ended
	June 30,					June 30,

	2003		2002			2003		2002

	(In thousands)
Selling, general and administrative services provided to Vialta, net of charges from Vialta	$	20	$	(51	)	$	50	$	(61	)
Lease charges to Vialta under Real Estate Matters Agreement		463		463			926		926
Chip purchases by Vialta		15		53			19		69

Total charges to Vialta, net of charges from Vialta	$	498	$	465		$	995	$	934

Charges by ESS to Vialta under the Master Transitional Services Agreement for selling, general and administrative services provided by us to Vialta are recorded in our statements of operation as an offset to our applicable operating expenses. Charges from us to Vialta under the Real Estate Matters Agreement are recorded in our Statements of Operations as other income. We did not purchase any products from Vialta during the periods presented above. Charges for product purchases by Vialta are recorded in our Statements of Operations under Net revenues from related party — Vialta.

NOTE 12. TRANSACTIONS WITH DYNAX ELECTRONICS

We sell our products through distributors. Dynax Electronics (HK) LTD (“Dynax Electronics”) is our largest distributor. We work directly with many of our customers in Hong Kong and China on product design and development; however, whenever one of these customers buys our products, the order is processed through Dynax Electronics, which functions much like a trading company. Dynax Electronics manages the order processing, arranges shipment into China and Hong Kong, manages the letters of credit, and provides credit and collection expertise and services. The title and risk of loss for the inventories are transferred to Dynax Electronics upon shipment of inventories to Dynax Electronics; Dynax Electronics is legally responsible to pay our invoices regardless of when the inventories are sold to end-customers. Revenues on sales to Dynax Electronics are deferred until Dynax Electronics sells the products to end-customers.

The following table summarizes the percentage of our net revenues during each of the periods presented, which were attributable to sales made through Dynax Electronics:


	Three Months Ended

	June 30,			March 31,			December 31,			September 30,			June 30,
	2003			2003			2002			2002			2002

	(In thousands, except percentage data)
Net revenues	$	31,011		$	33,151		$	47,554		$	60,746		$	86,037
Net revenues from Dynax	$	21,318		$	22,592		$	26,757		$	34,498		$	52,053
Percentage of net revenues from Dynax		69	%		68	%		56	%		57	%		61	%

The following table summarizes Dynax Electronics’ percentage of trade accounts receivable during each of the periods presented:


	Three Months Ended

	June 30,			March 31,			December 31,			September 30,			June 30,
	2003			2003			2002			2002			2002

	(In thousands, except percentage data)
Trade accounts receivable	$	31,350		$	28,041		$	29,523		$	30,018		$	39,882
Trade accounts receivable from Dynax	$	22,330		$	22,408		$	24,318		$	20,127		$	31,729
Percentage of trade accounts receivable from Dynax		71	%		80	%		82	%		67	%		80	%

NOTE 13. ACQUISITION AND RELATED CHARGES

On June 9, 2003, we acquired 100% of the outstanding shares of Pictos Technologies, Inc., a Delaware corporation for $27.0 million in cash. Pictos, based in Newport Beach, CA, is a privately held company that designs, manufactures and markets digital imaging semiconductor products. The acquisition expands our product lines in the digital imaging consumer electronics market with advanced CMOS sensor and image processor solutions for digital still cameras and cellular camera phones. The acquisition was accounted for as purchase combination under SFAS No. 141, “Business combination,” (“ SFAS 141”). Accordingly, the estimated fair value of assets acquired and liabilities assumed were included in our condensed consolidated balance sheet as of June 9, 2003, the effective date of the purchase. The results of operations are included in our condensed consolidated results of operations as of and since the effective date of the purchase. There were no significant differences between the accounting policies of ESS and Pictos.

We allocated the purchase price of $27.0 million and $417,000 of legal and other professional expenses directly associated with the acquisition as follows based on an independent appraisal. The fair value of $1.4 million allocated to in-process research and development was expensed immediately during the three months ended June 30, 2003. Identifiable intangible assets of $7.9 million will be amortized over their respective estimated useful lives.

The total purchase price of $27.4 million were preliminary allocated as follows:


Purchase price allocation		Amounts

		(In thousands)
Tangible assets		$	8,160
Identifiable intangible assets			7,850
Goodwill			18,144

	Total assets acquired		34,154
Liabilities assumed			(4,938	)
Deferred tax liabilities			(3,219	)

	Net assets acquired		25,997
In process research and development			1,420

Total consideration		$	27,417

The following table lists the components of $7.9 million identifiable intangible assets and their respective useful lives.


		Estimated Fair
Identifiable intangible assets		Value		Estimated Life

		(In thousands)		(Years)
Existing technology		$	3,600		3
Patents and core technology			1,800		3
Customer relationships			1,080		3
Distributor relationships			90		2
Foundry agreement			930		2
Order backlog			350		0.5

	Total identifiable intangible assets	$	7,850

The identifiable intangible assets of $7.9 million are amortized from six months to three years. The following table summarizes the annual amortization expenses through 2006.


Amortization Expenses for		Amounts

Year Ending December 31		(In thousands)

2003		$	1,841
2004			2,670
2005			2,385
2006			954

	Total	$	7,850

Summarized below are the unaudited pro forma results of ESS, reflecting the results of the Pictos acquisition from the beginning of all periods indicated. Adjustments have been made for the estimated increases in amortization of intangibles, amortization of stock-

based compensation and other appropriate pro forma adjustments. The charges for purchased in-process research and development are not included in the pro forma results, because they are non-recurring.


		Three Month Ended June 30,					Six Months Ended June 30,

		2003			2002		2003			2002

		(In thousands, except per share data)
Total revenues		$	32,358		$	86,037	$	66,281		$	165,178
Operating income (loss)		$	(10,363	)	$	16,374	$	(18,930	)	$	33,586
Net income		$	9,345		$	16,594	$	1,522		$	32,958
Net income per share:
	Basic	$	0.24		$	0.37	$	0.04		$	0.74
	Diluted	$	0.23		$	0.34	$	0.04		$	0.68

The above amounts are based upon certain assumptions and estimates, which we believe are reasonable, and they do not reflect any potential benefit from the economy of size, which may result from our combined operations. The pro forma financial information presented above is not necessarily indicative of either the results of operations that would have occurred had the acquisitions taken place at the beginning of the periods indicated or of future results of operations of the combined companies.

NOTE 14. SHAREHOLDERS’ EQUITY

Stock Repurchase

We announced on April 16, 2003 that our Board of Directors authorized us to repurchase up to 5.0 million shares of our common stock, in addition to all shares that remain available for repurchase under previously announced programs, on the same terms and conditions as these prior repurchase programs.

During the quarter ended June 30, 2003, we repurchased 760,323 shares of our common stock for an aggregate price of $4.9 million at market prices ranging from $5.93 to $6.70 per share under the stock repurchase programs approved by our Board of Directors and announced on May 7, 2002 and August 8, 2002. Upon repurchase, these shares were retired and no longer deemed outstanding. As of June 30, 2003, we have an aggregate of approximately 5,202,236 shares available for future repurchase under our stock repurchase programs.

Public Offering

On February 1, 2002, we 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 the selling shareholders. ESS 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. The selling shareholders further granted to the underwriters an over-allotment option of 720,000 shares, which were exercised on February 19, 2002. Net of underwriting discount, we received proceeds of $45,550,000 before expenses.

NOTE 15. WARRANTY

We provide a standard twelve months warranty coverage for our products. We account for the general warranty cost as a charge to cost of goods sold when revenue is recognized. The estimated warranty cost is based on historical product performance and field expenses. In addition to the general warranty reserves, we also provide specific warranty reserves for certain parts if there are potential warranty issues. The following table shows the details of the product warranty accrual, as required by the Financial Accounting Standards Board (“FASB”) Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” for the three months and six months ended June 30, 2003 and 2002.


	Three Months Ended June 30,					Six Months Ended June 30,

	(In thousands)
	2003			2002		2003			2002

Beginning balance	$	550		$	529	$	550		$	543
Accruals for warranties issued during the period		221			990		342			990
Settlements made during the period		(115	)		—		(236	)		(14	)

Ending balance	$	656		$	1,519	$	656		$	1,519

NOTE 16. INVESTMENTS

In January 2003, we acquired 4,545,400 shares of Convertible Non-Cumulative Preference Series B shares of Best Elite International Limited (“Best Elite”) for approximately $5,000,000 in cash, representing less than a 1% equity interest in Best Elite on a fully diluted basis. The investment was recorded using the cost method of accounting. Best Elite was organized under the laws of the British Virgin Islands as an investment vehicle for the purpose of establishing a foundry in Mainland China.

In March 2002, we acquired 2,750,000 shares of Broadmedia, Inc. (“Broadmedia”) common stock for approximately $4,200,000 in cash, representing an 8% equity interest in Broadmedia. Broadmedia is a dynamic product design and manufacturing house of OEMs with expertise in broadband network access equipment technologies. In December 2002, our Broadmedia common stock was exchanged for stock of Archtek Corporation (“Archtek”) as a result of corporate restructuring by Broadmedia and Archtek.

In May 2003, the merger between Broadmedia/Archtek and C-Com Corporation, a publicly traded company in Taiwan, was approved by the shareholders of both companies. In connection with the merger between these two companies, ESS will receive C-Com common stock in exchange for its investment in Broadmedia. During the three months ended June 30, 2003, the Company recorded a pre-tax non-operating loss of $1.6 million to reflect the fair market value of the C-Com shares to be received.

NOTE 17. RECENT ACCOUNTING PRONOUNCEMENTS

In June 2002, FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”). SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities. SFAS 146 requires that a liability for a cost associated with an exit or disposal activity is recognized when the liability is incurred. In summary, SFAS 146 requires that the liability be recognized and measured initially at its fair value in the period in which the liability is incurred, except for one-time termination benefits that meet certain requirements. Since SFAS 146 is effective prospectively for exit or disposal activities initiated after December 31, 2002, the adoption of SFAS 146 has no effect on our current financial position or results of operations.

In November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosures Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 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 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 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. We have adopted FIN 45. The adoption of FIN 45 did not have a material effect on our financial position or results of operations.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure” (“SFAS 148”). SFAS 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS 148 also requires that disclosures of the pro forma effect of using the fair value method of accounting for stock-based employee compensation be displayed more prominently and in a tabular format. Additionally, SFAS 148 requires disclosures of the pro forma effect in interim financial statements. The transition and annual disclosure requirements of SFAS 148 are effective for fiscal years ending after December 15, 2002. The interim disclosure requirements are effective for interim periods beginning after December 15, 2002. We have adopted the disclosure provision of SFAS 148.

In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” (“FIN 46”). FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. We do not expect that the adoption of FIN 46 will have a material effect on our financial position or results of operations.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”(“ SFAS 150”). SFAS 150 establishes the standards for issuers to classify and measure certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. SFAS 150 is effective for financial instruments enter into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. It is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of the statement and still existing at the beginning of the interim periods of adoption. Restatement is not permitted. We believe that the adoption of this standard will have no material impact on our financial statements.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Certain information contained in or incorporated by reference in the following Management’s Discussion and Analysis of Financial Condition and Results of Operations, in “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, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements include statements concerning the future of our industry, our product development, our business strategy, our future acquisitions, the continued acceptance and growth of our products, and our dependence on significant customers and distributors. Actual results may differ materially from those projected in the forward-looking statements as a result of various factors including those discussed in “Factors that May Affect Future Results” below and elsewhere in this Report. In some cases, these statements can be identified by terminologies such as “may,” “will,” “expect,” “anticipate,” “estimate,” “continue,” “believe” or other similar words. Although we believe that the assumptions underlying the forward-looking statements contained in this Report are reasonable, they may be inaccurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such statements should not be regarded as a representation by us or any other person that the results or conditions described in such statements will be achieved. We undertake no obligation to revise or update publicly any forward-looking statements for any reason.

This information should be read in conjunction with the condensed consolidated financial statements and notes thereto included in Item 1 of this quarterly report on Form 10-Q and the consolidated financial statements and notes thereto, as well as our annual report on Form 10-K for the year ended December 31, 2002.

OVERVIEW

ESS was incorporated in California in 1984 and became a public company in 1995. In April 1999, we expanded our business beyond 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. On June 9, 2003, we acquired 100% of the outstanding shares of Pictos Technologies, Inc., a Delaware corporation

(“Pictos”). See Note 13, “Acquisition and Related Charges.”

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Use of Estimates

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions upon which we rely are reasonable based upon information available to us at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected. The significant accounting policies that we believe are the most critical in understanding and evaluating our reported financial results include the following:

• Revenue Recognition;

• Inventories and Inventory Reserves;

• Goodwill and Other Intangible Assets;

• Impairment of Long-lived Assets;

• Income Taxes and Tax Reserves; and

• Legal Contingencies.

In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application. There are also cases in which management’s judgment is required in selecting appropriate accounting treatment among available alternatives under GAAP. Our management has reviewed these critical accounting policies and related disclosures with our Audit Committee.

Revenue Recognition

Revenue is primarily generated by product sales and is generally recognized at the time of shipment when persuasive evidence of an arrangement exists, the price is fixed or determinable and collection of the resulting receivable is reasonably assured, except for products sold to certain distributors with certain rights of return and allowance, in which case, revenue is deferred until such distributor resells the products to a third party. Such deferred revenues related to distributor sales, net of deferred cost of goods sold are included in accrued expenses on our balance sheets.

We provide for rebates based on current contractual terms and future returns based on historical experiences at the time revenue is recognized as reductions to product revenue. Actual amounts may be different from management’s estimates. Such differences, if any, are recorded in the period they become known.

Income from MediaTek royalties for the sale of products utilizing licensed technology will be reported as revenues based on the number of units sold as reported by MediaTek.

Inventories and Inventory Reserves

Our inventories are comprised of raw materials, work-in-process and finished goods, all of which are manufactured by third-party contractors. Inventories are valued at the lower of standard cost (which approximates actual cost on a first-in, first-out basis) or market. We reduce the carrying value of inventories for estimated slow-moving, excess, obsolete, damaged or otherwise unmarketable products by an amount that is the difference between cost and estimated market value based on forecasts of future demand and market conditions.

We evaluate excess or obsolete inventories primarily by estimating demand for individual products within specific time horizons,

typically one year or less. We generally provide a 100% reserve for the cost of products with on-hand and committed quantities in excess of the estimated demand after considering factors such as product life cycles. Once established, reserves for excess or obsolete inventories are only released when the reserved products are scrapped or sold. We also evaluate the carrying value of inventories at the lower of standard cost or market on an individual product basis, and these evaluations are based on the difference between net realizable value and standard cost. Net realizable value is the forecasted selling price of the product less the estimated costs of completion and disposal. When necessary, we reduce the carrying value of inventories to net realizable value.

The estimates of future demand, forecasted sales prices and market conditions used in the valuation of inventories form the basis for our published and internal revenue forecast. If actual results are substantially lower than the forecast, we may be required to record additional write-downs of product inventories in future periods and this may have a negative impact on gross margins.

Goodwill and Other Intangible Assets

Effective January 1, 2002, we adopted Statement of Financial Accounting Standard (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”), which addresses the accounting that must be applied to goodwill and intangible assets subsequent to their initial recognition. SFAS 142 requires that goodwill no longer be amortized, and instead, be tested for impairment at the reporting unit level at least annually.

We have goodwill and other intangible assets related to our acquisitions of NetRidium in 2000, SAS in 2001 and Pictos in 2003. In accordance with SFAS 142, we reclassified acquired workforce intangible assets, which were previously recognized apart from goodwill, as goodwill and ceased amortization of goodwill as of January 1, 2002.

Impairment of Long-Lived Assets

Pursuant to SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”), we review the recoverability of our long-lived assets based upon our estimates of the future undiscounted cash flows to be generated by the long-lived assets and will reserve for impairment whenever such estimated future cash flows indicate the carrying amount of the assets may not be fully recoverable. The adoption of SFAS 144 did not have a material effect on our financial statements.

Income Taxes

We account for income taxes under an asset and liability approach that requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of timing differences between the carrying amounts and the tax bases of assets and liabilities. U.S. deferred income taxes are not provided on all un-remitted earnings of our foreign subsidiaries as such earnings are considered permanently invested. Assumptions underlying recognition of deferred tax assets and non-recognition of U.S. income tax on un-remitted earnings can change if our business plan is not achieved or if Congress adopts changes in the Internal Revenue Code of 1986, as amended.

Legal Contingencies

These contingencies require management judgment in order to assess the likelihood of any adverse judgments or outcomes and the potential range of probable losses. Liabilities for legal matters are accrued for when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated, based upon current law and existing information. Estimates of contingencies may change in the future due to new developments or changes in legal approach.

Recent Accounting Pronouncements

initiated after December 31, 2002, the adoption of SFAS 146 has no effect on our current financial position or results of operations.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure - an Amendment of SFAS 123” (“SFAS 148”). SFAS 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS 148 also requires that disclosures of the pro forma effect of using the fair value method of accounting for stock-based employee compensation be displayed more prominently and in a tabular format. Additionally, SFAS 148 requires disclosures of the pro forma effect in interim financial statements. The transition and annual disclosure requirements of SFAS 148 are effective for fiscal years ending after December 15, 2002. The interim disclosure requirements are effective for interim periods beginning after December 15, 2002. We have adopted the disclosure provision of SFAS 148.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“ SFAS 150”). SFAS 150 establishes the standards for issuers to classify and measure certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. SFAS 150 is effective for financial instruments enter into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. It is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of the statement and still existing at the beginning of the interim periods of adoption. Restatement is not permitted. We believe that the adoption of this standard will have no material impact on our financial statements.

RESULTS OF OPERATIONS

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


		Three Months Ended June 30,						Six Months Ended June 30,

		2003			2002			2003			2002

Net revenues			100.0	%		100.0	%		100.0	%		100.0	%
Cost of revenues			67.7			59.1			69.1			57.9

	Gross margin		32.3			40.9			30.9			42.1
Operating expenses:
	Research and development		23.6			8.1			21.2			8.1
	In-process research and development		4.6			—			2.2			—
	Selling, general and administrative		21.4			12.9			20.8			13.0

Operating income (loss)			(17.3	)		19.9			(13.3	)		21.0
Non-operating income (loss), net			142.4			1.2			70.3			(0.1	)

Income before benefit from income taxes			125.1			21.1			57.0			20.9
Provision for income taxes			73.8			1.0			35.5			0.5

Net Income			51.3	%		20.1	%		21.5	%		20.4	%

COMPARISON OF THREE MONTHS ENDED JUNE 30, 2003 AND JUNE 30, 2002

Net Revenues

Net revenues were $31.0 million for the three months ended June 30, 2003, a decrease of $55.0 million or 64.0% compared to $86.0 million for the three months ended June 30, 2002, primarily due to the decrease in sales of our DVD and VCD products.

The following table summarizes revenues by major product category:


	Percentage of Net Revenues
	Three Months Ended,
	June 30,

	2003			2002

DVD		45	%		62	%
VCD		46	%		30	%
CDA		4	%		0	%
Communication and Other		3	%		5	%
PC Audio		1	%		3	%
Digital Imaging		1	%		0	%

Total		100	%		100	%

DVD revenues were $14.0 million for the three months ended June 30, 2003, a decrease of $38.9 million, or 73.5%, from revenues of $52.9 million for the three months ended June 30, 2002 primarily due to lower unit sales and average selling prices (“ASP”) per unit. For the three months ended June 30, 2003, unit sales decreased by 58.2% and ASP per unit decreased by 36.2% from the three months ended June 30, 2002. We believe this resulted from the entry of a new competitor, MediaTek, and their introduction into the market place of a new chip which integrated the servo controller front-end functionality of a DVD player with the back-end decoder functionality. We filed a lawsuit in September, 2002 in the United States against MediaTek, requesting both damages and an injunction to stop the importation into the United States of DVD players containing the new chips that we believed infringe our intellectual property rights. On June 11, 2003, we entered into a License Agreement and Mutual Release with MediaTek. Under the terms of this confidential settlement agreement, both sides have dismissed all claims against each other and MediaTek paid a one-time license fee of $45.0 million for past damages related to sales of certain DVD products, plus on-going royalties with a quarterly cap of $5.0 million and lifetime cap of $45.0 million. The maximum total payment under this agreement is $90.0 million. See Non-operating Income, Net, below.

VCD revenues were $14.3 million for the three months ended June 30, 2003, a decrease of $11.7 million, or 45.0%, from revenues of $26.0 million for the three months ended June 30, 2002, primarily due to lower ASP partially offset by an increase in volume.

Consumer Digital Audio, or CDA, revenues were $1.3 million for the three months ended June 30, 2003 and $0 for the three months ended June 30, 2002. We introduced our CDA products to the market during the third quarter of 2002.

Communication and Other revenues were $0.8 million for the three months ended June 30, 2003, a decrease of $3.6 million, or 81.8%, from revenues of $4.4 million for the three months ended June 30, 2002 primarily due to lower unit sales and ASP per unit. For the three months ended June 30, 2003, unit sales decreased by 66.9% and ASP per unit decreased by 45.7% from the three months ended June 30, 2002. We are no longer emphasizing this product line, which is in a mature market characterized by unit and unit price declines.

PC Audio revenues were $0.4 million for the three months ended June 30, 2003, a decrease of $2.4 million, or 85.7%, from revenues of $2.8 million for the three months ended June 30, 2002, primarily due to lower unit sales. For the three months ended June 30, 2003, unit sales decreased by 85.4 % from the three months ended June 30, 2002. Since the technology of this product line is being incorporated into PC’s central processor chip, we are no longer emphasizing this product line.

Digital Imaging products revenues were $0.2 million for the three months ended June 30, 2003 and $0 for the three months ended June 30, 2002. These revenues resulted from of the acquisition of Pictos in June 2003.

International revenues accounted for approximately 99.3% of net revenues for the three months ended June 30, 2003 and 99.7% of net revenues for the three months ended June 30, 2002. Our international sales are denominated in U.S. dollars. We expect that international sales will continue to remain a high percentage of our net revenues.

Gross Margin

Gross profit was $10.0 million, or 32.3% of net revenues, for the three months ended June 30, 2003, compared to $35.2 million, or 40.9% of net revenues, for the three months ended June 30, 2002. Gross profit decreased primarily due to the decrease in revenues. Gross profit as a percentage of net revenues decreased primarily due to lower ASP for DVD and VCD products. Partially offsetting the decrease in gross profit was a net decrease in the provision for excess and obsolete inventories of approximately $3.4 million. Excess and obsolete reserves released during the three months ended June 30, 2003 amounted to $1.8 million, compared to $1.6 million of reserves provided during the three months ended June 30, 2002. The released reserves were a result of the sale of products that had previously been fully reserved.

As a result of intense competition in our markets, we expect the overall ASP per unit for our existing products to decline over their product life. We believe that in order to maintain or increase gross profit in 2003, we must achieve higher unit volume in shipments, reduce costs, add new features to our existing products and introduce new products.

Research and Development

Research and development expenses were $7.3 million, or 23.6% of net revenues, for the three months ended June 30, 2003 compared to $7.0 million, or 8.1% of net revenues, for the three months ended June 30, 2002. The increase in research and development expenses was primarily due to higher non-recurring engineering (“NRE”) charges and depreciation expenses of $0.4 million. The increase in NRE of $0.2 million was for the development of the next generation VCD products. The increase in depreciation expense of $0.2 million was the result of the Pictos acquisition. Research and development expenses related to Pictos since the acquisition through June 30, 2003 were $0.5 million.

In-Process Research and Development

In-process research and development expense was $1.4 million, or 4.6% of net revenues, for the three months ended June 30, 2003. This reflects the write-off of in-process research and development expenses of the digital imaging products due to the acquisition of Pictos.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $6.7 million, or 21.4% of net revenues, for the three months ended June 30, 2003 compared to $11.1 million, or 12.9% of net revenues, for the three months ended June 30, 2002. The 39.6% decrease in selling, general and administrative expenses from the three months ended June 30, 2002 was primarily due to the decrease in marketing development fund (“MDF”) expenses, outside commission expenses, and bonuses. MDF expenses decreased by $3.3 million from the three months ended June 30, 2002 primarily due to the cancellation of our MDF program, which was replaced by a rebate program. Outside commission expenses decreased by $0.9 million from the three months ended June 30, 2002 as a result of lower sales. Bonuses decreased by $0.3 million from the three months ended June 30, 2002. The decrease was partially offset by the increase of the insurance premium for the directors’ and officers’ insurance coverage. Selling, general and administrative expenses related to Pictos since the acquisition through June 30, 2003 was $0.4 million.

Non-operating Income, Net

Net non-operating income was $44.2 million for the three months ended June 30, 2003 compared to $1.1 million for the three months ended June 30, 2002. For the three months ended June 30, 2003, net non-operating income consisted primarily of a license fee payment of $45.0 million from MediaTek, a reimbursement of $0.5 million in legal fees associated with the MediaTek litigation, interest income of $0.6 million and rental income of $0.5 million from Vialta, partially offset by the $1.6 million write-off of our investment in Broadmedia, Inc. For the three months ended June 30, 2002, net non-operating income consisted of interest income $1.0 million.

On June 11, 2003, we entered into a License Agreement and Mutual Release (“Agreement”) with MediaTek relating to a patent infringement lawsuit. Under the terms of the Agreement, both sides will terminate all claims against

each other and MediaTek will receive a non-exclusive worldwide license to ESS’s proprietary DVD user interface and other key DVD software. The agreement requires MediaTek to pay us a one-time license fee of $45.0 million for past damages related to sales of certain DVD products, plus ongoing royalties with a quarterly cap of $5.0 million and lifetime cap of $45.0 million. The maximum total payments under this agreement are $90.0 million. Income from MediaTek royalties for future sales of products utilizing the licensed technology will be reported as revenues based on the number of units sold. In connection with the Agreement, we recorded a one time, pretax gain of $45.0 million in other non-operating income during the three months ended June 30, 2003. Taxes on the proceeds of the one-time license fee of $45.0 million were accrued at 53% to provide for potential US income tax and Taiwanese withholding tax associated with this payment. ESS and MediaTek are working with the Taiwanese tax authority to determine our tax withholding obligations in Taiwan related to this payment. Tax expenses may be adjusted in accordance with the future resolution of this issue.

Provision for Income Taxes

Our effective tax rate was 59% for the three months ended June 30, 2003 compared to 5% for the three months ended June 30, 2002. The principal reason for the increase in our tax rate from our historic effective tax rate of 5% is the various income and withholding taxes accrued for the $45.0 million one-time license fee payment under the MediaTek settlement. ESS and MediaTek are working with the Taiwanese tax authority regarding to determine our tax withholding obligations in Taiwan related to this payment. Tax expense may be adjusted in accordance with the future resolution of this issue. The 5 % tax rate for the three months ended June 30, 2002 is primarily due to the lower foreign tax rate on earnings from our foreign subsidiary, which were considered to be permanently reinvested, and tax credits.

Net Income

Net income for the three months ended June 30, 2003 was $15.9 million compared to $17.3 million for the three months ended June 30, 2002. The $1.4 million decrease was primarily due to lower gross profit resulting from lower sales volume and ASP per unit, offset by the one-time license fee payment from MediaTek and lower operating expenses.

COMPARISON OF SIX MONTHS ENDED JUNE 30, 2003 AND JUNE 30, 2002

Net Revenues

Net revenues were $64.2 million for the six months ended June 30, 2003, a decrease of $101.0 million or 61.1% compared to $165.2 million for the six months ended June 30, 2002 primarily due to the decreased sales of our DVD and VCD products.

The following table summarizes revenues by major product category:


	Percentage of Net Revenues
	Six Months Ended
	June 30,

	2003			2002

DVD		43	%		60	%
VCD		48	%		30	%
Communication and Other		4	%		5	%
CDA		3	%		0	%
PC Audio		2	%		5	%
Digital Imaging		0	%		0	%

Total		100	%		100	%

DVD revenues were $28.0 million for the six months ended June 30, 2003, a decrease of $70.5 million, or 71.6%, from revenues of $98.5 million for the six months ended June 30, 2002 primarily due to lower unit sales and ASP per unit. For the six months ended June 30, 2003, unit sales decreased by 55.8% and ASP per unit decreased by 35.8% from the six months ended June 30, 2002. We believe this resulted from the entry of a new competitor, MediaTek, and their introduction into the market place of a new chip which integrated the servo controller front-end functionality of a DVD player with the back-end decoder functionality. We filed a lawsuit in September, 2002 in the United States against MediaTek, requesting both damages and an injunction to stop the importation into the United States of DVD players

containing the new chips that we believed infringe our intellectual property rights. On June 11, 2003, we entered into a License Agreement and Mutual Release with MediaTek during the quarter. Under the terms of this confidential settlement agreement, both sides have dismissed all claims against each other and MediaTek will pay a one-time license fee of $45.0 million for past damages related to sales of certain DVD products, plus on-going royalties with a quarterly cap of $5.0 million and lifetime cap of $45.0 million. The maximum total payment under this agreement is $90.0 million. See Non-operating Income, Net under Comparison of Three Months Ended June 30, 2003 and June 30, 2002.

VCD revenues were $30.9 million for the six months ended June 30, 2003, a decrease of $19.4 million, or 38.6%, from revenues of $50.3 million for the six months ended June 30, 2002, primarily due to lower ASP per unit partially offset by an increase in volume.

Communication and Other revenues were $2.1 million for the six months ended June 30, 2003, a decrease of $5.8 million, or 73.4%, from revenues of $7.9 million for the six months ended June 30, 2002, primarily due to a decrease in both unit sales and ASP per unit. For the six months ended June 30, 2003, unit sales decreased by 55.3% and ASP per unit decreased by 40.6% from the six months ended June 30, 2002. We are no longer emphasizing this product line, which is in a mature market characterized by unit and unit price declines.

Consumer Digital Audio, or CDA, revenues were $1.8 million for the six months ended June 30, 2003 and $0 for the six months ended June 30, 2002. We introduced our CDA products to the market during the third quarter of 2002.

PC Audio revenues were $1.3 million for the six months ended June 30, 2003, a decrease of $7.1 million, or 84.5%, from revenues of $8.4 million for the six months ended June 30, 2002, primarily due to a decrease in unit sales. For the six months ended June 30, 2003, unit sales decreased by 84.9 % from the six months ended June 30, 2002. Since the technology of this product line is being incorporated into PC’s central processor chip, we are no longer emphasizing this product line.

Digital Imaging products revenues were $0.2 million for the six months ended June 30, 2003 and $0 for the six months ended June 30, 2002. The revenues were the result of the acquisition of Pictos Technologies, Inc. in June 2003.

International revenues accounted for approximately 99.5% of net revenues for the six months ended June 30, 2003 and 99.4% of net revenues for the six months ended June 30, 2002. Our international sales are denominated in U.S. dollars. We expect that international sales will continue to remain a high percentage of our net revenues.

Gross Margin

Gross profit was $19.8 million, or 30.9% of net revenues, for the six months ended June 30, 2003, compared to $69.5 million, or 42.1% of net revenues, for the six months ended June 30, 2002. Gross profit decreased primarily due to the decrease in revenues. Gross profit as a percentage of net revenues decreased primarily due to lower ASP per unit for DVD and VCD products. Partially offsetting the decrease in gross profit was a net decrease in the provision for excess and obsolete inventories of approximately $6.3 million. Excess and obsolete reserves released during the six months ended June 30, 2003 amounted to $4.7 million, compared to reserves provided during the six months ended June 30, 2002 amounted to $1.6 million. The released reserves were a result of the sale of products that had previously been fully reserved.

Research and Development

Research and development expenses remained relatively flat at $13.6 million, or 21.2% of net revenues, for the six months ended June 30, 2003 compared to $13.4 million, or 8.1% of net revenues, for the six months ended June 30, 2002. We expect that research and development will continue to be critical to our business as we introduce new products. Research and development expenses related to Pictos from the acquisition through June 30, 2003 was $0.5 million.

In-Process Research and Development

In-process research and development expense was $1.4 million, or 2.2% of net revenues, for the six months ended June 30, 2003. This reflects the write-off of in-process research and development expenses of the digital imaging products due to the acquisition of Pictos.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $13.3 million, or 20.8% of net revenues, for the six months ended June 30, 2003 compared to $21.4 million, or 13.0% of net revenues, for the six months ended June 30, 2002. The 37.9% decrease in selling, general and administrative expenses from the six months ended June 30, 2002 was primarily due to the decrease in marketing development fund (“MDF”) expenses, outside commission expenses and bonuses. MDF expenses decreased by $6.4 million from the six months ended June 30, 2002 primarily due to the cancellation of our MDF program, which was replaced by a rebate program. Outside commission expenses decreased by $1.4 million from the six months ended June 30, 2002 as a result of lower sales. Bonuses decreased by $0.5 million from the six months ended June 30, 2002. The decrease was partially offset by the increase insurance premium mainly for the directors’ and officers’ insurance coverage. Selling, general and administrative expenses related to Pictos from the acquisition through June 30, 2003 was $0.4 million.

Non-operating Income (Loss), Net

Net non-operating income (loss) was $45.1 million for the six months ended June 30, 2003 compared to ($0.2) million for the six months ended June 30, 2002. For the six months ended June 30, 2003, net non-operating income consisted primarily of a license fee payment of $45.0 million from MediaTek, interest income of $1.4 million and rental income of $0.9 million from Vialta, partially offset by the ($2.0) million write-off on our investment in Broadmedia, Inc. For the six months ended June 30, 2002, net non-operating loss consisted of ($2.5) million of “other than temporary” write-down on our investment in the stock of Cisco Systems, Inc., ($0.4) million write-down on our investment in Broadmedia, partially offset by interest income of $1.9 million and rental income of $0.9 million from Vialta. See Non-operating Income, Net under Comparison of Three Months Ended June 30, 2003 and June 30, 2002.

Provision for Income Taxes

Our effective tax rate was 62% for the six months ended June 30, 2003 compared to 5% for the six months ended June 30, 2002. The principal reason for the increase in our tax rate from our historic effective tax rate of 5% is the various income and withholding taxes accrued for the one-time $45.0 million license fee payment under the MediaTek settlement. ESS and MediaTek are working with the Taiwanese tax authority regarding to determine our tax withholding obligations in Taiwan related to this payment. Tax expense may be adjusted in accordance with the future resolution of this issue. The 5% tax rate for the six months ended June 30, 2002 is primarily due to lower foreign tax rate on earnings from our foreign subsidiary, which were considered to be permanently reinvested, and tax credits.

Net Income

Net income for the six months ended June 30, 2003 was $13.8 million compared to $33.7 million for the six months ended June 30, 2002. The $19.9 million decrease was primarily due to lower gross profit resulting from lower sales volume and ASP per unit, offset by the license fee payment from MediaTek and by the decrease in the operating expenses.

Acquisitions and Related Charges

Pictos

On June 9, 2003, we acquired 100% of the outstanding shares of Pictos Technologies, Inc., a Delaware corporation (“Pictos”), for $27.0 million in total consideration. Pictos, based in Newport Beach, CA, was a privately held company that designs, manufactures and markets digital imaging semiconductor products. The acquisition expands our product lines in the digital consumer electronics market with advanced CMOS sensor and image processor solutions for digital still cameras and cellular camera phones. The acquisition was accounted for as purchase combination under FAS 141. Accordingly, the estimated fair value of assets acquired and liabilities assumed were included in our condensed consolidated balance sheet as of June 9, 2003, the effective date of the purchase. The results of operations are included in our condensed consolidated results of operations as of and since the effective date of the purchase. There were no significant differences between the accounting policies of ESS and Pictos.

We allocated the purchase price of $27.0 million and $417,000 of legal and other professional expenses directly associated with the acquisition based on an independent appraisal. The fair value of $1.4 million allocated to in-process research and development was expensed immediately during the three months ended June 30, 2003. Identifiable intangible assets of $7.9 million will be amortized over their respective estimated useful lives of six months to three years.

The total purchase price of $27.4 million were preliminary allocated as follows:


Purchase price allocation		Amounts

		(In thousands)
Tangible assets		$	8,160
Identifiable intangible assets			7,850
Goodwill			18,144

	Total assets acquired		34,154
Liabilities assumed			(4,938	)
Deferred tax liabilities			(3,219	)

	Net assets acquired		25,997
In process research and development			1,420

Total consideration		$	27,417

SAS

In April 2001, we entered into a definitive agreement to acquire Silicon Analog Systems (“SAS”) in a merger transaction to be accounted for as a purchase business combination. SAS was a Canadian start-up company engaged in developing single chip solutions for wireless communications. This acquisition was effective on April 12, 2001. We paid $1.0 million on the effective date and an additional $1.0 million on April 12, 2002. The total purchase price of $2.0 million along with $75,000 of acquisition cost was primarily allocated to goodwill and other intangible assets, based on an independent appraisal. The assets, liabilities and operating expenses for SAS were not material to our financial position or results of operations.

At the time of acquisition, SAS had generated approximately $300,000 in consulting revenue. SAS had also developed intellectual property in wireless communications as well as analog circuit design, areas of key interest to us. Because of our experience with mixed signal products, we expected that this acquisition would advance our expertise in advanced analog design enabling us to develop intellectual property for key products.

As of June 30, 2003, the SAS design team is concentrating on video product development, and designs from this group have been integrated into several video products. SAS has several patent applications pending and intends to seek further U.S. and international patents on its technology whenever possible.

NetRidium

NetRidium Communications, Inc. (“NetRidium”) was founded in January 1999 and was acquired in February 2000, when it was still a development-stage company with no revenue. We acquired NetRidium with net cash of $4.3 million. 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. Purchased in-process research and development aggregating $2.6 million for the NetRidium acquisition was charged to operations in the second quarter of 2000. Technical infrastructure and covenants not to compete are being amortized over four years. In connection with the acquisition, we also granted certain option price guarantees to certain former NetRidium employees for joining ESS. We recorded approximately $0.2 million and $0.3 million as compensation expenses under this guarantee, for three months ended June 30, 2003 and 2002, respectively.

NetRidium was developing its intellectual property and foundation technologies in the area of broadband data delivery to homes and in-home data distribution. NetRidium’s first product was scheduled for release in the summer of 2000. We expected this acquisition to provide these foundation technologies as a turnkey solution to network equipment manufacturers and personal computer providers. We planned to introduce a complete line of highly integrated technology products that would enable network manufacturers to produce reliable HomeLAN solutions over ordinary telephone wires.

Research and development expenses incurred on product development post acquisition through June 30, 2003 were approximately $14.1 million. The product was not completed until March of 2002. No significant revenues have been recognized to date nor were significant revenues originally anticipated in 2003; however, we believe that home networking is an important future market for us and this technology will be important to our efforts to exploit that market. As of June 30, 2003, net unamortized intangible assets relating to the NetRidium acquisition were approximately $550,000, including $400,000 of goodwill and $150,000 of technical infrastructure. We continue to monitor the carrying value of intangible assets related to the NetRidium acquisition in accordance with

SFAS 142 and SFAS 144.

LIQUIDITY AND CAPITAL RESOURCES

Since inception, we have financed our cash requirements from cash generated by operations, the sale of equity securities, and other short-term and long-term debt. At June 30, 2003, we had cash, cash equivalents and short-term investments of $135.9 million and working capital of $164.1 million. At June 30, 2003, we had a $10.0 million unsecured line of credit with U.S. Bank National Association, which will expire on June 5, 2006. This line of credit requires us to maintain certain financial ratios and operating results. As of June 30, 2003 and as of the filing date of this Report, we are in compliance with the borrowing criteria. As of June 30, 2003, we had $10.0 million of borrowing capability under this line of credit.

We spun off Vialta effective August 21, 2001. We do not have any contractual obligations that are expected to have a material impact upon our revenues, operating results or cash flows under any of the spin-off agreements with Vialta, which include the Master Distribution Agreement, its ancillary agreements, consisting of the Master Technology Ownership and License Agreement, the Employee Matters Agreement and the Tax Sharing and Indemnity Agreement, the Real Estate Matters Agreement, the Master Confidential Disclosure Agreement and the Master Transitional Service Agreement. The Master Transitional Service Agreement terminated in August of 2002. The Real Estate Matters Agreement will terminate initially on December 31, 2003 and may be renewed for up to three years. Under this agreement, Vialta pays us approximately $1.85 million per year, receivable in installments of $154,498 per month, to lease office space for its corporate headquarters. See Note 11, “Related Party Transactions” to the consolidated financial statements.

Net cash used in operating activities was $3.0 million for the six months ended June 30, 2003 and net cash provided by operating activities was $43.2 million for the six months ended June 30, 2002. The net cash used in operating activities for the six months ended June 30, 2003 was primarily attributable to an increase in receivable-MediaTek of $45.0 million, an increase in accounts receivables, net of $0.8 million and a decrease in accounts payable and accrued expenses of $1.1 million, partially offset by net income of $13.8 million, depreciation and amortization of $2.3 million, write-down of investments of $2.0 million, a decrease in inventory of $2.2 million, an expense for in-process research and development of $1.4 million, and an increase in income tax payable and deferred income taxes of $23.3 million. The net cash provided by operating activities for the six months ended June 30, 2002 was primarily attributable to a net income of $33.7 million, depreciation and amortization of $3.5 million, write-down of investments of $2.9 million, a decrease in accounts receivable of $8.1 million, increases in accounts payable and accrued expenses of $2.4 million and income tax payable and deferred income taxes of $3.8 million, partially offset by an increase in inventory of $11.7 million.

Net cash used in investing activities was $32.1 million for the six months ended June 30, 2003 and $34.6 million for the six months ended June 30, 2002. The net cash used in investing activities for the six months ended June 30, 2003 was primarily attributable to the net cash paid for the acquisition of Pictos of $24.0 million, the purchase of property, plant and equipment of $2.7 million, the purchase of short-term and long-term investments of $18.3 million and $5.0 million, respectively, offset by proceeds from sales of short-term investments of $17.7 million. The net cash used in investing activities for the six months ended June 30, 2002 was primarily attributable to purchase of short-term and long-term investments of $45.6 million and $5.2 million, respectively and purchase of property, plant and equipment of $0.4 million, offset by proceeds from sales of short-term and long-term investments of $15.1 million and $0.4 million, respectively, and proceeds from the sale of Cisco stock of $1.0 million.

Net cash used in financing activities was $28.4 million for the year ended June 30, 2003, and net cash provided by financing activities was $14.1 million for the six months ended June 30, 2002. The net cash used in financing activities for the six months ended June 30, 2003 was primarily attributable to cash paid for repurchase of common stock of $29.3 million, partially offset by proceeds from the issuance of common stock under employee stock plans of $0.9 million. The net cash provided by financing activities for the six months ended June 30, 2002 was primarily attributable to proceeds from the sale of common stock in the public offering of $45.2 million and issuance of common stock under employee stock plans of $7.7 million, partially offset by cash paid for repurchase of common stock of $38.8 million.

We have no long-term debt. Our capital expenditures for the next twelve months are anticipated to be approximately $5.0 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. Also, from time to time the Board of Directors may approve the expenditure of cash resources to repurchase our common stock as market conditions warrant. Based on past performance and current expectations, we believe that our existing cash and short-term investments as of June 30, 2003, together with short-term investments, funds expected to be generated by operations, available borrowings under our line of credit and other financing options, will be sufficient to satisfy our working capital needs, capital expenditures, mergers and acquisitions, strategic investment requirements, acquisitions of property and equipment, stock repurchases and other potential needs for the next twelve months.

Commitments and Contingencies

We maintain leased office space in various locations, in addition to certain testing equipment leased from third parties. Future minimum rental payments under these operating leases are as follows:


Year Ending December 31,	Amounts

	(In thousands)
2003	$	1,594
2004		444
2005		78
2006		16

Total	$	2,132

From time to time, we are subject to legal proceedings and claims, including claims of alleged infringement of trademarks, copyrights and other intellectual property rights and other claims arising out of the ordinary course of business. Further, we are currently engaged in certain shareholder class action and derivative lawsuits. We intend to defend these suits vigorously and we may incur substantial expenses in litigating claims against third parties and defending against existing and future third-party claims that may arise. In the event of a determination adverse to us, we may incur substantial monetary liability and be required to change our business practices. Either of these results could have a material adverse effect on our financial position, results of operations and cash flows. See Part II, Item 1, Legal Proceedings and Note 10, “Commitments and Contingencies” to the Consolidated Financial Statements.

Stock Repurchase

During this quarter, we repurchased 760,323 shares of our common stock for an aggregate price of $4.9 million at market prices ranging from $5.93 to $6.70 per share under the stock repurchase programs approved by our Board of Directors and announced on May 7 and August 8, 2002. Upon repurchase, these shares were retired and no longer deemed outstanding. We announced on April 16, 2003 that our Board of Directors authorized us to repurchase up to 5 million shares of our common stock, in addition to all shares that remain available for repurchase under previously announced programs, on the same terms and conditions as these prior repurchase programs. As of August 1, 2003, we have an aggregate of approximately 5,202,236 shares available for future repurchase under our stock repurchase programs.

Factors That May Affect Future Results

Our business is highly dependent on the expansion of the consumer electronics market.

Since the second half of 2001, we have shifted our primary focus from the PC Audio business to developing products primarily for the consumer digital home entertainment market. Currently, our sales of video system processor chips to the DVD and VCD (including VCD and SVCD) player markets account for a majority of our net revenues. We expect that the consumer digital home entertainment market will continue to account for a significant portion of our net revenues for the foreseeable future. Further, we continue to invest in new product lines such as our Digital Imaging products that target the consumer electronics market. However, our strategy in this market may not be successful. Given the current economic environment and other competing consumer electronics products, consumer spending on DVD players and other home electronics may not increase as expected or may even weaken or fall. If the markets for these products and applications decline or fail to develop as expected, or we are not successful in our efforts to market and sell our products to manufacturers who incorporate integrated circuits into these products, our financial results will be harmed.

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.

Our quarterly operating results are subject to fluctuations that may cause volatility or a decline in the price of our stock.

Historically, our quarterly operating results have fluctuated significantly. Our future quarterly operating results will likely fluctuate from time to time and may not meet the expectations of securities analysts and investors in a particular future period. The price of our common stock could decline due to such fluctuations. The following factors may cause significant fluctuations in our future quarterly operating results:

• Changes in demand for our products;

• Changes in the mix of products sold and our revenue mix;

• Charges related to excess inventory;

• Charges related the net realizable value of inventory;

• Seasonal customer demand;

• Increasing pricing pressures and resulting reduction in the ASP of any or all of our products;

• 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;

• Availability and cost of foundry capacity;

• A shift in manufacturing of consumer electronic products away from China; and

• Loss of key employees which could impact sales or the pace of product development.

We often purchase inventory based on sales forecasts and if anticipated sales do not materialize, we may continue to experience significant inventory charges.

We currently place non-cancelable orders to purchase our products from independent foundries on an approximately three-month rolling basis, while our customers generally place purchase orders with us that may be cancelled without significant penalty. 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. As our business grows, we may increasingly rely on distributors, which may further impede our ability to accurately forecast product orders. We have experienced significant inventory charges in the past and we may continue to experience these charges in future periods.

Our research and development investments may fail to enhance our competitive position.

We invest a significant amount of time and resources in our research and development activities to 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 significant 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 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 processor chip, or complete other significant research and development projects, our business, financial condition and results of operations could be materially adversely affected.

We may need to acquire other companies or technologies to successfully compete in our industry and we may not be successful acquiring key targets or integrating these acquisitions with our business.

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 or be able to acquire them at costs that are competitive. 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;

• The failure of the acquired products or technology to attain market acceptance;

• The failure to leverage the acquired products and technology to attain market acceptance;

• 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 and changes in customer demand.

Since we are primarily focused on the consumer electronics market, we are likely to be affected both by changes in consumer demand and by seasonality in the sales of our products. Historically, over half of consumer electronic products are sold during the holiday seasons. Consumer electronic product sales have historically been much higher during the holiday shopping seasons than during other times of the year, although the manufacturers’ shipments vary from quarter to quarter depending on a number of factors, including retail levels and retail promotional activities. In addition, consumer demand often varies from one product to another in consecutive holiday seasons, and is strongly influenced by the overall state of the economy. Because the consumer electronic market experiences substantial seasonal fluctuations, seasonal trends may cause our quarterly operating results to fluctuate significantly and our inability to forecast these trends may adversely affect the market price of our common stock. In 2002, for example, we did not experience as much of a seasonal demand for our DVD chips as we expected. We believe that this was due in part to the entry of a new competitor, but also in part to lower than expected consumer demand for DVD players, which experienced strong sales during the 2001 holiday seasons. In the future, if the market for our products is not as strong during the holiday seasons, whether as a result of changes in consumer tastes or because of an overall reduction in consumer demand due to economic conditions, we may fail to meet expectation of securities analysts and investors which could cause our stock price to fall.

Our products are subject to increasing pricing pressures.

The markets for most of the applications for our chips are characterized by intense price competition. The willingness of OEMs to design our chips into their products depends, to a significant extent, upon our ability to sell our products at cost-effective prices. We

expect the ASP of our existing products to decline significantly over the life of each product as the markets for our products mature, new products or technology emerges 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, in part, of large domestic and international companies that have substantially greater financial, manufacturing, technical, marketing, distribution and other resources, greater intellectual property rights, broader product lines and longer-standing relationships with customers than we have. 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 VCD players face significant competition from video-on-demand, VCRs and other video formats. In addition, we expect that the DVD platform for the DHS will face competition from other platforms including set-top boxes, or STBs, as well as multi-function game boxes being manufactured and sold by dominant 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 effect 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 in addition to being our Chairman of the Board. 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 key personnel 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. The loss of services of any of our key personnel, the inability to attract and retain qualified personnel in the future, or delays in hiring required personnel, particularly design personnel and software engineers, could make it difficult to implement our key business strategies, such as timely and effective product introductions.

We rely on a single distributor for a significant portion of our revenues and if this relationship deteriorates our financial results could be adversely affected.

Sales through our largest distributor Dynax Electronics (HK) LTD (a Hong Kong based company) were approximately 69% and 61% of our net revenues as of the three months ended June 30, 2003 and 2002, respectively. 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 certain rights of return for unsold product and rights to pricing allowances to compensate for rapid, unexpected price changes, therefore we do not recognize revenue until Dynax Electronics sells through to our end-customers. If our relationship with Dynax Electronics deteriorates, our quarterly results could fluctuate significantly as we experience short-term disruption to our sales and collection processes, particularly in light of the fact that we maintain significant account receivable from Dynax Electronics. As our business grows, we may increasingly rely on distributors, which may reduce our exposure to future sales opportunities. Although we believe that we could replace Dynax Electronics as our distributor for the Hong Kong and China markets, there can be no assurance that we could replace Dynax Electronics in a timely manner or if a replacement were found that the new distributor would be as effective as Dynax Electronics in generating revenue for us.

Our customer base is highly concentrated, so the loss of a major customer could adversely affect our business.

A substantial portion of our net revenues has been derived from sales to a small number of our customers. During the three months ended June 30, 2003, sales to our top five end customers (including end-customers that buy our products from our distributor Dynax Electronics (HK) LTD (“Dynax Electronics”)) were approximately 40% of our net revenues. We expect this concentration of sales to continue along with other changes in the composition of our customer base. The reduction, delay or cancellation of orders from one or

more major customers or the loss of one or more major customers could materially and adversely affect our business, financial condition and results of operations. In addition, any difficulty in collecting amounts due from one or more key customers could harm our financial condition.

We may not be able to adequately protect our intellectual property rights from unauthorized use and we may be subject to claims of infringement of third-party intellectual property rights.

To protect our intellectual property rights we rely on a combination of patents, trademarks, copyrights and trade secret laws and confidentiality procedures. As of June 30, 2003, we had 41 patents granted in the United States. These patents will expire over time commencing in 2008 and ending in 2021. In addition, as of June 30, 2003, we had 15 corresponding foreign patents, which are going to expire over time commencing in 2005 and ending in 2020. 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. For example, if we lose the Townshend modem case, 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.

We have significant international sales and operations that are subject to the special risks of doing business outside the United States.

Substantially all of our sales are to customers in China, Hong Kong, Japan, Taiwan, Korea, Singapore and Brazil. During the second quarter of 2003, sales to customers in China, Hong Kong and Japan were in excess of 83% of our net revenues. If our sales in one of these markets, such as China, were to fall, our financial condition could be materially impaired. We expect that international sales will continue to represent a significant portion of our net revenues. In addition, substantially all of our products are manufactured, assembled and tested by independent third parties in Asia. There are special risks associated with conducting business outside of the United States, including:

• Unexpected changes in legislative or regulatory requirements and related compliance problems;

• Political, social and economic instability;

• Lack of adequate protection of our intellectual property rights;

• Changes in diplomatic and trade relationships, including changes in most favored nations trading status;

• Tariffs, quotas and other trade barriers and restrictions;

• Longer payment cycles 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., United Microelectronics Corporation and other independent foundries in Asia. 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.

Because we purchase raw materials from a limited number of suppliers, we could experience disruptions or cost increases.

We depend on a limited number of suppliers to obtain adequate supplies of quality raw materials on a timely basis. We do not generally have guaranteed supply arrangements with our suppliers. If we have difficulty in obtaining materials in the future, alternative suppliers may not be available, or if available, these suppliers may not provide materials in a timely manner or on favorable terms. If we cannot obtain adequate materials for the manufacture of our products, we may be forced to pay higher prices, experience delays and our relationships with our customers may suffer.

We have extended sales cycles, which increase our costs in obtaining orders and reduce the predictability of our earnings.

Our potential customers often spend a significant amount of time to evaluate, test and integrate our products. Our sales cycles often last for several months and may last for up to a year or more. These longer sales cycles require us to invest significant resources prior to the generation of revenues and subject us to 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.

Our products are subject to recall risks.

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.

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 ASPs. Current trade association data indicate that the semiconductor industry has experienced a severe downturn since the third quarter of 2000 and this downturn is expected to continue for the foreseeable future. This downturn could harm our net revenues and gross margins if ASPs

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.

We may need additional funds to execute our business plan, and if we are unable to obtain such funds, we may not be able to expand our business, and if we do raise such funds, your ownership in ESS may be subject to dilution.

We may be required to obtain substantial additional capital to finance our future growth, fund our ongoing research and development activities and acquire new technologies or companies. To the extent that our existing sources of liquidity and cash flow from operations are insufficient to fund our activities, we may need to seek additional equity or debt financing from time to time. If our performance or prospects decrease, we may need to consummate a private placement or public offering of our capital stock at a lower price than you paid for your shares. If we raise additional capital through the issuance of new securities at a lower price than you paid for your shares, you will be subject to additional dilution. Further, such equity securities may have rights, preferences or privileges senior to those of our existing common stock. Additional financing may not be available to us when needed or, if available, it may not be available on terms favorable to us.

Our success within the semiconductor industry depends upon our ability to develop new products in response to rapid technological changes and evolving industry standards.

The semiconductor industry is characterized by rapid technological changes, evolving industry standards and product obsolescence. Our success is highly dependent upon the successful development and timely introduction of new products at competitive prices and performance levels. 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.

We operate in highly competitive markets.

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 in increased price competition that would adversely affect the ASPs and margins of our products.

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

• The timely shipment of our anticipated DVD integrated chip, Vibratto II;

• The timely shipment of the next generation of our current DVD decoder chip, Vibratto S;

• The timely shipment of our new VCD chip, Visba IV; (need to update)

• 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;

• The 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.

The value of our common stock may be adversely affected by market volatility.

The price of our common stock fluctuates significantly. Many factors influence the price of our common stock, including:

• Future announcements concerning us, our competitors or our principal customers, such as quarterly operating results, changes in earnings estimates by analysts, technological innovations, new product introductions, governmental regulations, or litigation;

• The liquidity within the market for our common stock;

• Sales by our officers, directors and other insiders;

• Investor perceptions concerning the prospects of our business and the semiconductor industry;

• Market conditions and investor sentiment affecting market prices of equity securities of high technology companies; and

• General economic, political and market conditions, such as recessions or international currency fluctuations.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We are exposed to the impact of foreign currency fluctuations and interest rate changes which may lead to changes in the market values of our investments.

Foreign Exchange Risks

We fund our operations with cash generated by operations, the sale of marketable securities and short and long-term debt. 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 three years. All of the investments have been classified as available for sale, and on June 30, 2003, the fair market value of our investments approximated their costs.

Item 4. Disclosure Controls and Procedures

The Company maintains “disclosure controls and procedures,” as such term is defined under Exchange Act Rules 13a-15(e) and 15d-15(e), that are designed to ensure that information required to be disclosed in the Company’s Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures. In designing and evaluating the disclosure controls and procedures, the Company’s management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and the Company’s management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. We also established a disclosure committee that consists of certain members of the Company’s senior management.

The disclosure committee, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, carried out an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based upon their evaluation and subject to the foregoing, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective in ensuring that material information relating to the Company is made known to the Chief Executive Officer and Chief Financial Officer by others within the Company during the period in which this report was being prepared.

There have been no changes in the Company’s internal control over financial reporting that occurred during the Company’s last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

On September 27, 2002, we filed a complaint in the United States District Court for the Northern District of California (Case No. C02-04705) against MediaTek Incorporation, a Taiwanese company (“MediaTek”), alleging copyright infringement and unfair competition. The complaint seeks damages and an injunction barring importation into the United States of certain MediaTek semiconductor chips alleged to infringe our proprietary intellectual property as well as all downstream products, specifically DVD players, incorporating such MediaTek chips. We believe that MediaTek unlawfully acquired and copied our proprietary source code and graphical user interface relating to our DVD products, and then used that technology to target our customers and market MediaTek’s chips in unfair competition. Simultaneous with the complaint, we filed a motion for expedited discovery to force MediaTek to turn over the suspected infringing code for expert analysis in support of a temporary restraining order. MediaTek’s source code was produced at the end of December 2002. On February 26, 2003, MediaTek answered the complaint, asserting affirmative defenses and counterclaims for a declaratory judgment of non-infringement and for trade secret misappropriation. On March 7, 2003, we filed a motion for preliminary injunction against MediaTek’s manufacture, distribution, and importation of DVD chips, or in the alternative, for an expedited trial on our copyright claims. We also sought a recall order requiring MediaTek to recall all DVD chips from its customers, distributors, retailers, and end users. On June 11, 2003, we entered into a License Agreement and Mutual Release with MediaTek. Under the terms of this confidential settlement agreement, both sides have dismissed all claims against each other in consideration of a license fee and royalty payment to ESS of up to $90.0 million, MediaTek will receive a non-exclusive worldwide license to ESS’ proprietary DVD user interface and other key DVD software.

After we revised our revenues and earnings guidance for the third quarter of 2002 on September 12, 2002, several holders of our common stock, purporting to represent a class of similarly aggrieved shareholders, filed lawsuits against us. The complaints allege that we issued misleading statements regarding our business and failed to disclose material facts during the alleged class period (January 23, 2002 through September 12, 2002). To date, eight putative class action lawsuits have been filed in the United States District Court,

Northern District of California. These cases are: Daniel C. Rann v. ESS Technology, Inc., et al. (Case No. C02-4497), filed September 13, 2002; James W. Becker and Randy Bohart v. ESS Technology, Inc., et al. (Case No. C02-4695), filed September 27, 2002; Palmer Fauconnier v. ESS Technology, Inc., et al. (Case No. C02-4734), filed September 30, 2002; Mike Forrestal v. ESS Technology, Inc., et al. (Case No. C02-4739), filed September 30, 2002; Sandy Dorman v. ESS Technology, Inc., et al. (Case No. C02-4732), filed September 30, 2002; Patriot Shipping Corporation v. ESS Technology, Inc., et al. (Case No. C02-4749), filed October 1, 2002; Adam D. Saphier v. ESS Technology, Inc., et al. (Case No. C02-5028), filed October 17, 2002; and Mayer Abramowitz v. ESS Technology, Inc., et al. (Case No. C02-5354), filed on November 7, 2002. These actions have been consolidated and are proceeding as a single action under the caption “In re ESS Technology Securities Litigation.” The plaintiffs are seeking unspecified damages for the class and unspecified costs and expenses. On May 20, 2003, the Plaintiffs filed an amended complaint. ESS filed a Motion to Dismiss on June 18, 2003, which is scheduled to be heard on August 22, 2003. Discovery is on hold through the pleading stage and no trial date has been set.

Similarly, after we revised our revenues and earnings guidance for the third quarter of 2002 on September 12, 2002, several holders of our common stock, purporting to represent the corporation, have brought derivative suits against us as a nominal defendant and certain of our officers and directors, alleging, among other things, breaches of fiduciary duty and insider trading. To date, three derivative suits have been filed in the California Superior Court, Alameda County. These cases are: Robert Haven, Derivatively on Behalf of ESS Technology v. Blair, et al. (Case No. 02-67527), filed October 3, 2002, James Shroff, Derivatively on Behalf of ESS Technology v. Blair, et al. (Case No. 02-68418), filed Octobers 10, 2002 and David Chestnut, Derivatively on behalf of ESS Technology v. Chan, et al. (Case No. 02-69064), filed October 16, 2002. These actions have been consolidated and are proceeding as a single action entitled “ESS Cases.” The derivative plaintiffs seek compensatory and other damages, disgorgement of profits and other relief. With respect to these state court derivative actions, we filed a demurrer to the claims and a motion to stay discovery on March 24, 2003. The demurrer and motion to stay discovery were heard on May 15, 2003. The Court denied the demurrer, however issued an order staying discovery pending the resolution of the pleading stage in the District Court case.

On March 12, 2001, the Company 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 patent misuse. The 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 the Company with a license on reasonable and nondiscriminatory terms, as is required by applicable law. The patents relate to the manufacture and sale of high-speed modems. On April 30, 2002, the Company filed an amended complaint. On September 27, 2002, Townshend filed an answer and counterclaims, alleging patent infringement. The Company filed its answer to the counterclaims on October 17, 2002. Townshend also filed patent infringement actions against Agere, Analog Devices, Cisco, and Intel, alleging infringement of the same patents. On March 7, 2003, the Court issued an order finding that the cases are related and should be tried together. The parties have agreed to mediation, which began on August 1, 2003. Discovery is currently on hold. The Company will vigorously pursue this litigation.

Although we believe that we and our officers and directors have meritorious defenses to both actions and intend to defend these suits vigorously, we cannot predict with certainty the outcome of these lawsuits. Our defense against these lawsuits may be costly and may require a significant commitment of time and resources by our senior management. Management believes that these lawsuits are subject to coverage under our directors’ and officers’ liability insurance policies, although to date our carriers have reserved their rights with respect to coverage for these claims. In the event of a determination adverse to us, either with respect to coverage or with respect to the underlying merits of the lawsuits, we may incur substantial monetary liability, which could have a material adverse effect on our financial position, results of operation and cash flows.

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

The Annual Meeting of Shareholders of ESS Technology, Inc. was held on May 29, 2003 in Fremont, California. Of the total of 38,949,453 shares outstanding as of the record date, 35,314,023 were present or represented by proxies at the meeting. The table below presents the results of the election of the Company’s board of directors.


NOMINEE	FOR		WITHHELD

Fred S. L. Chan		34,844,547		469,476
Robert Blair		34,846,223		467,800


NOMINEE	FOR		WITHHELD

David Lee		28,696,969		6,617,054
Peter T. Mok		28,700,669		6,613,354
Dominic Ng		28,696,269		6,617,754
Alfred J. Stein, Jr.		28,693,109		6,620,914

The shareholders approved the amendments to the 1997 Equity Incentive Plan to increase the number of shares of common stock reserved for issuance thereunder by 1,000,000 shares. The proposal received 20,949,892 affirmative votes, 13,000,795 negative votes, and 1,363,337 abstentions.

The shareholders approved the amendments to the 1995 Employee Stock Purchase Plan to increase the number of shares of common stock reserved for issuance thereunder by 500,000 shares and to extend the termination date for the 1995 Employee Stock Purchase Plan from July 31, 2005 to April 26, 2013. The proposal received 32,384,952 affirmative votes, 1,568,890 negative votes, and 1,360,182 abstentions.

The shareholders also ratified the selection of PricewaterhouseCoopers LLP as the independent accountants of the Company for the fiscal year ending December 31, 2003. The proposal received 27,440,359 affirmative votes, 7,419,282 negative votes, and 446,283 abstentions.

Items 2, 3 and 5 are not applicable for the reporting period and have been omitted.

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits:


EXHIBIT
NUMBER		DESCRIPTION

2.1		Agreement and Plan of Merger, dated June 9, 2003, by and among Registrant, Pictos Technologies, Inc. and Pictos Acquisition Corporation, incorporated herein by reference to Exhibit 2.1 to the Registrant’s Current Report on Form 8-K filed on June 24, 2003.

3.01		Registrant’s Articles of Incorporation, incorporated herein by reference to Exhibit 3.01 to the Registrant’s Form S-1 registration statement (File No. 33-95388) declared effective by the SEC on October 5, 1995 (the “Form S-1”).

3.02		Registrant’s Bylaws as amended, incorporated herein by reference to Exhibit 3.02 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 1998, filed on March 31, 1999.

4.01		Registrant’s Registration Rights Agreement dated May 28, 1993 among the Registrant and certain security holders, incorporated herein by reference to Exhibit 10.07 to the Form S-1.

10.49		Registrant’s 1995 Employee Stock Purchase Plan, as amended.*

10.50		Registrant’s 1997 Equity Incentive Plan, as amended.*

10.51		License Agreement and Mutual Release dated June 11, 2003 (certain exhibits to this agreement have been omitted; the Registrant agrees to furnish supplementally to the Commission, upon request, a copy of these exhibits).**

31.1		Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32		Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

*		Represents a management contract or compensatory plan of arrangement.

**		Confidential treatment requested as to certain portions of this agreement.

(b) Reports on Form 8-K:

On April 30, 2003, we filed a Current Report on Form 8-K under Item 9 furnishing our consolidated financial results for the first quarter of fiscal year 2003. On June 12, 2003, we filed a Current Report on Form 8-K under Item 9 furnishing a press release, announcing the signing of a worldwide license agreement with MediaTek, Inc. and the settlement of all litigation with MediaTek, Inc. On June 24, 2003 we filed an 8-K announcing our acquisition of Pictos Technologies, Inc. for $27 million in cash pursuant to the Agreement and Plan of Merger dated June 9, 2003.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this quarterly report on Form 10-Q to be signed on its behalf by the undersigned thereunto duly authorized.


	ESS TECHNOLOGY, INC. (Registrant)

Date: August 14, 2003	By:	/s/ Robert L. Blair

		Robert L. Blair
		President and Chief Executive Officer

Date: August 14, 2003	By:	/s/ James B. Boyd

		James B. Boyd
		Chief Financial Officer and Chief Accounting Officer

INDEX TO EXHIBITS


EXHIBIT
NUMBER		DESCRIPTION

2.1		Agreement and Plan of Merger, dated June 9, 2003, by and among Registrant, Pictos Technologies, Inc. and Pictos Acquisition Corporation, incorporated herein by reference to Exhibit 2.1 to the Registrant’s Current Report on Form 8-K filed on June 24, 2003.

3.01		Registrant’s Articles of Incorporation, incorporated herein by reference to Exhibit 3.01 to the Registrant’s Form S-1 registration statement (File No. 33-95388) declared effective by the SEC on October 5, 1995 (the “Form S-1”).

3.02		Registrant’s Bylaws as amended, incorporated herein by reference to Exhibit 3.02 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 1998, filed on March 31, 1999.

4.01		Registrant’s Registration Rights Agreement dated May 28, 1993 among the Registrant and certain security holders, incorporated herein by reference to Exhibit 10.07 to the Form S-1.

10.49		Registrant’s 1995 Employee Stock Purchase Plan, as amended.*

10.50		Registrant’s 1997 Equity Incentive Plan, as amended.*

10.51		License Agreement and Mutual Release dated June 11, 2003 (certain exhibits to this agreement have been omitted; the Registrant agrees to furnish supplementally to the Commission, upon request, a copy of these exhibits).**

31.1		Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32		Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

*		Represents a management contract or compensatory plan of arrangement.

**		Confidential treatment requested as to certain portions of this agreement.

	•		Revenue Recognition;

	•		Inventories and Inventory Reserves;

	•		Goodwill and Other Intangible Assets;

	•		Impairment of Long-lived Assets;

	•		Income Taxes and Tax Reserves; and

	•		Legal Contingencies.

	•		Changes in demand for our products;

	•		Changes in the mix of products sold and our revenue mix;

	•		Charges related to excess inventory;

	•		Charges related the net realizable value of inventory;

	•		Seasonal customer demand;

	•		Increasing pricing pressures and resulting reduction in the ASP of any or all of our products;

	•		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;

	•		Availability and cost of foundry capacity;

	•		A shift in manufacturing of consumer electronic products away from China; and

	•		Loss of key employees which could impact sales or the pace of product development.

	•		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;

	•		The failure of the acquired products or technology to attain market acceptance;

	•		The failure to leverage the acquired products and technology to attain market acceptance;

	•		Issuances of equity securities dilutive to our existing shareholders; and

	•		The incurrence of substantial debt and assumption of unknown liabilities.

	•		Unexpected changes in legislative or regulatory requirements and related compliance problems;

	•		Political, social and economic instability;

	•		Lack of adequate protection of our intellectual property rights;

	•		Changes in diplomatic and trade relationships, including changes in most favored nations trading status;

	•		Tariffs, quotas and other trade barriers and restrictions;

	•		Longer payment cycles 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.

	•		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.

	•		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.

	•		The timely shipment of our anticipated DVD integrated chip, Vibratto II;

	•		The timely shipment of the next generation of our current DVD decoder chip, Vibratto S;

	•		The timely shipment of our new VCD chip, Visba IV; (need to update)

	•		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;

	•		The 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.

	•		Future announcements concerning us, our competitors or our principal customers, such as quarterly operating results, changes in earnings estimates by analysts, technological innovations, new product introductions, governmental regulations, or litigation;

	•		The liquidity within the market for our common stock;

	•		Sales by our officers, directors and other insiders;

	•		Investor perceptions concerning the prospects of our business and the semiconductor industry;

	•		Market conditions and investor sentiment affecting market prices of equity securities of high technology companies; and

	•		General economic, political and market conditions, such as recessions or international currency fluctuations.