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 September 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		94-2928582
incorporation or organization)		(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 November 3, 2003 the registrant had 38,866,184 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 6. Exhibits and Reports on Form 8-K
SIGNATURES
INDEX TO EXHIBITS
EXHIBIT 10.52
EXHIBIT 10.53
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 September 30, 2003 and December 31, 2002		3
	Condensed Consolidated Statements of Operations for the three months ended and nine months ended September 30, 2003 and 2002		4
	Condensed Consolidated Statements of Cash Flows for the nine months ended September 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.	Controls and Procedures		38
PART II	OTHER INFORMATION		39
Item 1.	Legal Proceedings		39
Item 6.	Exhibits and Reports on Form 8-K		40
SIGNATURES			41
INDEX TO EXHIBITS

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (unaudited)

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


		September 30,		December 31,
		2003		2002

		(In thousands)
ASSETS
Cash and cash equivalents		$	48,833	$	138,072
Short-term investments			55,127		61,030
Accounts receivable, net			38,584		28,435
Related party receivable — Vialta			212		33
Receivable — MediaTek			50,000		—
Inventories, net			22,001		24,155
Prepaid expenses and other assets			3,483		2,834

	Total current assets		218,240		254,559
Property, plant and equipment, net			21,192		18,985
Goodwill			43,611		2,074
Other intangible assets			12,925		249
Other assets			9,156		5,735

	Total assets	$	305,124	$	281,602

LIABILITIES AND SHAREHOLDERS’ EQUITY
Accounts payable and accrued expenses		$	52,391	$	35,084
Income tax payable and deferred income taxes			25,555		9,474

	Total current liabilities		77,946		44,558
Non-current deferred tax liability			12,926		7,676

	Total liabilities		90,872		52,234
Commitments and contingencies (Note 10)
	Shareholders’ equity:
Common stock			171,999		196,344
Accumulated other comprehensive income (Note 8)			401		504
Retained earnings			41,852		32,520

	Total shareholders’ equity		214,252		229,368

	Total liabilities and shareholders’ equity	$	305,124	$	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 September 30,					Nine Months Ended September 30,

		2003			2002		2003			2002

		(In thousands, except per share data)
Net revenues		$	48,067		$	59,411	$	112,210		$	224,495
Net revenues from related party — Vialta			176			1,335		195			1,403

	Total net revenues		48,243			60,746		112,405			225,898
Cost of revenues			33,281			45,665		77,639			141,321

	Gross profit		14,962			15,081		34,766			84,577
Operating expenses:
	Research and development		10,090			7,160		23,676			20,584
	In-process research and development		1,270			—		2,690			—
	Selling, general and administrative		8,874			6,452		22,208			27,859

Operating income (loss)			(5,272	)		1,469		(13,808	)		36,134
Non-operating income (loss), net			(659	)		1,438		44,472			1,256

Income (loss) before provision for (benefit from) income taxes			(5,931	)		2,907		30,664			37,390
Provision for (benefit from) income taxes			(8,680	)		148		14,127			923

Net income		$	2,749		$	2,759	$	16,537		$	36,467

Net income per share:
	Basic	$	0.07		$	0.06	$	0.42		$	0.83

	Diluted	$	0.07		$	0.06	$	0.40		$	0.77

Shares used in calculating net income per share:
	Basic		38,694			43,484		39,669			44,127

	Diluted		40,579			45,706		40,925			47,408

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

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


					Nine Months Ended September 30,

					2003			2002

					(In thousands)
Cash flows from operating activities:
Net income					$	16,537		$	36,467
	Adjustments to reconcile net income to net cash provided by operating activities:
		Depreciation and amortization				4,489			5,053
		(Gain) loss on sale of property, plant and equipment				3			(85	)
		(Gain) loss from sale of investments				(32	)		189
		Acquired in-process research and development				2,690			—
		Write-down of investments				1,986			3,262
		Gain on MediaTek settlement				(45,000	)		—
		Changes in assets and liabilities, net of acquisition related amounts:
			Accounts receivable, net			(8,612	)		11,082
			Related party receivable — Vialta			(179	)		(303	)
			Receivable — MediaTek			(5,000	)		—
			Inventories, net			5,164			(7,429	)
			Prepaid expenses and other assets			1,084			(1,771	)
			Accounts payable and accrued expenses			8,935			(7,410	)
			Related party payable — Vialta			—			(47	)
			Income tax payable and deferred income taxes			11,428			3,923

				Net cash provided (used in) by operating activities		(6,507	)		42,931

Cash flows from investing activities:
	Cash paid for acquisition, net of cash acquired					(51,874	)		—
	Purchase of property, plant and equipment					(3,533	)		(919	)
	Sale of property, plant and equipment					3			85
	Purchase of short-term investments					(20,494	)		(52,846	)
	Sale of short-term investments					26,062			18,979
	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		(54,836	)		(38,464	)

Cash flows from financing activities:
	Repurchase of common stock					(29,301	)		(40,293	)
	Issuance of common stock from public offering					—			45,181
	Issuance of common stock under employee stock purchase plan and stock option plans					1,405			8,523

				Net cash provided by (used in) financing activities		(27,896	)		13,411

Net increase (decrease) in cash and cash equivalents						(89,239	)		17,878
Cash and cash equivalents at beginning of period						138,072			96,995

Cash and cash equivalents at end of period					$	48,833		$	114,873

Supplemental disclosure of cash flow information
	Cash paid for income taxes				$	(2,878	)	$	(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 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 digital video recorders (“DVR”), recordable DVD players, digital still cameras and digital camcorders. 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. The terms “Company,” “we,” “us,” “our,” and similar terms refer to ESS Technology, Inc. and its subsidiaries, unless the context otherwise requires.

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, Taiwan, Korea, Japan, Singapore and Turkey. We employ sales and support personnel located outside of the United States in China, Hong Kong, Taiwan, Korea and Japan 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.

We were 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”). On August 15, 2003, we acquired 100% of the outstanding shares of Divio, Inc., a California corporation (“Divio”). 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 September 30,						Nine Months Ended September 30,

		2003			2002			2003			2002

		(In thousands, except per share data)
Net income
	As reported	$	2,749		$	2,759		$	16,537		$	36,467
	Stock-based compensation expense included in reported net income		—			—			—			—
	Amortization of stock compensation expense		(2,450	)		(2,859	)		(7,045	)		(8,215	)

	Pro forma net income (loss)	$	299		$	(100	)	$	9,492		$	28,252

Net income (loss) per share — basic:
	As reported	$	0.07		$	0.06		$	0.42		$	0.83
	Pro forma	$	0.01		$	(0.00	)	$	0.24		$	0.64
Net income (loss) per share — diluted:
	As reported	$	0.07		$	0.06		$	0.40		$	0.77
	Pro forma	$	0.01		$	(0.00	)	$	0.23		$	0.60

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 for the three months and nine months ended September 30, 2003 and 2002:


	Employee Stock Option Plans

	Three Months Ended September 30,						Nine Months Ended September 30,

	2003			2002			2003			2002

Expected dividend yield		0.0	%		0.0	%		0.0	%		0.0	%
Weighted average risk-free interest rate		1.92	%		2.04	%		1.80	%		2.70	%
Expected volatility		93	%		100	%		94	%		99	%
Weighted average expected life (in years)		3.14			3.77			3.17			4.03
Weighted average grant date fair value	$	9.29		$	12.47		$	8.58		$	13.93

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 nine months ended September 30, 2003 and 2002:


	1995 Employee Stock Purchase Plan

	Three Months Ended September 30,						Nine Months Ended September 30,

	2003			2002			2003			2002

Expected dividend yield		0.0	%		0.0	%		0.0	%		0.0	%
Risk-free interest rate		1.01	%		1.01	%		1.01	%		1.01	%
Expected volatility		55	%		108	%		55	%		108	%
Expected life (in months)		6			6			6			6
Weighted average grant date fair value	$	1.99		$	2.45		$	1.84		$	3.55

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


		September 30,			December 31,
		2003			2002

		(In thousands)
Cash and cash equivalents:
	Cash and money market accounts	$	14,408		$	14,121
	U.S. government notes and bonds		34,425			123,951

		$	48,833		$	138,072

Short-term investments:
	U.S. government notes and bonds	$	54,940		$	60,426
	Marketable equity securities		—			46
	Unrealized gain on short-term investment		187			558

		$	55,127		$	61,030

Accounts receivable, net:
	Accounts receivable	$	39,602		$	29,384
	Less: allowance for doubtful accounts		(1,018	)		(949	)

		$	38,584		$	28,435

Inventories, net:
	Raw materials	$	2,098		$	12,569
	Work-in-process		3,959			7,138
	Finished goods		15,944			4,448

		$	22,001		$	24,155

Property, plant and equipment, net:
	Land	$	2,860		$	2,860
	Building and building improvements		24,132			23,339
	Machinery and equipment		34,470			31,905
	Furniture and fixtures		14,806			13,482

			76,268			71,586
	Less: accumulated depreciation		(55,076	)		(52,601	)

		$	21,192		$	18,985

Other assets:
	Investments	$	7,569		$	4,266
	Other		1,587			1,469

		$	9,156		$	5,735

Accounts payable and accrued expenses:
	Accounts payable	$	18,410		$	10,045
	Accrued compensation costs		6,186			4,033
	Accrued commission and royalties		10,545			10,842
	Marketing and advertising related accruals		—			1,876
	Deferred revenue related to distributor sales, net of deferred cost of goods sold		5,559			818
	Deferred revenue-MediaTek		5,000			—
	Other accrued liabilities		6,691			7,470

		$	52,391		$	35,084

NOTE 4. MARKETABLE SECURITIES

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


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

		(In thousands)
Money market accounts & currencies		$	104	$	—	$	—		$	104
Municipal bonds			54,660		50		—			54,710
Corporate debt securities			30,646		102		(3	)		30,745
Corporate equity securities			1,012		302		—			1,314
Government agency bonds			4,059		38		—			4,097

	Total available-for-sale		90,481		492		(3	)		90,970
Less: Cash equivalents			34,529		—		—			34,529
	Short-term marketable securities		54,940		190		(3	)		55,127

Long-term marketable securities		$	1,012	$	302	$	—		$	1,314


				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 September 30, 2003 regardless of the consolidated balance sheet classification are as follows:


September 30, 2003	Estimated Fair Value

	(In thousands)
Maturing 90 days or less from purchase	$	34,425
Maturing between 90 days and one year from purchase		23,255
Maturing more than one year from purchase		31,872

Total available-for-sale debt securities	$	89,552

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 nine months ended September 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 September 30, 2003. The line of credit requires us to achieve certain financial ratios and operating results. As of September 30, 2003, we were in compliance with the borrowing criteria and had $10.0 million of borrowing capability under this line of credit.

NOTE 6. EARNINGS PER SHARE

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 September 30,

		2003						2002

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

				(In thousands, except per share amounts)
Basic EPS		$	2,749		38,694	$	0.07	$	2,759		43,484	$	0.06

Effects of dilutive securities:
	Stock options		—		1,885		—		—		2,222		—

Diluted EPS		$	2,749		40,579	$	0.07	$	2,759		45,706	$	0.06


		Nine Months Ended September 30,

		2003						2002

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

				(In thousands, except per share amounts)
Basic EPS		$	16,537		39,669	$	0.42	$	36,467		44,127	$	0.83

Effects of dilutive securities:
	Stock options		—		1,256		—		—		3,281		—

Diluted EPS		$	16,537		40,925	$	0.40	$	36,467		47,408	$	0.77

For the three months ended September 30, 2003 and 2002, there were options to purchase approximately 3,502,464 and 3,030,000 shares, respectively, of common stock with exercise prices greater than the average market value of such common stock during the period. For the nine months ended September 30, 2003 and 2002, there were options to purchase approximately 4,143,629 and 705,000 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 nine months ended September 30, 2003 and 2002:


	Three Months Ended September 30,						Nine Months Ended September 30,

	2003			2002			2003			2002

	(In thousands)
Licensing fee from MediaTek settlement	$	—		$	—		$	45,000		$	—
Legal fee relate to MediaTek settlement		—			—			(515	)		—
Taiwanese tax exemption application fee		(1,500	)					(1,500	)
Interest income		472			830			1,894			2,710
Write-down of investments		—			(350	)		(1,986	)		(3,262	)
Vialta rental income		128			463			1,054			1,389
Other		241			495			525			419

Total non-operating income (loss)	$	(659	)	$	1,438		$	44,472		$	1,256

MediaTek Settlement

$45.0 million. The maximum total payments under the Settlement Agreement are $90.0 million. Income from MediaTek royalty payments resulting from future sales of products utilizing the licensed technology will be reported as revenues based on the number of units sold. As of September 30, 2003, no revenues have been recognized from MediaTek royalty payments. In connection with the Settlement Agreement, we recorded a one-time, pre-tax 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 initially accrued at 53% during the three months ended June 30, 2003 to provide for potential US income tax and Taiwanese withholding tax associated with this payment. In September 2003, we obtained a favorable tax-exempt ruling from the Taiwan government for the MediaTek settlement. Accordingly, we recorded a $5.9 million tax benefit during the three months ended September 30, 2003.

NOTE 8. COMPREHENSIVE INCOME

Comprehensive income is comprised of net income and the change in unrealized gain (loss) on marketable securities. Comprehensive income was $2.7 million for the three months ended September 30, 2003 and comprehensive income was $2.7 million for the three months ended September 30, 2002. The following table reconciles net income to comprehensive income for the three months and nine months ended September 30, 2003 and 2002:


	Three Months Ended September 30,						Nine Months Ended September 30,

	2003			2002			2003			2002

	(In thousands)
Net income	$	2,749		$	2,759		$	16,537		$	36,467
Change in unrealized gain (loss) on marketable equity securities		(39	)		(24	)		(103	)		1,508

Total comprehensive income	$	2,710		$	2,735		$	16,434		$	37,975

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


	September 30,		December 31,
	2003		2002

	(In thousands)
Unrealized gain on MosChip shares	$	187	$	180
Unrealized gain on C-Com shares		98		—
Unrealized gain on marketable equity securities		116		324

Accumulated other comprehensive income	$	401	$	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, Recordable, which includes digital video recorder (“DVR”) and recordable DVD players, Consumer digital media (formerly Consumer Digital Audio (“CDA”)), Digital Imaging and PC Related and Other (formerly PC Audio, Communication and Other) products.

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


	Three Months Ended				Nine Months Ended
	September 30,				September 30,

	2003		2002		2003		2002

	(In thousands)
DVD	$	19,178	$	37,815	$	46,818	$	136,343
VCD		18,626		17,612		49,476		67,901
Recordable		4,900		—		5,215		—


	Three Months Ended				Nine Months Ended
	September 30,				September 30,

	2003		2002		2003		2002

	(In thousands)
Consumer digital media		1,317		—		3,141		—
Digital Imaging		3,149		—		3,315		—
PC Related and Other		1,073		5,319		4,440		21,654

Total	$	48,243	$	60,746	$	112,405	$	225,898

NOTE 10. COMMITMENTS AND CONTINGENCIES

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


Year Ending December 31,		Amounts

		(In thousands)
	2003	$	650
	2004		541
	2005		89
	2006		34

	Total	$	1,314

As of September 30, 2003, our commitments to purchase inventory from the third-party contractors aggregated approximately $39.6 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. As of September 30, 2003, commitments under these arrangements totaled $1.2 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 Vialta and us 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 Vialta and us and allocates ownership rights generally along our product lines and those of 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 us 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 benefit plans that we have sponsored and maintained. Prior to the distribution, we 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 of our employees who held our options, based on our 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 are otherwise treated under terms that essentially mirror the provisions of our corresponding option held by the our employee.

The Tax Sharing and Indemnity Agreement allocates responsibilities for tax matters between Vialta and us. Vialta will indemnify us 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 matters relating to the properties we lease to Vialta, including the Fremont facility, which currently serves as the corporate headquarters of Vialta. On July 1, 2003, we entered into the First Amendment to the Amended and Restated Commercial Lease Agreement with Vialta to reduce the size of the Fremont facility subject to the lease and adjust the rental amount. To rent the Fremont facility pursuant to the amendment, effective July 1, 2003, Vialta pays us approximately $312,000 per year, payable in monthly installments of approximately $26,000.

The Master Confidential Disclosure Agreement provides that Vialta and us 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 we have 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 provide and charge Vialta on a per usage basis for IT hardware support, cafeteria and the corporate dormitory.

Our only other agreement with Vialta is a supply agreement under which we agree to give Vialta the best price available to any other customers. We supply 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 Vialta and us for the periods presented:


	TRANSACTION BETWEEN ESS AND VIALTA

	Three Months Ended					Nine Months Ended
	September 30,					September 30,

	2003		2002			2003		2002

	(In thousands)
Selling, general and administrative services provided to Vialta, net of charges from Vialta	$	12	$	11		$	62	$	(50	)
Lease charges to Vialta under Real Estate Matters Agreement		128		463			1,054		1,389
Product purchases from Vialta		—		(54	)		—		(54	)
Chip purchases by Vialta		176		1,334			195		1,403

Total charges to Vialta, net of charges from Vialta	$	316	$	1,754		$	1,311	$	2,688

We record in our Statements of Operation as an offset to our applicable operating expenses the fees we charge Vialta for the selling, general and administrative services we provide Vialta pursuant to the Master Transitional Services Agreement. We record in our Statements of Operations as other income the rent we charge Vialta pursuant to the Real Estate Matters Agreement and related agreements. Charges from us to Vialta under the Real Estate Matters Agreement are recorded in our Statements of Operations as other income. 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

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

	(In thousands, except percentage data)

Net revenues	$	48,243		$	31,011		$	33,151		$	47,554		$	60,746
Net revenues from Dynax Electronics	$	30,118		$	21,318		$	22,592		$	26,757		$	34,498
Percentage of net revenues from Dynax Electronics		62	%		69	%		68	%		56	%		57	%

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


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

	(In thousands, except percentage data)

Trade accounts receivable	$	39,734		$	31,350		$	28,041		$	29,523		$	30,018
Trade accounts receivable from Dynax Electronics	$	30,866		$	22,330		$	22,408		$	24,318		$	20,127
Percentage of trade accounts receivable from Dynax Electronics		78	%		71	%		80	%		82	%		67	%

NOTE 13. ACQUISITION AND RELATED CHARGES

Divio

On August 15, 2003, we acquired 100% of the outstanding shares of Divio for $27.1 million in cash plus transaction costs. Divio, formerly a privately held company based in Sunnyvale, CA, designs, manufactures and markets digital encoding semiconductor products. The acquisition expands our product lines in the digital consumer electronics market with advanced MPEG 1, 2 and 4 encoders and DV codecs for digital video recorders, digital still cameras and solid-state digital camcorders. 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 August 15, 2003, the effective date of the purchase. The results of operations are included in our condensed consolidated results of operations since the effective date of the purchase. There were no significant differences between our accounting policies and those of Divio.

We allocated the purchase price of $27.1 million and $2.9 million of legal, other professional expenses and other costs directly associated with the acquisition as follows based on managements’ estimates and an appraisal. The fair value of $1.3 million allocated to in-process research and development was expensed immediately during the three months ended September 30, 2003. Identifiable intangible assets of $6.3 million will be amortized over their respective estimated useful lives.

The total purchase price, including transaction costs of $30.0 million was preliminarily allocated as follows:


Purchase price allocation		Amounts

		(In thousands)
Tangible assets		$	1,661
Identifiable intangible assets			6,310
Goodwill			23,393

	Total assets acquired		31,364
Deferred tax liabilities			(2,587	)

	Net assets acquired		28,777
In process research and development			1,270

Total consideration		$	30,047

The following table lists the components of $6.3 million identifiable intangible assets and their respective useful lives.


		Estimated Fair
Identifiable intangible assets		Value		Estimated Life

		(In thousands)
Existing technology		$	4,790	3	years
Patents and core technology			820	3	years
Customer contacts and related relationships			510	3	years
Partner agreements and related relationships			110	3	years
Order backlog			80	3	months

	Total identifiable intangible assets	$	6,310

The following table summarizes the annual amortization expenses through 2006.


Amortization Expenses for	Amounts
Year Ending December 31,	(In thousands)

2003	$	858
2004		2,077
2005		2,077
2006		1,298

Total	$	6,310

Pictos

On June 9, 2003, we acquired 100% of the outstanding shares of Pictos for $27.0 million in cash. Pictos, formerly a privately held company based in Newport Beach, CA, 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 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 since the effective date of the purchase. There were no significant differences between our accounting policies and those of 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 managements’ estimates and an 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 cost of $27.4 million was preliminarily 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)
Existing technology		$	3,600	3	years
Patents and core technology			1,800	3	years
Customer relationships			1,080	3	years
Distributor relationships			90	2	years
Foundry agreement			930	2	years
Order backlog			350	6	months

	Total identifiable intangible assets	$	7,850

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 our unaudited pro forma results, reflecting the results of the Pictos and Divio acquisitions 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 September 30,						Nine Months Ended September 30,

		2003			2002			2003			2002

					(In thousands, except per share data)

Total revenues		$	47,760		$	64,418		$	116,129		$	232,416
Operating income (loss)		$	(5,649	)	$	(6,273	)	$	(30,269	)	$	20,914
Net income (loss)		$	2,594		$	(9,724	)	$	(539	)	$	17,929
Net income (loss) per share:
	Basic	$	0.07		$	(0.22	)	$	(0.01	)	$	0.41
	Diluted	$	0.06		$	(0.21	)	$	(0.01	)	$	0.38

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 remained available for repurchase under previously announced programs, on the same terms and conditions as those prior repurchase programs.

As of September 30, 2003, we have an aggregate of 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. We did not receive any of the proceeds from the sale of shares by the selling shareholders: Annie M.H. Chan, the Annie M.H. Chan Living Trust and the Shiu Leung Chan &

Annie M.H. Chan Gift Trust. 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-month 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 nine months ended September 30, 2003 and 2002.


	Three Months Ended September 30,						Nine Months Ended September 30,

	2003			2002			2003			2002

	(In thousands)

Beginning balance	$	656		$	1,519		$	550		$	543
Accruals for warranties issued during the period		—			—			342			990
Settlements made during the period		(41	)		(987	)		(277	)		(1,001	)

Ending balance	$	615		$	532		$	615		$	532

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 for 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, we were given a right to receive 5,578,571 shares of C-Com common stock in exchange for our investment in Broadmedia. During the three months ended September 30, 2003, we received 3,905,000 shares of C-Com common stock. The remaining 1,673,571 shares will be received over the next four years. During the three months ended June 30, 2003, we recorded a pre-tax non-operating loss of $1.6 million to reflect the fair market value of the C-Com shares.

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 (“VIEs”) 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 VIEs created or acquired after January 31, 2003. For arrangements entered into with VIEs created prior to February 1, 2003, the provisions of FIN 46 were originally effective as of July 1, 2003, however, the FASB subsequently delayed the effective date of this provision until the first interim or annual period ending after December 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 entered 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.

NOTE 18. SUBSEQUENT EVENTS

In October 2003, pursuant to a License Agreement and Mutual Release we signed with MediaTek on June 11, 2003, we received cash of $55.0 million from MediaTek, of which $45.0 million was for the initial license fee and $10.0 million was for the first and the second installment of the quarterly royalty pre-payments.

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 terms 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 audited consolidated financial statements and notes thereto in our annual report on Form 10-K for the year ended December 31, 2002.

OVERVIEW

We were 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”). On August 15, 2003, we acquired 100% of the outstanding shares of Divio, Inc., a California corporation (“Divio”). 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 our gross margins.

Goodwill and Other Intangible Assets

Effective January 1, 2002, we adopted Statement of Financial Accounting Standard 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 and Divio 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

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.

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 entered 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 September 30,						Nine Months Ended September 30,

		2003			2002			2003			2002

Net revenues			100.0	%		100.0	%		100.0	%		100.0	%
Cost of revenues			69.0			75.2			69.1			62.6

	Gross profit		31.0			24.8			30.9			37.4
Operating expenses:
	Research and development		20.9			11.8			21.1			9.1
	In-process research and development		2.6			—			2.4			—
	Selling, general and administrative		18.4			10.6			19.7			12.3

Operating income (loss)			(10.9	)		2.4			(12.3	)		16.0
Non-operating income (loss), net			(1.4	)		2.4			39.6			0.5

Income (loss) before provision for (benefit from) income taxes			(12.3	)		4.8			27.3			16.5
Provision for (benefit from) income taxes			(18.0	)		0.3			12.6			0.4

Net Income			5.7	%		4.5	%		14.7	%		16.1	%

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

Net Revenues

Net revenues were $48.2 million for the three months ended September 30, 2003, a decrease of $12.5 million, or 20.6%, from net revenues of $60.7 million for the three months ended September 30, 2002, primarily due to the decrease in sales of our DVD products.

The following table summarizes revenues by major product category:


	Percentage of Net Revenues
	Three Months Ended,
	September 30,

	2003			2002

DVD		40	%		62	%
VCD		39	%		29	%
Recordable		10	%		—
Consumer digital media		3	%		—
Digital Imaging		6	%		—
PC Related and Other		2	%		9	%

Total		100	%		100	%

DVD revenues were $19.2 million for the three months ended September 30, 2003, a decrease of $18.6 million, or 49.2%, from revenues of $37.8 million for the three months ended September 30, 2002, primarily due to lower unit sales and decreased average selling prices (“ASP”) per unit. For the three months ended September 30, 2003, DVD unit sales decreased by 24.1% and DVD ASP per unit decreased by 33.2% from the three months ended September 30, 2002. We believe this decrease resulted from the entry in the third quarter of 2002 of MediaTek, a then new competitor, who introduced to the marketplace a DVD chip that we believed infringed our intellectual property rights. See Non-operating Income, Net under “Comparison of Nine Months Ended September 30, 2003 and September 30, 2002.”

VCD revenues were $18.6 million for the three months ended September 30, 2003, an increase of $1.0 million, or 5.7%, from revenues of $17.6 million for the three months ended September 30, 2002, primarily due to an increase in volume, partially offset by a lower ASP.

Recordable, or digital video recorder and recordable DVD player, revenues were $4.9 million for the three months ended September 30, 2003 and $0 for the three months ended September 30, 2002. We introduced our Recordable products to the market during the first quarter of 2003.

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

Digital Imaging product revenues were $3.1 million for the three months ended September 30, 2003 and $0 for the three months ended September 30, 2002. These revenues were from Pictos which we acquired in June 2003.

PC Related and Other revenues were $1.1 million for the three months ended September 30, 2003, a decrease of $4.2 million, or 79.2%, from revenues of $5.3 million for the three months ended September 30, 2002, primarily due to lower unit sales and ASP per unit. For the three months ended September 30, 2003, unit sales decreased by 67.5% and ASP per unit decreased by 28.5% from the three months ended September 30, 2002. We are no longer emphasizing this product line, which is in a legacy market characterized by unit and unit price declines.

International revenues accounted for approximately 99.6% of net revenues for the three months ended September 30, 2003 and 97.7% of net revenues for the three months ended September 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 Profit

Gross profit was $15.0 million, or 31.0% of net revenues, for the three months ended September 30, 2003, compared to $15.1 million, or 24.8% of net revenues, for the three months ended September 30, 2002. Gross profit as a percentage of net revenues increased primarily due to a net decrease in the provision for inventory reserves of approximately $10.5 million. Net inventory reserves released during the three months ended September 30, 2003 amounted to $1.2 million. Reserves were released as a result of the sale of product that had previously been fully reserved. Gross profit for the three months ended September 30, 2002 includes a $9.3 million charge principally due to lower of cost or market write down of older VCD products. Excluding the effects of inventory reserves, gross profit as a percentage of net revenues for the three months ended September 30, 2003 decreased from the same period last year primarily due to lower average selling prices for DVD products.

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 lives. We believe that in order to maintain or increase gross profit, 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 $10.1 million, or 20.9% of net revenues, for the three months ended September 30, 2003 compared to $7.2 million, or 11.8% of net revenues, for the three months ended September 30, 2002. The increase in research and development expenses primarily resulted from the increase of $1.4 million of salaries and fringe benefits due to a higher headcount, $0.4 million of mask expenses due to new tapeouts for new products, $0.4 million of common expenses allocation due to a higher headcount and $0.2 million of facility expenses resulted from the Pictos and Divio acquisitions. The overall increase in headcount was mainly due to the Pictos and Divio acquisitions.

In-Process Research and Development

In-process research and development expense was $1.3 million, or 2.6% of net revenues, for the three months ended September 30, 2003 compared to $0 for the three months ended September 30, 2002. This reflects the write-off of in-process research and development expenses of the encoding products due to the acquisition of Divio.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $8.9 million, or 18.4% of net revenues, for the three months ended September 30, 2003 compared to $6.5 million, or 10.6% of net revenues, for the three months ended September 30, 2002. The 36.9% increase in selling, general and administrative expenses from the three months ended September, 2002 was primarily due to $1.9 million in expenses related to the Pictos and Divio acquisitions, and $0.5 million of directors’ and officers’ insurance.

Non-operating Income (Loss), Net

Net non-operating loss was ($0.7) million for the three months ended September 30, 2003 compared to income of $1.4 million for the three months ended September 30, 2002. For the three months ended September 30, 2003, net non-operating loss consisted primarily of interest income of $0.5 million and rental income of $0.1 million from Vialta, offset by the $1.5 million expense related to the Taiwanese withholding tax exemption filing for the MediaTek settlement payments.

Provision for Income Taxes

Our effective tax benefit rate was 146% for the three months ended September 30, 2003 compared to 5% effective tax rate for the three months ended September 30, 2002. The principal reason for the decrease in our tax rate from our historic effective tax rate of 5% was primarily the release of tax reserves related to (i) the favorable ruling by the Taiwanese government which exempted license and royalty fees paid to us by MediaTek from Taiwanese withholding taxes, and (ii) the expiration of the statute of limitations on our 1999 tax return. The 5% tax rate for the three months ended September 30, 2002 was primarily due to the lower foreign tax rate on earnings from our foreign subsidiary, which were considered to be permanently reinvested.

Net Income

Net income for the three months ended September 30, 2003 was $2.7 million compared to $2.8 million for the three months ended September 30, 2002.

COMPARISON OF NINE MONTHS ENDED SEPTEMBER 30, 2003 AND SEPTEMBER 30, 2002

Net Revenues

Net revenues were $112.4 million for the nine months ended September 30, 2003, a decrease of $113.5 million or 50.2% compared to $225.9 million for the nine months ended September 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
	Nine Months Ended
	September 30,

	2003			2002

DVD		42	%		61	%
VCD		44	%		30	%
Recordable		4	%		—
Consumer digital media		3	%		—
Digital Imaging		3	%		—
PC Related and Other		4	%		9	%

Total		100	%		100	%

DVD revenues were $46.8 million for the nine months ended September 30, 2003, a decrease of $89.5 million, or 65.7%, from revenues of $136.3 million for the nine months ended September 30, 2002 primarily due to lower unit sales and lower ASP per unit. For the nine months ended September 30, 2003, unit sales decreased by 46.2% and ASP decreased by 36.2% from the nine months ended September 30, 2002. We believe this decrease resulted from the entry in the third quarter of 2002 of MediaTek, a then new competitor, who introduced to the marketplace a DVD chip that we believed infringed our intellectual property rights. See Non-operating Income, Net, below.

VCD revenues were $49.5 million for the nine months ended September 30, 2003, a decrease of $18.4 million, or 27.1%, from revenues of $67.9 million for the nine months ended September 30, 2002, primarily due to lower unit sales and ASP per unit. For the

nine months ended September 30, 2003, unit sales decreased by 9.1% and ASP per unit decreased by 19.8% from the nine months ended September 30, 2002.

Recordable, or digital video recorder and recordable DVD player, revenues were $5.2 million for the nine months ended September 30, 2003 and $0 for the nine months ended September 30, 2002. We introduced our Recordable products to the market during the first quarter of 2003.

Consumer digital media products revenues were $3.1 million for the nine months ended September 30, 2003 and $0 for the nine months ended September 30, 2002. We introduced our CDA products to the market during the third quarter of 2002.

Digital Imaging products revenues were $3.3 million for the nine months ended September 30, 2003 and $0 for the nine months ended September 30, 2002. The revenues were from Pictos which we acquired in June 2003.

PC Related and Other revenues were $4.4 million for the nine months ended September 30, 2003, a decrease of $17.3 million, or 79.7%, from revenues of $21.7 million for the nine months ended September 30, 2002, primarily due to a decrease in both unit sales and ASP per unit. For the nine months ended September 30, 2003, unit sales decreased by 73.0% and ASP per unit decreased by 23.9% from the nine months ended September 30, 2002. We are no longer emphasizing this product line, which is in a legacy market characterized by unit and unit price declines.

International revenues accounted for approximately 99.5% of net revenues for the nine months ended September 30, 2003 and 98.9% of net revenues for the nine months ended September 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 Profit

Gross profit was $34.8 million, or 30.9% of net revenues, for the nine months ended September 30, 2003, compared to $84.6 million, or 37.4% of net revenues, for the nine months ended September 30, 2002. Gross profit decreased primarily due to the decrease in revenues. Net inventory reserves released during the nine months ended September 30, 2003 amounted to $5.9 million. The release resulted primarily from the sale of products that had previously been fully reserved. For the nine months ended September 30, 2002, $10.9 million of inventory reserves were charged to cost of revenues. Excluding the effects of inventory reserves, gross profit as a percentage of net revenues for the nine months ended September 30, 2003 decreased from the same period last year primarily due to lower ASP for DVD and VCD products.

Research and Development

Research and development expenses were $23.7 million, or 21.1% of net revenues, for the nine months ended September 30, 2003 compared to $20.6 million, or 9.1% of net revenues, for the nine months ended September 30, 2002. The increase in research and development expenses primarily resulted from the increase of $1.2 million of salaries and fringe benefits due to a higher headcount, $0.7 million of common expenses allocation due to a higher headcount, $0.3 million of mask expenses due to new tapeouts for new products, $0.2 million of non-recurring engineering expenses related to the development of the next generation of VCD products, and $0.2 million of facility expenses resulted from the Pictos and Divio acquisitions. The overall increase in headcount was mainly due to the Pictos and Divio acquisitions. 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 the Pictos and Divio acquisitions were $3.5 million through September 30, 2003.

In-Process Research and Development

In-process research and development expense was $2.7 million, or 2.4% of net revenues, for the nine months ended September 30, 2003 compared to $0 for the nine months ended September 30, 2002. This reflects the write-off of in-process research and development expenses of the digital imaging and encoding products due to the acquisitions of Pictos and Divio.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $22.2 million, or 19.7% of net revenues, for the nine months ended September 30, 2003 compared to $27.9 million, or 12.3% of net revenues, for the nine months ended September 30, 2002. The 20.4% decrease in selling, general and administrative expenses from the nine months ended September 30, 2002 primarily resulted from a $6.0 million decrease in funding for the marketing development program, which was cancelled and replaced by a rebate program, $1.5 million of outside commission expenses due to lower sales and $0.9 million of common expenses allocations. The decrease was partially offset by the increase of $1.5 million of insurance premium mainly for the directors’ and officers’ insurance coverage, $1.0 million of legal and accounting expenses resulted from the Pictos and Divio acquisitions, and $0.7 million of intangible asset amortizations resulted from the Pictos and Divio acquisitions.

Non-operating Income, Net

Net non-operating income was $44.5 million for the nine months ended September 30, 2003 compared to $1.3 million for the nine months ended September 30, 2002. For the nine months ended September 30, 2003, net non-operating income consisted primarily of a license fee payment of $45.0 million from MediaTek, interest income of $1.9 million and rental income of $1.0 million from Vialta, partially offset by the $2.0 million write-off on our investment in Broadmedia, Inc., and the $1.5 million expense from the Taiwanese withholding tax exemption filing.

On June 11, 2003, we entered into a License Agreement and Mutual Release (the “Settlement Agreement”) with MediaTek Incorporation (“MediaTek”) relating to a copyright infringement lawsuit. Under the terms of the Settlement Agreement, both sides terminated all claims against each other and MediaTek received a non-exclusive worldwide license of our proprietary DVD user interface and other key DVD software. Under the Settlement Agreement, MediaTek paid us a one-time license fee of $45.0 million related to sales of certain DVD products and would pay ongoing royalties with a quarterly cap of $5.0 million and lifetime cap of $45.0 million. The maximum total payments under the Settlement Agreement are $90.0 million. Income from MediaTek royalty payments resulting from future sales of products utilizing the licensed technology will be reported as revenues based on the number of units sold. As of September 30, 2003, no revenues have been recognized from MediaTek royalty payments. In connection with the Settlement Agreement, we recorded a one-time, pre-tax 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 initially accrued at 53% during the three months ended June 30, 2003 to provide for potential US income tax and Taiwanese withholding tax associated with this payment. In September 2003, we obtained a favorable tax-exempt ruling from the Taiwan government for the MediaTek settlement. Accordingly, we recorded a $5.9 million tax benefit during the three months ended September 30, 2003.

Provision for Income Taxes

Our effective tax rate was 46% for the nine months ended September 30, 2003 compared to 5% for the nine months ended September 30, 2002. The principal reason for the increase in our tax rate from our historic effective tax rate of 5% was primarily due to the MediaTek settlement being subject to U.S. income tax. The 5% tax rate for the nine months ended September 30, 2002 was 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 nine months ended September 30, 2003 was $16.5 million compared to $36.5 million for the nine months ended September 30, 2002. The $20.0 million decrease was primarily due to lower gross profit resulting from lower sales volume and lower ASPs, offset by the license fee payment from MediaTek.

Acquisitions and Related Charges

Divio

and liabilities assumed were included in our condensed consolidated balance sheet as of August 15, 2003, the effective date of the purchase. The results of operations are included in our condensed consolidated results of operations since the effective date of the purchase. There were no significant differences between our accounting policies and those of Divio.

The total purchase price, including transaction costs of $30.0 million was preliminarily allocated as follows:


Purchase price allocation		Amounts

		(In thousands)
Tangible assets		$	1,661
Identifiable intangible assets			6,310
Goodwill			23,393

	Total assets acquired		31,364
Deferred tax liabilities			(2,587	)

	Net assets acquired		28,777
In process research and development			1,270

Total consideration		$	30,047

Pictos

On June 9, 2003, we acquired 100% of the outstanding shares of Pictos for $27.0 million in total consideration. Pictos, formerly a privately held company based in Newport Beach, CA, 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 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 since the effective date of the purchase. There were no significant differences between our accounting policies and those of 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 managements’ estimates and an 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 cost of $27.4 million was preliminarily 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 September 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 us. We recorded approximately $0.6 million and $0.6 million as compensation expenses under this guarantee, for each of the three months ended September 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 September 30, 2003 were approximately $15.2 million. The product was not completed until March of 2002. No significant revenues have been recognized to date nor were significant revenues 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 September 30, 2003, net unamortized intangible assets relating to the NetRidium acquisition were approximately $500,000, including $400,000 of goodwill and $100,000 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 September 30, 2003, we had cash, cash equivalents and short-term investments of $104.0 million and working capital of $140.3 million. At September 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 September 30, 2003 and as of the filing date of this Report, we are in compliance with the borrowing criteria and have $10.0 million of borrowing capability under this line of credit.

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. We did not receive any of the proceeds from the sale of shares by the selling shareholders. Net of underwriting discount, we received proceeds of $45,550,000 before expenses.

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 and its ancillary agreements. See Note 11, “Related Party Transactions” to the consolidated financial statements.”

Net cash used in operating activities was $6.5 million for the nine months ended September 30, 2003 and net cash provided by operating activities was $42.9 million for the nine months ended September 30, 2002. The net cash used in operating activities for the nine months ended September 30, 2003 was primarily attributable to an increase in receivable-MediaTek of $50.0 million and, an increase in accounts receivables, net of $8.6 million, partially offset by net income of $16.5 million, an increase in accounts payable and accrued expenses of $8.9 million, depreciation and amortization of $4.5 million, write-down of investments of $2.0 million, a decrease in inventories, net of $5.2 million, an expense for in-process research and development of $2.7 million, and an increase in income tax payable and deferred income taxes of $11.4 million. The net cash provided by operating activities for the nine months ended September 30, 2002 was primarily attributable to a net income of $36.5 million, depreciation and amortization of $5.1 million, write-down of investments of $3.3 million, a decrease in accounts receivable, net of $11.1 million and an increase in income tax payable and deferred income taxes of $3.9 million, offset by an increase in inventories, net of $7.4 million and a decrease in accounts payable and accrued expenses of $7.4 million.

Net cash used in investing activities was $54.8 million for the nine months ended September 30, 2003 and $38.5 million for the nine months ended September 30, 2002. The net cash used in investing activities for the nine months ended September 30, 2003 was primarily attributable to the net cash paid for the acquisitions of Pictos and Divio of $51.9 million, the purchase of property, plant and equipment of $3.5 million, the purchase of short-term and long-term investments of $20.5 million and $5.0 million, respectively, offset by proceeds from sales of short-term investments of $26.1 million. The net cash used in investing activities for the nine months ended September 30, 2002 was primarily attributable to the purchase of short-term and long-term investments of $52.8 million and $5.2 million, respectively and the purchase of property, plant and equipment of $0.9 million, offset by proceeds from sales of short-term and long-term investments of $19.0 million and $0.4 million, respectively, and proceeds from the sales of Cisco stock of $1.0 million.

Net cash used in financing activities was $27.9 million for the nine months ended September 30, 2003, and net cash provided by financing activities was $13.4 million for the nine months ended September 30, 2002. The net cash used in financing activities for the nine months ended September 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 $1.4 million. The net cash provided by financing activities for the nine months ended September 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 $8.5 million, partially offset by cash paid for repurchase of common stock of $40.3 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 September 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, and lease certain testing equipment from third parties. Future minimum rental payments under these operating leases are as follows:


Year Ending December 31,	Amounts

	(In thousands)
2003	$	650
2004		541
2005		89
2006		34

Total	$	1,314

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

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 remained available for repurchase under previously announced programs, on the same terms and conditions as those prior repurchase programs. As of September 30, 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) (“Dynax Electronics”) were approximately 62% and 57% of our net revenues as of the three months ended September 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 September 30, 2003, sales to our top five end customers (including end-customers that buy our products from our distributor 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 September 30, 2003, we had 50 patents granted in the United States. These patents will expire over time commencing in 2008 and ending in 2021. In addition, as of September 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. See Part II, Item 1, Legal Proceedings.

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, Taiwan, Korea, Japan, Singapore and Turkey. During the second quarter of 2003, sales to customers in China, Hong Kong and Taiwan were in excess of 82% 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;

• 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 September 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.

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 March 12, 2001, we filed a complaint in the U.S. District Court for the Northern District of California (Case No. C01-20208) against Brent Townshend, (“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 Townshend to provide us 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, we filed an amended complaint. On September 27, 2002, Townshend filed an answer and counterclaims, alleging patent infringement. We filed our 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. Analog Devices has settled its claims with Townshend. The remaining parties have agreed to mediation, which began on August 1, 2003. Discovery is currently on hold. We will vigorously pursue this litigation.

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. We filed a motion to dismiss on June 18, 2003, which was granted by the court on October 3, 2003. The plaintiffs’ were granted leave to amend the complaint, and their second amended consolidated complaint is now due October 31, 2003. We will again file a motion to dismiss the second amended complaint. Discovery remains on hold and no trial date had been set.

Although we believe that we and our officers and directors have meritorious defenses to these 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.

Items 2, 3, 4 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 August 15, 2003, by and among Registrant, Divio Technologies, Inc. and Divio Acquisition Corporation, incorporated herein by reference to Exhibit 2.1 to the Registrant’s Current Report on Form 8-K filed on September 2, 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.

10.52			Addendum to the License Agreement and Mutual Release dated July 8, 2003 by and between ESS Technology, Inc., ESS Technology International, Inc. and MediaTek Incorporation.*

10.53			Amendment Number One to Loan Agreement by and between ESS Technology, Inc. and U.S. Bank National Association dated July 17, 2003.

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.

Confidential treatment requested as to certain portions of this agreement.

(b) Reports on Form 8-K:

On July 30, 2003, we filed a Current Report on Form 8-K under Item 12 furnishing our consolidated financial results for the second quarter of fiscal year 2003. On August 25, 2003, we filed an 8-K/A to provide the financial statements and the pro forma financial information related to the Pictos acquisition. On September 2, 2003 we filed an 8-K announcing our acquisition of Divio Technologies, Inc. pursuant to the Agreement and Plan of Merger dated August 15, 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: November 14, 2003	By:	/s/ Robert L. Blair Robert L. Blair
		President and Chief
		Executive Officer

Date: November 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 August 15, 2003, by and among Registrant, Divio Technologies, Inc. and Divio Acquisition Corporation, incorporated herein by reference to Exhibit 2.1 to the Registrant’s Current Report on Form 8-K filed on September 2, 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.

10.52			Addendum to the License Agreement and Mutual Release dated July 8, 2003 by and between ESS Technology, Inc., ESS Technology International, Inc. and MediaTek Incorporation.*

10.53			Amendment Number One to Loan Agreement by and between ESS Technology, Inc. and U.S. Bank National Association dated July 17, 2003.

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.

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;

•		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.