UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended June 30, 2004.

OR

For the transition period from: to

Commission File Number: 0-26660

ESS TECHNOLOGY, INC.

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 July 27, 2004 the registrant had 39,503,853 of common stock outstanding.

ESS TECHNOLOGY, INC.

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (unaudited)

ESS TECHNOLOGY, INC.

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

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ESS TECHNOLOGY, INC.

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

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ESS TECHNOLOGY, INC.

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

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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 analog and digital processor chips, imaging sensor chips, digital amplifiers, and camera lens modules. Our digital processor chips are the primary processors driving digital video and audio devices, including DVD, Video CD (“VCD”), consumer digital audio players, and digital media players. Our imaging chips utilize advanced Complimentary Metal Oxide Semiconductor (“CMOS”) sensor technology to capture an image for cellular camera phone applications. Our camera lens modules are made up of a lens, image sensor chip, housing and flex cable necessary to provide camera capabilities to electronic devices such as cellular phones and Personal Digital Assistants (“PDAs”). Our digital amplifiers boost the digital sound to a level required to drive loudspeakers, in such applications as DVD and CD players, home theater systems, audio receivers, boom boxes and television sets. We have also developed encoding processors to address the growing demand for digital video recorders (“DVRs”) and recordable DVD players. We believe that multi-featured DVD, DVR and recordable DVD players will serve as a platform for the digital home system (“DHS”), integrating various digital home entertainment and information delivery products into a single box. We are also a supplier of chips for use in modems, other communication devices, and PC audio products. Our chips use multiple processors and a programmable architecture that enable us to offer a broad array of features and functionality. We focus on our design and development strengths and outsource all of our chip fabrication and assembly as well as the majority of our test operations.

     We market our products worldwide through our direct sales force, distributors and sales representatives. Substantially all of our sales are to customers in Hong Kong, Taiwan, China, Japan, Singapore, Korea 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. See Item 2, “Factors That May Affect Future Results — We have significant international sales and operations that are subject to the special risks of doing business outside the United States.”

     We were incorporated in California in 1984 and became a public company in 1995. 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 3, “Significant Business Combinations.”

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, 2003 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.

     The condensed consolidated financial statements include the financial statements of ESS Technology, Inc. and all of its subsidiaries. The financial condition and results of operations for the three months ended and six months ended June 30, 2004 and 2003 include the results of acquired subsidiaries from the effective date of their respective acquisitions. All significant intercompany transactions and balances are eliminated in consolidation.

Use of estimates

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

Revenue Recognition

     Except for sales to distributors, revenue from product sales 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. For products sold to certain distributors with certain rights of return and allowances, revenue is deferred until the distributor resells the products to a third party.

     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 Incorporation (“MediaTek”) royalties for the sale of products utilizing licensed technology is reported as revenue based on the number of units sold as reported to us by MediaTek.

Reclassifications

     Certain comparative amounts have been reclassified to conform with current period presentations.

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, except as otherwise provided by law. 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. The enrollment date is on the first business day of May and November of each year. Unless otherwise specified, the purchase dates under the Purchase Plan are on the last business day of April or October. We provide additional pro forma disclosures as required under Statement of Financial Accounting Standard (“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.”

     The Purchase Plan permits eligible employees to acquire shares of our common stock through payroll deductions at a price equal to the lower of 85% of the fair market value of our common stock at the beginning of the offering period or on the purchase date. The Purchase Plan provides a 24-month rolling period beginning on each enrollment date and the purchase price is automatically adjusted to reflect the lower enrollment price. The Purchase Plan, as most recently amended on May 29, 2003, authorizes the aggregate issuance of 1,425,000 shares under the Purchase Plan. As of June 30, 2004, 893,210 shares have been issued under the Purchase Plan.

     Our reported net income and pro forma net income (loss) 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 at the grant dates, as prescribed in SFAS 123. The fair value of each option granted under our stock option plans is estimated on the date of grant.

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     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 periodically, the above pro forma disclosures are not representative of pro forma effects on reported net income for future periods.

NOTE 3. SIGNIFICANT BUSINESS COMBINATIONS

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, California, 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 a 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 consolidated balance sheet as of August 15, 2003, the effective date of the purchase. The results of operations of Divio have been included in our 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 $27.1 million purchase price and $3.1 million of legal, other professional expenses and other costs directly associated with the acquisition as follows, based on management’s estimates and appraisal:

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

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     Amortization expenses related to those identifiable intangible assets were $519,000 for the three months ended June 30, 2004 and $1,038,000 for the six months ended June 30, 2004. The following table summarizes the annual amortization expenses through 2006:

Pictos

     On June 9, 2003, we acquired 100% of the outstanding shares of Pictos for $27.0 million in cash plus transaction costs. Pictos, formerly a privately held company based in Newport Beach, California, designs, manufactures and markets digital imaging semiconductor products. The acquisition expands our business into 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 a purchase combination under SFAS 141. Accordingly, the estimated fair value of assets acquired and liabilities assumed were included in our consolidated balance sheet as of June 9, 2003, the effective date of the purchase. The results of operations have been included in our 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 $453,000 of legal and other professional expenses directly associated with the acquisition as follows, based on management’s estimates and appraisal:

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

     Amortization expenses related to these identifiable intangible assets were $668,000 and $1,336,000 for the three months ended and six months ended June 30, 2004, respectively. The following table summarizes the annual amortization expenses through 2006:

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     Summarized below are our unaudited pro forma results, reflecting the results of the Pictos and Divio acquisitions had they been consolidated from January 1, 2003. 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.

     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 period indicated or of future results of operations of the combined companies.

NOTE 4. BALANCE SHEET COMPONENTS

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     For the three months ended June 30, 2004 and 2003, depreciation expenses were approximately $1.3 million and $1.1 million, respectively. For the six months ended June 30, 2004 and 2003, depreciation expenses were approximately $2.6 million and $2.0 million, respectively.

     We include warranty reserve under other accrued liabilities. We provide standard warranty coverage for twelve months. 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 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 ended and six months ended June 30, 2004 and 2003:

     NOTE 5. MARKETABLE SECURITIES

     The amortized costs and estimated fair value of securities available-for-sale as of June 30, 2004 and December 31, 2003 are as follows:

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     The contractual maturities of debt securities classified as available-for-sale as of June 30, 2004 regardless of the consolidated balance sheet classification are as follows:

     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 three months ended June 30, 2004 and 2003 were not material to our financial position or results of operations.

NOTE 6. INVESTMENTS

Best Elite International Limited

     In January 2003, we acquired 4,545,400 shares of Convertible Non-Cumulative Preference Series B shares of Best Elite International Limited (“Best Elite”) for approximately $5,000,000 in cash. In January 2004, we acquired an additional 4,545,455 shares of Convertible Non-Cumulative Preference Series B-1 of Best Elite for approximately $5,000,000 in cash, on the same terms and price as the initial investment. Our investments represent less than a 1.3% equity interest in Best Elite on a fully diluted basis. The investments were 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.

NOTE 7. OTHER COMPREHENSIVE INCOME

     Comprehensive income is comprised of net income and the change in unrealized gain (loss) on marketable securities. Total comprehensive income was $2.1 million and $16.0 million for the three months ended June 30, 2004 and 2003, respectively. Total comprehensive income was $5.1 million and $13.7 million for the six months ended June 30, 2004 and 2003, respectively. The following table reconciles net income to comprehensive income for the three months ended and six months ended June 30, 2004 and 2003:

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NOTE 8. NON-OPERATING INCOME, NET

     The following table lists the major components of non-operating income for the three months ended and six months ended June 30, 2004 and 2003:

MediaTek Settlement

     On June 11, 2003, we entered into a License Agreement and Mutual Release (the “Settlement Agreement”) with MediaTek Incorporation relating to a copyright infringement lawsuit. Under the terms of the Settlement Agreement, both parties 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 is required to 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 is reported as revenues based on the number of units sold. During the three months ended June 30, 2004, $5.0 million in revenues were recognized from MediaTek royalty payments. During the six months ended June 30, 2004, $10.0 million in revenues were recognized from MediaTek royalty payments.

Write-down of Investment

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

NOTE 9. INCOME TAXES

     Our effective tax rate was 6.6% for the three months ended June 30, 2004 compared to 59% effective tax rate for the three months ended June 30, 2003. The principal reason for the difference in our tax rate for the two periods is the various income and withholding taxes accrued during the three months ended June 30, 2003 for the one time $45.0 million license fee payment under the MediaTek settlement. See Note 11. The reason for the increase in our tax rate for the three months ended June 30, 2004 from our historic effective tax rate of 5% is the change in geographic segmentation of income as a result of the mix of new products. The 6.6% tax rate for the current quarter is lower than the statutory federal rate primarily due to the lower foreign tax rate on earnings from our foreign subsidiaries, which are considered to be permanently reinvested.

     Our effective tax rate was 6.6% for the six months ended June 30, 2004 compared to 62% for the six months ended June 30, 2003. The principal reason for the difference in our tax rate for the two periods is the various income and withholding taxes accrued during

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the six months ended June 30, 2003 for the one time $45.0 million license fee payment under the MediaTek settlement. The reason for the increase in our tax rate for the six months ended June 30, 2004 from our historic effective tax rate of 5% is the change in geographic segmentation of income as a result of the mix of new products. The 6.6% tax rate for the six months ended June 30, 2004 is lower than the statutory federal rate primarily due to the lower foreign tax rate on earnings from our foreign subsidiaries, which are considered to be permanently reinvested.

NOTE 10. 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 EPS, 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:

     For the three months ended June 30, 2004 and 2003, there were options to purchase approximately 3,762,674 and 3,824,896 shares, respectively, of common stock with exercise prices greater than the average market value of such common stock during the period. For the six months ended June 30, 2004 and 2003, there were options to purchase approximately 1,668,816 and 4,185,806 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 because the effect would be anti-dilutive.

NOTE 11. BUSINESS SEGMENT INFORMATION AND CONCENTRATION OF CERTAIN RISKS

Business Segment

     We operate in one reportable business segment: the semiconductor segment. We design, develop, support and market highly integrated analog and digital processor chips, imaging sensor chips, digital amplifiers and camera lens modules.

     The following table summarizes revenues for the three months ended and six months ended June 30, 2004 and 2003 by major product category:

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     DVD revenue includes revenue from sales of DVD decoder chips. VCD revenue includes revenue from sales of VCD and SVCD chips. Digital imaging revenue includes revenue from sales of image sensor chips, image processor chips and camera lens modules. Recordable revenue includes revenue from sales of integrated encoder and decoder chipsets. Royalty revenue consists of MediaTek royalty payments.

MediaTek Settlement

     On June 11, 2003, we entered into a License Agreement and Mutual Release (the “Settlement Agreement”) with MediaTek relating to a copyright infringement lawsuit. Under the terms of the Settlement Agreement, both parties 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 is required to 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 is reported as revenues based on the number of units sold. During the three months ended June 30, 2004, $5.0 million in revenues were recognized from MediaTek royalty payments. During the six months ended June 30, 2004, $10.0 million in revenues were recognized from MediaTek royalty payments.

Significant Customer

     We sell to both direct customers and distributors. We use both a direct sales force as well as sales representatives to help us sell to our direct customers. During the three months ended June 30, 2004 and 2003, except Dynax Electronics (HK) LTD (“Dynax Electronics”) as described below, no other single customer accounted for more than 10% of net revenues. During the six months ended June 30, 2004 and 2003, except for Dynax Electronics, no other single customer accounted for more than 10% of net revenues.

Transactions With Dynax Electronics

     We also sell our products through distributors. 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 ESS 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:

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     The following table summarizes percentage of our trade accounts receivable from Dynax Electronics as of each of the following dates:

     During the quarters ended June 30, 2004 and 2003, except for Dynax Electronics, no other single customer accounted for more than 10% of trade accounts receivable. During the six months ended June 30, 2004 and 2003, except for Dynax Electronics, no other single customer accounted for more than 10% of trade accounts receivable.

NOTE 12. RELATED PARTY TRANSACTIONS WITH VIALTA, INC.

     In August 2001, we completed the spin-off of our majority-owned subsidiary, Vialta, Inc. (“Vialta”), to our shareholders. Vialta develops and markets consumer electronics products. We continue to sell semiconductors, lease a facility and provide certain services to Vialta. The following is a summary of major transactions between Vialta and us for the periods presented:

     As of June 30, 2004, we had a receivable from Vialta of $259,000.

     Fred S.L. Chan, our Chairman of Board of Directors, also serves as the Chairman of the Board for Vialta. Each company compensates Fred S.L. Chan separately.

NOTE 13. STOCK REPURCHASE

     Our board of directors authorized the repurchase of 5.2 million shares of our common stock. During the three months ended and six months ended June 30, 2004, we did not repurchase any shares. During the three months ended June 30, 2003, we repurchased 760,323 shares of our common stock for an aggregate price of $4.9 million. During the six months ended June 30, 2003, we repurchased 4,859,936 shares of our common stock for an aggregate price of $29.3 million. Upon repurchase, these shares were retired and no longer deemed outstanding.

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NOTE 14. COMMITMENTS AND CONTINGENCIES

     The following table sets forth the amounts of payments due under specified contractual obligations, aggregated by category of contractual obligations, as of June 30, 2004:

(1)		Includes approximately $53.8 million under our non-cancelable inventory purchase commitments as of June 30, 2004. Under these contractual agreements, we may order inventories 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 June 30, 2004, commitments under these arrangements totaled $3.0 million.
(2)		There are no material contractual obligations extending beyond 2006.

     We are not a party to any agreements with, or commitments to, any special purpose entities that would constitute material off-balance sheet financing other than the operating lease commitments listed above.

     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.”

     We enter into various agreements in the ordinary course of business. Pursuant to these agreements, we may agree to indemnify our customers for losses suffered or incurred by them as a result of any patent, copyright, or other intellectual property infringement claims by any third party with respect to our products. These indemnification obligations may have perpetual terms. Our normal business practice is to limit the maximum amount of indemnification to the license fees received. On occasion, the maximum amount of indemnification we may be required to make may exceed our normal business practices. We estimate the fair value of our indemnification obligations as insignificant, based upon our history of litigation concerning product and patent infringement claims. Accordingly, we have no liabilities recorded for indemnification under these agreements as of June 30, 2004.

     We have agreements whereby our officers and directors are indemnified for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. However, we have a directors and officers’ insurance policy that may reduce our exposure and 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. Agreements entered into prior to December 31, 2002 were grandfathered under the provisions of FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of others — an Interpretation of FASB Statements No. 5, 57 and 107 and rescission of FASB Interpretation No. 34.”

NOTE 15. CREDIT FACILITY

     We have a $10.0 million unsecured line of credit with a bank. In July 2004, the expiration date of this line of credit was extended from June 5, 2006 to June 5, 2007. Under the terms of the agreement, we may borrow at a fixed per annum rate of LIBOR plus 1.5% or prime rate. The line of credit requires us to achieve certain financial ratios and operating results. As of June 30, 2004, we were in compliance with the borrowing criteria and had $10.0 million of borrowing capability under this line of credit. There were no borrowings under this line of credit as of June 30, 2004.

NOTE 16. RECENT ACCOUNTING PRONOUNCEMENTS

     In April 2004, the Emerging Issues Task Force (‘EITF”) issued Statement No. 03-06 “Participating Securities and the Two-Class Method Under FASB Statement No. 128, Earnings Per Share” (“EITF 03-06”). EITF 03-06 addresses a number of questions regarding the computation of earning per share by a company that has issued securities other than common stock that contractually entitle the

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holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock. The issue also provides further guidance in applying the two-class method of calculating earnings per share, clarifying what constitutes a participating security and how to apply the two-class method of computing earnings per share once it is determined that a security is participating, including how to allocate undistributed earnings to such a security. EITF 03-06 is effective for fiscal periods beginning after March 31, 2004. We adopted EITF 03-06 during the quarter ended June 30, 2004. The adoption of EITF 03-06 has not had a material impact on our financial position or results of operations.

     At its November 2003 meeting, the EITF reached a consensus on disclosure guidance previously discussed under EITF 03-01,“The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-01”). The consensus provided for certain disclosure requirements that were effective for fiscal years ending after December 15, 2003. At its March 2004 meeting, the EITF reached a consensus on recognition and measurement guidance previously discussed under EITF 03-01. The consensus clarifies the meaning of other-than-temporary impairment and its application to investments classified as either available-for-sale or held-to-maturity under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and investments accounted for under the cost method or the equity method. The recognition and measurement guidance for which the consensus was reached in the March 2004 meeting is to be applied to other-than-temporary impairment evaluations in reporting periods beginning after June 15, 2004. We are currently evaluating the effect of adopting EITF 03-01 on our financial positions or results of operations.

NOTE 17. SUBSEQUENT EVENTS

     After the quarter ended June 30, 2004, we announced our decision to exit the digital still camera business, including digital still cameras and digital camcorders, to concentrate our engineering, sales, marketing and management resources on the higher growth opportunities in the camera phone and recordable markets. As a result of the decision, approximately 20 employees and the lease of the office in Scotts Valley, California are expected to be terminated by the end of the third quarter of 2004. The majority of the expenses are anticipated to occur during the third quarter of 2004.

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,” other similar words or the negative of such 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. The terms “Company,” “we,” “us,” “our,” and similar terms refer to ESS Technology, Inc. and its subsidiaries, unless the context otherwise requires.

     This information should be read in conjunction with the condensed consolidated financial statements and notes thereto included in Item 1 of this Report and the audited consolidated financial statements and notes thereto in our annual report on Form 10-K for the year ended December 31, 2003.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Use of Estimates

     Our interim condensed consolidated financial statements included herein have been 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 that affect the amounts reported in our financial statements and accompanying notes. 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

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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
	•		Legal Contingencies

     For further discussion of our critical accounting policies and estimates, see Note 2 of notes to the condensed consolidated financial statements in Item 1 of this report and Management’s Discussion and Analysis of Financial Condition and the Results of Operation in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2003.

Revenue Recognition

     Except for sales to distributors, revenue from product sales 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. For products sold to certain distributors with certain rights of return and allowances, revenue is deferred until the distributor resells the products to a third party.

     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 Incorporation (“MediaTek”) royalties for the sale of products utilizing ESS licensed technology is reported as revenue based on the number of units sold as reported to us by MediaTek.

Inventories and Inventory Reserves

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

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

     The estimates of future demand, forecasted sales prices and market conditions used in the valuation of inventories form the basis for our published and internal revenue forecast. If actual results are substantially lower than the forecast, we may be required to record additional write-downs of product inventories in future periods and this may have a negative impact on gross margins. This risk is particularly acute in our new digital imaging business that we acquired when we purchased Pictos and Divio, since forecasting customer demand is more difficult in this new product line, which currently has few customers and low sales volume.

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Legal Contingencies

     From time to time, we are subject to legal proceedings and claims, including claims of alleged infringement of patents, trademarks, copyrights and other intellectual property rights and other claims arising out of the ordinary course of business. Further, we are currently engaged in certain shareholder class action and derivative lawsuits.

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

Recently Issued Accounting Pronouncements

     See Note 16 to our condensed consolidated financial statements in Item 1 for disclosure of the recently issued accounting pronouncements that may impact our financial statements in the future.

EXECUTIVE OVERVIEW

     We are a leading designer, developer and marketer of highly integrated analog and digital processor chips, imaging sensor chips, digital amplifiers, and camera lens modules. Our digital processor chips are the primary processors driving digital video and audio devices, including DVD, Video CD (“VCD”), consumer digital audio players, and digital media players. Our imaging chips utilize advanced Complimentary Metal Oxide Semiconductor (“CMOS”) sensor technology to capture an image for cellular camera phone applications. Our camera lens modules are made up of a lens, image sensor chip, housing and flex cable necessary to provide camera capabilities to electronic devices such as cellular phones and Personal Digital Assistants (“PDAs”). Our digital amplifiers boost the digital sound to a level required to drive loudspeakers, in such applications as DVD and CD players, home theater systems, audio receivers, boom boxes and television sets. We have also developed encoding processors to address the growing demand for digital video recorders (“DVRs”) and recordable DVD players. We believe that multi-featured DVD, DVR and recordable DVD players will serve as a platform for the digital home system (“DHS”), integrating various digital home entertainment and information delivery products into a single box. We are also a supplier of chips for use in modems, other communication devices and PC audio products. Our chips use multiple processors and a programmable architecture that enable us to offer a broad array of features and functionality. We focus on our design and development strengths and outsource all of our chip fabrication and assembly as well as the majority of our test operations.

     We market our products worldwide through our direct sales force, distributors and sales representatives. Substantially all of our sales are to customers in Hong Kong, Taiwan, China, Japan, Singapore, Korea 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. See “Factors That May Affect Future Results — We have significant international sales and operations that are subject to the special risks of doing business outside the United States.”

     We were incorporated in California in 1984 and became a public company in 1995. Effective August 21, 2001, we spun off our majority-owned subsidiary, Vialta, Inc., which was established in April 1999. See Item 1, Note 12, “Related Party Transactions with Vialta, Inc.” 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 Item 1, Note 3, “Significant Business Combinations.”

     Our net income for the second quarter of 2004 was $3.2 million, compared to net income of $15.9 million for the second quarter of 2003 and net income of $3.3 million for the first quarter of 2004. During the second quarter, we made the decision to exit the digital still camera business, including digital still cameras and digital camcorders, to concentrate our engineering, sales, marketing and management resources on the higher growth opportunities in the camera phone and recordable markets. As a result of the decision, we took a $2.4 million inventory reserve. There are certain inventory risks associated with the semiconductor business. See “Factors That May Affect Future Results — We often purchase inventories based on sales forecasts and if anticipated sales do not materialize, we may continue to experience significant inventory charges.”

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RESULTS OF OPERATIONS

COMPARISON OF THREE MONTHS ENDED JUNE 30, 2004 AND JUNE 30, 2003

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

Net Revenues

     Net revenues were $76.8 million for the three months ended June 30, 2004, an increase of $45.8 million, or 147.7%, compared to $31.0 million for the three months ended June 30, 2003, primarily due to the increases in DVD, VCD, digital imaging, recordable products and royalty revenues, partially offset by the decrease in other products.

     The following table summarizes revenues by our major product category:

     DVD revenue includes revenue from sales of DVD decoder chips. DVD revenue was $42.4 million for the three months ended June 30, 2004, an increase of $28.7 million, or 209.5%, from revenue of $13.7 million for the three months ended June 30, 2003, primarily due to higher unit sales, especially of the newly developed Vibratto II products, and partially offset by lower overall average selling price (“ASP”). For the three months ended June 30, 2004, sales volume increased by 344.9% and ASP decreased by 30.6% from the three months ended June 30, 2003.

     VCD revenue includes revenue from sales of VCD and SVCD chips. VCD revenue was $22.0 million for the three months ended June 30, 2004, an increase of $7.7 million, or 53.9%, from revenue of $14.3 million for the three months ended June 30, 2003, primarily due to higher unit sales, and slightly higher ASP. For the three months ended June 30, 2004, sales volume increased by 43.5%, and ASP increased by 7.3% from the three months ended June 30, 2003.

     Digital imaging revenue includes revenue from sales of image sensor chips, image processor chips and camera lens modules, which are new product lines we acquired through Pictos in June 2003. Digital imaging product revenue was $3.7 million for the three months ended June 30, 2004, an increase of $3.5 million, or 1,750.0%, from revenue of $0.2 million, due primarily to higher sales volume.

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     Recordable revenue includes revenue from sales of integrated encoder and decoder chips, and encoder and decoder chips sold together as a chipset. Recordable revenue was $1.7 million for the three months ended June 30, 2004, an increase of $1.4 million, or 466.7 %, from revenue of $0.3 million for the three months ended June 30, 2003, primarily due to higher unit sales. For the three months ended June 30, 2004, sales volume increased by 1,466.7% from the three months ended June 30, 2003. We introduced our recordable products to the market during the first quarter of 2003.

     Royalty revenue consists of MediaTek royalty payments. Under the settlement agreement between ESS and MediaTek dated June 11, 2003, for a non-exclusive license to our proprietary DVD user interface and other key DVD software, MediaTek is obligated to pay us ongoing royalties with a quarterly cap of $5.0 million and lifetime cap of $45.0 million. Royalty revenue was $5.0 million for the three months ended June 30, 2004.

     Other revenue includes revenue from PC Audio, communication, consumer digital media and others. Other revenue was $2.0 million for the three months ended June 30, 2004, a decrease of $0.5 million, or 20%, from revenue of $2.5 million for the three months ended June 30, 2003, primarily due to lower sales volume. For the three months ended June 30, 2004, sales volume decreased by 50.8% from the three months ended June 30, 2003.

     International revenue accounted for approximately 99% of net revenues for the three months ended June 30, 2004, remained the same as the three months ended June 30, 2003. Our international sales are denominated in U.S. dollars. We expect that international sales will continue to remain a high percentage of our net revenues in the future.

Gross Profit

     Gross profit was $22.9 million, or 29.8% of net revenues, for the three months ended June 30, 2004, compared to $10.0 million, or 32.3% of net revenues, for the three months ended June 30, 2003. Gross profit increased primarily due to increased revenue from DVD and VCD product lines, as well as from $5.0 million of MediaTek royalty revenue at 100% gross margin. Excluding the effects of royalty revenue and changes in the provision for excess and obsolete inventory, gross profit as a percentage of net revenues was 26.5% for the three months ended June 30, 2004, compared to 26.6% for the same period last year. Net excess and obsolete inventory reserves provided during the three months ended June 30, 2004 amounted to approximately $1.1 million, consisting of $2.4 million increase for the complete reserve of inventory related to digital still camera products and $1.3 million of net reserves released on other products. Net inventory reserves of $1.8 million were released during the three months ended June 30, 2003. The release of inventory reserves results from the sale of products that have previously been fully reserved. Since our digital imaging line of products is new and currently has few customers and low sales volume, it is particularly difficult for us to accurately forecast customer demand for these products, which may result in excess and obsolete inventory reserves in future periods. In additions, we currently have a single customer for our digital imaging chips used in cellular phones and we have purchased inventory for that customer that we are unlikely to be able to sell to any other customer. This customer has notified us on several occasions that it wishes to cancel the remaining portion of its order with us, although the customer has also subsequently renewed its order on several occasions. We believe we have adequate legal remedies under the terms of the purchase order, but there can be no guaranty or assurance that we will not ultimately write-down some or all of the value of such inventory that remains unpurchased, and the amount of any such write-down could be significant to our results of operations for a given quarter.

     As a result of intense competition in our markets, we expect the overall ASP per unit for our existing products to decline over their product life. We believe that in order to maintain or increase gross profit in 2004, we must achieve higher unit volume in shipments, reduce costs, add new features to our existing products and introduce new products.

Research and Development Expenses

     Research and development expenses were $10.5 million, or 13.7% of net revenues, for the three months ended June 30, 2004 compared to $7.3 million, or 23.6% of net revenues, for the three months ended June 30, 2003. The $3.2 million, or 43.8%, increase in research and development for the three months ended June 30, 2004 was primarily due to the research and development expenses of $3.0 million and $1.0 million from our new subsidiaries Pictos and Divio, respectively.

In-process Research and Development Expenses

     In-process research and development expenses for the three months ended June 30, 2003 were $1.4 million, or 4.6% of net revenues. The $1.4 million was in-process research and development expenses write-off of the digital imaging products acquired from Pictos. No in-process research and development expenses were recorded in the three month ended June 30, 2004.

Selling, General and Administrative Expenses

     Selling, general and administrative expenses were $9.8 million, or 12.7% of net revenues, for the three months ended June 30, 2004 compared to $6.7 million, or 21.4% of net revenues, for the three months ended June 30, 2003. The $3.1 million, or 46.6%,

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increase in selling, general and administrative expenses for the three month ended June 30, 2004 was primarily due to $1.1 million increase in salaries and fringe benefits due to higher headcount in Asia and through Pictos and Divio acquisitions, $0.7 million increase in legal expenses for general services, $0.4 million increase in consulting and services for Sarbanes-Oxley Act compliance, $0.5 million increase in amortization of technical infastructure resulted from the Pictos and Divio acquisitions and $0.3 million increase in third party commission due to higher revenues.

Non-operating Income, Net

     Net non-operating income was $0.8 million for the three months ended June 30, 2004 compared to $44.2 million for the three months ended June 30, 2003. For the three months ended June 30, 2004, net non-operating income mainly consisted of interest income of $0.4 million, rental income of $0.1 million from Vialta and other income of $0.3 million. For the three months ended June 30, 2003, non-operating income consisted primarily of a one-time license fee payment of $45.0 million from MediaTek, a payment of $0.5 million in legal fees associated with the MediaTek litigation, interest income of $0.6 million and rental income $0.5 million from Vialta, partially offset by the $1.6 million write-off of our investment in a public company.

Provision for Income Taxes

     Our effective tax rate was 6.6% for the three months ended June 30, 2004 compared to 59% effective tax rate for the three months ended June 30, 2003. The principal reason for the difference in our tax rate is the various income and withholding taxes accrued during the three months ended June 30, 2003 for the one time $45.0 million license fee payment under the MediaTek settlement. The reason for the increase in our tax rate for the three months ended June 30, 2004 from our historic effective tax rate of 5% is the change in geographic segmentation of income as a result of the mix of new products. The 6.6% tax rate for the current quarter is lower than the statutory federal rate primarily due to the lower foreign tax rate on earnings from our foreign subsidiaries, which are considered to be permanently reinvested.

Net Income

     Net income was $3.2 million from the three months ended June 30, 2004 compared to $15.9 million for the three months ended June 30, 2003. Net income decreased by $12.7 million from three months ended June 30, 2003, primarily due to the $45.0 million of license fee payment from MediaTek in June 2003 and higher operating expenses during the three month ended June 30, 2004, partially offset by higher revenues.

COMPARISON OF SIX MONTHS ENDED JUNE 30, 2004 AND JUNE 30, 2003

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

Net Revenues

     Net revenues were $153.6 million for the six months ended June 30, 2004, an increase of $89.4 million, or 139.3%, compared to $64.2 million for the six months ended June 30, 2003, primarily due to the increases in DVD, digital imaging, VCD, royalty revenues

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and recordable products, partially offset by the decrease in other products.

     The following table summarizes revenues by our major product category: