UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

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, 2004.

OR

   [  ]      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)

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 October 27, 2004 the registrant had 39,567,942 shares 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 design, develop and market 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 sensor chips utilize advanced Complimentary Metal Oxide Semiconductor (“CMOS”) sensor technology to capture an image for cellular camera phone applications. 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. Our camera lens modules provide camera capabilities to electronic devices such as cellular phones and Personal Digital Assistants (“PDAs”). We have also developed and marketed 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 China, Hong Kong, Taiwan, Japan, Korea, Turkey and Singapore. We employ sales and support personnel located outside of the United States in China, Taiwan, Hong Kong, 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 nine months ended September 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.

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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 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 September 30, 2004, 893,210 shares have been issued under the Purchase Plan.

     Our reported net income (loss) 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 (loss) 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 September 30, 2004 and $1,557,000 for the nine months ended September 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:

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     Amortization expenses related to these identifiable intangible assets were $668,000 and $2,004,000 for the three months ended and nine months ended September 30, 2004, respectively. The following table summarizes the annual amortization expenses through 2006:

     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 September 30, 2004 and 2003, depreciation expenses were approximately $1.4 million and $1.0 million, respectively. For the nine months ended September 30, 2004 and 2003, depreciation expenses were approximately $4.1 million and $3.0 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 nine months ended September 30, 2004 and 2003:

NOTE 5. MARKETABLE SECURITIES

     The amortized costs and estimated fair value of securities available-for-sale as of September 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 September 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 September 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. INVENTORY PROVISION

     During the quarter ended September 30, 2004, we recorded a $19.4 million charge to cost of revenues, including approximately $8.7 million representing accrued purchase order commitments recorded as other accrued liabilities. The charges were due to certain excess or obsolete video recording, DVD and digital imaging products.

     During the three months period ended September 30, 2004, we experienced a lower than expected demand for our video recording products. Consequently, inventories built earlier in the year in anticipation of the fast growth of this new market exceeded requirements for the period. In accordance with our inventory reserve policy, we took a $8.1 million reserve for these products.

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     In the same period, we experienced reduced market demand for DVD products. To maintain our market position and in anticipation of our lower-cost 2005 DVD products, we significantly reduced our prices to be more competitive. According, we took a $9.3 million lower of cost or market reserve for certain of our DVD product inventories.

     Lastly, we have written off an additional $2.0 million for certain custom and older digital imaging products for which we anticipate no demand.

NOTE 8. OTHER COMPREHENSIVE INCOME (LOSS)

     Comprehensive income (loss) is comprised of net income (loss) and the change in unrealized gain (loss) on marketable securities. Total comprehensive loss was $20.8 million and total comprehensive income $2.7 million for the three months ended September 30, 2004 and 2003, respectively. Total comprehensive loss was $15.7 million and total comprehensive income $16.4 million for the nine months ended September 30, 2004 and 2003, respectively. The following table reconciles net income (loss) to comprehensive income (loss) for the three months ended and nine months ended September 30, 2004 and 2003:

NOTE 9. NON-OPERATING INCOME (LOSS), NET

     The following table lists the major components of non-operating income (loss) for the three months ended and nine months ended September 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 sales of products utilizing the licensed technology is reported as revenues based on the number of units sold. During the three months ended September 30, 2004, $5.0 million in revenues were recognized from MediaTek royalty payments. During the nine months ended September 30, 2004, $15.0 million in revenues were recognized from MediaTek royalty payments.

Write-down of Investment

     In March 2002, we invested approximately $4.2 million in Broadmedia, Inc.(“Broadmedia”). 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 nine months ended September 30, 2003, we recorded a pre-tax non-operating loss of $2.0 million to reflect the decrease in fair market value of our investment in Broadmedia.

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NOTE 10. INCOME TAXES

      Our effective tax rate was 5.3% for the three months ended September 30, 2004. The tax rate for the current quarter was lower than the statutory federal rate primarily due to tax credits and favorable tax adjustments of $1.8 million from the expiration of certain statutes of limitations and a claimed loss benefit carry backward. Our effective tax rate was 146% for the three months ended September 30, 2003, which was higher than the statutory federal rate primarily due to the various income and withholding taxes accured during the period for the one-time $45.0 million license fee payment under the MediaTek settlement.

     Our effective tax rate was 4.7% for the nine months ended September 30, 2004. The tax rate was lower than the statutory federal rate primarily due to tax credits and favorable tax adjustments of $1.8 million from the expiration of certain statutes of limitations and a claimed loss benefit carry backward. Our effective tax rate was 46% for the nine months ended September 30, 2003, which was higher than the statutory federal rate primarily due to the various income and withholding taxes accrued during the period for the one-time $45.0 million license fee payment under the MediaTek settlement.

NOTE 11. NET INCOME (LOSS) PER SHARE

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

     For the three months ended September 30, 2004 and 2003, there were options to purchase approximately 9,443,238 and 3,502,464 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, 2004 and 2003, there were options to purchase approximately 9,201,087 and 4,143,629 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.

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NOTE 12. 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 and nine months ended September 30, 2004 and 2003 by major product category:

     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.

Significant Customers

     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 September 30, 2004, in addition to Dynax Electronics (HK) LTD (“Dynax Electronics”) as described below, one customer accounted for 11% of net revenues. During the three months ended September 30, 2003, Dynax Electronics was our only customer that accounted for more than 10% of our net revenues. During the nine months ended September 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 September 30, 2004 and 2003 and during the nine months ended September 30, 2004 and 2003, except for our distributor, Dynax Electronics, no other single customer accounted for more than 10% of our trade accounts receivable.

NOTE 13. 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 September 30, 2004, we had a receivable from Vialta of $182,000.

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

NOTE 14. STOCK REPURCHASE

     As of September 30, 2004, there is board authorization to repurchase up to 5.2 million shares of our common stock. During the three months ended and nine months ended September 30, 2004, we did not repurchase any shares. During the three months ended September 30, 2003, we did not repurchase any shares of our common stock. During the nine months ended September 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.

NOTE 15. 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 September 30, 2004:

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     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 September 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.

NOTE 16. CREDIT FACILITY

      Since July 22, 2002, we have had a $10.0 million unsecured line of credit with U.S. Bank National Association. Under the terms of the agreement, subject to our compliance with the covenants to maintain certain financial ratios and operating results, we could borrow at a variable LIBOR rate plus 1.5% or prime rate. As of September 30, 2004 and the date of this Report, there were no borrowings under this line of credit. Due to the loss incurred in the three months ended September 30, 2004, on September 30, 2004 we were not in compliance with the fixed charge coverage ratio covenant under the line of credit. After assessing the Company’s need for the line of credit, on November 9, 2004, we terminated this agreement, which was originally scheduled to expire on June 5, 2007. We did not incur any material early termination penalties in connection with the termination of this agreement.

NOTE 17. 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 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 did not have a material impact on our financial position or results of operations.

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     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 implementation of the recognition and measurement guidance provisions has been delayed. The Company will evaluate the effect of adopting EITF 03-01 on its results of operations once the final guidance is issued.

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 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. These forward-looking statements are based on management’s estimates, projections and assumptions as of the date hereof and include the assumptions that underlie such statements. 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 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:

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	•		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, “ Basis of Presentation,” 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 digital imaging business, which currently has few customers and low sales volume.

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.

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     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

     See Note 17, “ Recent Accounting Pronouncements,” in Item 1 for disclosure of the recently issued accounting pronouncements that may impact our financial statements in the future.

EXECUTIVE OVERVIEW

      We design, develop and market 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 sensor chips utilize advanced Complimentary Metal Oxide Semiconductor (“CMOS”) sensor technology to capture an image for cellular camera phone applications. 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. Our camera lens modules provide camera capabilities to electronic devices such as cellular phones and Personal Digital Assistants (“PDAs”). We have also developed and marketed 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 China, Hong Kong, Taiwan, Japan, Korea, Turkey, and Singapore. We employ sales and support personnel located outside of the United States in China, Taiwan, Hong Kong, 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 13, “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 financial results for the quarter ended September 30, 2004 were impacted by the fact that worldwide video and audio processor chips demand did not materialize as we had expected. Specifically, demand growth for video recording products has been slower than we had expected. Consequently, the inventories built earlier this year in anticipation of the fast growth of this product line were higher than necessary, resulting in a reserve for the excess inventories. Further, the lower than expected demand for all DVD products required us to reduce our prices to compete and maintain our market position. Accordingly, we have taken an additional inventory reserve to reflect lower anticipated selling prices of our DVD inventory.

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RESULTS OF OPERATIONS

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

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

Net Revenues

     Net revenues were $60.6 million for the three months ended September 30, 2004, an increase of $12.4 million, or 25.6%, compared to $48.2 million for the three months ended September 30, 2003, primarily due to the increases in DVD, royalty, other products revenues, and partially offset by the decreases in recordable, digital imaging and VCD revenues.

     The following table summarizes revenues by major product category:

     DVD revenue includes revenue from sales of DVD decoder chips. DVD revenue was $34.8 million for the three months ended September 30, 2004, an increase of $15.6 million, or 81.4%, from revenue of $19.2 million for the three months ended September 30, 2003, primarily due to higher sales volume, especially of Vibratto II products introduced in 2003, and partially offset by lower overall average selling price (“ASP”). For the three months ended September 30, 2004, sales volume increased by 175.2% and ASP decreased by 34.2% from the three months ended September 30, 2003.

     VCD revenue includes revenue from sales of VCD and SVCD chips. VCD revenue was $16.2 million for the three months ended September 30, 2004, a decrease of $2.4 million, or 13.0%, from revenue of $18.6 million for the three months ended September 30, 2003, primarily due to lower sales volume. For the three months ended September 30, 2004, sales volume decreased by 11.3%.

     Digital imaging revenue includes revenue from sales of image sensor chips, image processor chips and camera lens modules, which are product lines we acquired through Pictos in June 2003. Digital imaging revenue was $46.4 thousand for the three months ended September 30, 2004, a decrease of $3.1 million, or 98.5%, from revenue of $3.1 million. We discontinued digital still camera products in July 2004 to concentrate our resources on the higher growth opportunities in the camera phone and recordable markets.

     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 September 30, 2004, a decrease of $3.2 million, or 65.9%, from revenue of $4.9 million for the three months ended September 30, 2003, primarily due to lower sales volume and lower ASPs. For the three months ended September 30, 2004, sales volume decreased by 54.2% and ASP decreased by 25.5% from the three months ended September 30, 2003.

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     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 September 30, 2004. As of September 30, 2003, no revenues had been recognized from MediaTek royalty payments.

     Other revenue includes revenue from PC Audio, communication, consumer digital media and other products. Other revenue was $2.9 million for the three months ended September 30, 2004, an increase of $0.5 million, or 21.1%, from revenue of $2.4 million for the three months ended September 30, 2003, primarily due to higher ASP and partially offset by lower sales volume. For the three months ended September 30, 2004, ASP increased by 68.5% and sales volume decreased by 28.1% from the three months ended September 30, 2003.

     International revenue accounted for approximately 98.6% of net revenues for the three months ended September 30, 2004 and 99.6% of net revenues for the three months ended September 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 (Loss)

      Gross loss was $3.9 million, or (6.4)% of net revenues, for the three months ended September 30, 2004, compared to gross profit of $15.0 million, or 31.0% of net revenues, for the three months ended September 30, 2003. Gross loss for the three months ended September 30, 2004 included a net $19.4 million inventories-related charge. This amount consists, in part, of reserves for excess or obsolete inventory of approximately $8.1 million for our recordable products and $2.0 million for our digital imaging products. In addition, due to anticipated decreases in the ASP for certain of our Vibratto II DVD products we have provided $9.3 million of lower of cost or market reserves for these products. See Item 1, Note 7, “Inventory Provision”. Gross loss for the third quarter of 2004 includes $5.0 million of MediaTek royalty revenue at 100% gross margin. No royalty revenue was recognized in the third quarter of 2003. Gross profit for the three months ended September 30, 2003 benefited from a $1.2 million reserve release due to the sale of products that had previously been fully reserved.

     Excluding the effects of royalty income, inventory reserves, and a $1.2 million nonrecurring credit resulting from a decrease in an inventory related accrual, gross profit as a percentage of net revenues for the three months ended September 30, 2004 was 16.8%, compared to 28.5% for the same period last year. The decreased gross margin is primarily a result of lower ASPs for DVD products and an increase in manufacturing overhead expenses. ASPs for DVD products are expected to decrease for at least the remainder of 2004. Due to decreased actual and anticipated revenue, manufacturing activities were substantially reduced during the three months ended September 30, 2004. As a result, substantially all fixed overhead costs of approximately $3.2 million were expensed. This unfavorable overhead variance is expected to be only marginally lower in the fourth quarter of 2004.

     As a result of intense competition in our markets, we expect the overall ASP for all of our existing products to decline over their product life. We believe that in order to maintain or increase gross profit in 2005, we must achieve higher units 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 $9.0 million, or 14.9% of net revenues, for the three months ended September 30, 2004 compared to $10.1 million, or 20.9% of net revenues, for the three months ended September 30, 2003. The $1.1 million, or 10.6%, decrease in research and development for the three months ended September 30, 2004 was primarily due to $0.8 million decrease in salaries and fringe benefits due to lower headcount resulting from the discontinuation of our digital still camera research and development unit and $0.7 million decrease in mask set expenses due to product delays, partially offset by $0.4 million increase in engineering expenses related to camera phone products.

In-process Research and Development Expenses

     In-process research and development expenses for the three months ended September 30, 2003 consist of $1.3 million, or 2.6% of net revenues. The expense was in-process research and development related to the encoding products acquired from Divio. No in-process research and development expenses were recorded in the three month ended September 30, 2004.

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Selling, General and Administrative Expenses

     Selling, general and administrative expenses were $10.2 million, or 16.8% of net revenues, for the three months ended September 30, 2004 compared to $8.9 million, or 18.4% of net revenues, for the three months ended September 30, 2003. The $1.3 million, or 14.7%, increase in selling, general and administrative expenses for the three month ended September 30, 2004 was primarily due to $1.1 million increase in legal expenses related to license fee settlement, $0.4 million increase in salaries and fringe benefits due to higher headcount in Asia, $0.5 million reserve for facilities consolidations related to the discontinuation of our digital still camera unit. These increases were partially offset by $0.4 million decrease in insurance expense due to lower director and officer insurance premiums.

Non-operating Income (Loss), Net

     Net non-operating income was $0.7 million for the three months ended September 30, 2004 compared to net non-operating loss of $0.7 million for the three months ended September 30, 2003. For the three months ended September 30, 2004, net non-operating income mainly consisted of interest income of $0.5 million, rental income of $0.1 million from Vialta and other income of $0.1 million. 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.

Benefit from Income Taxes

      Our effective tax rate was 5.3% for the three months ended September 30, 2004. The tax rate for the current quarter was lower than the statutory federal rate primarily due to tax credits and favorable tax adjustments of $1.8 million from the expiration of certain statutes of limitations and a claimed loss benefit carry backward. Our effective tax rate was 146% for the three months ended September 30, 2003, which was higher than the statutory federal rate primarily due to the various income and withholding taxes accrued during the period for the one-time $45.0 million license fee payment under the MediaTek settlement.

Net Income (Loss)

     Net loss was $21.2 million from the three months ended September 30, 2004 compared to net income of $2.7 million for the three months ended September 30, 2003. Net income (loss) decreased by $23.9 million from three months ended September 30, 2003, primarily due to the $19.4 million of inventory reserve and the $3.2 million unfavorable manufacturing overhead absorption, partially offset by the $1.2 million reversal of accrued expenses.

COMPARISON OF NINE MONTHS ENDED SEPTEMBER 30, 2004 AND SEPTEMBER 30, 2003

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