Ess Technology (ESST) 10-Q 2007 Q2 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2007.

OR

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

For the transition period from:          to

Commission File Number: 0-26660

ESS TECHNOLOGY, INC.

(Exact name of registrant as specified in its charter)

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

48401 FREMONT BOULEVARD
FREMONT, CALIFORNIA 94538
(Address of principal executive offices, including zip code)

(510) 492-1088
(Registrant’s telephone number, including area code)

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

Yesþ     Noo

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filero      Accelerated filerþ      Non-accelerated filero

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yeso     Noþ

     As of August 2, 2007 the registrant had 35,531,323 shares of common stock outstanding.

ESS TECHNOLOGY, INC.

TABLE OF CONTENTS

PART I FINANCIAL INFORMATION	3
Item 1. Financial Statements (unaudited):	3
Condensed Consolidated Balance Sheets as of June 30, 2007 and December 31, 2006	3
Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2007 and 2006	4
Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2007 and 2006	5
Notes to Condensed Consolidated Financial Statements	6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 3. Quantitative and Qualitative Disclosures About Market Risk	25
Item 4. Controls and Procedures	25
PART II OTHER INFORMATION	27
Item 1. Legal Proceedings	27
Item 1A. Risk Factors	28
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	38
Item 5. Other Information	38
Item 6. Exhibits	39
SIGNATURES	40
INDEX TO EXHIBITS	41
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32

2

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

ESS TECHNOLOGY, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)

	June 30,			December 31,
	2007			2006
	(In thousands)
ASSETS
Cash and cash equivalents	$	44,382		$	33,731
Short-term investments		6,808			10,264
Accounts receivable, net		6,915			9,189
Other receivables		4,434			1,154
Inventory		5,742			8,278
Prepaid expenses and other assets		960			1,764
Total current assets		69,241			64,380
Property, plant and equipment, net		13,822			16,996
Non-current deferred tax asset		6,606			—
Investment and other assets		8,365			9,052
Total assets	$	98,034		$	90,428
LIABILITIES AND SHAREHOLDERS’ EQUITY
Accounts payable and accrued expenses	$	15,869		$	20,404
Income tax payable and deferred income taxes		235			23,001
Total current liabilities		16,104			43,405
Non-current deferred tax liability		34,520			—
Total liabilities		50,624			43,405
Commitments and contingencies (Note 13)
Shareholders’ equity:
Common stock		176,132			175,528
Accumulated other comprehensive income		1			86
Accumulated deficit		(128,723	)		(128,591	)
Total shareholders’ equity		47,410			47,023
Total liabilities and shareholders’ equity	$	98,034		$	90,428

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

3

ESS TECHNOLOGY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2007			2006			2007			2006
	(In thousands, except per share data)
Net revenues	$	17,184		$	29,066		$	34,956		$	55,952
Cost of revenues		12,514			28,354			22,915			52,877
Gross profit		4,670			712			12,041			3,075
Operating expenses:
Research and development		2,570			9,941			7,161			19,538
Selling, general and administrative		4,738			7,045			9,678			15,044
Impairment of property, plant and equipment		—			—			859			—
Gain on sale of technology and tangible assets		(2,000	)		—			(10,481	)		—
Operating income (loss)		(638	)		(16,274	)		4,824			(31,507	)
Non-operating income, net		580			883			495			1,359
Income (loss) before income taxes		(58	)		(15,391	)		5,319			(30,148	)
Provision for (benefit from) income taxes		606			(167	)		1,380			(854	)
Net income (loss)	$	(664	)	$	(15,224	)	$	3,939		$	(29,294	)
Net income (loss) per share — basic and diluted	$	(0.02	)	$	(0.39	)	$	0.11		$	(0.75	)
Shares used in per share calculation — basic and diluted		35,522			39,150			35,515			39,136

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

4

ESS TECHNOLOGY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

	Six Months Ended
	June 30,
	2007			2006
	(In thousands)
Net income (loss)	$	3,939		$	(29,294	)
Adjustments to reconcile net income (loss) to net cash used in operating activities:
Depreciation and amortization		1,937			3,273
Amortization of intangible assets		—			795
Gain on sale of technology and tangible assets		(10,481	)		—
Impairment of property, plant and equipment		859			—
(Gain) loss on sale of property, plant and equipment		137			(241	)
Loss on equity investments		643			534
Stock-based compensation		588			2,546
Changes in assets and liabilities:
Accounts receivables, net		2,274			(1,428	)
Other receivables		(3,280	)		4,507
Inventory		2,536			(12,938	)
Prepaid expenses and other assets		691			1,653
Accounts payable and accrued expenses		(4,535	)		4,411
Income tax payable and deferred income taxes		1,070			(2,814	)
Net cash used in operating activities		(3,622	)		(28,996	)
Cash flows from investing activities:
Purchase of property, plant and equipment		(72	)		(1,598	)
Sale of property, plant and equipment		41			241
Purchase of short-term investments		(3,313	)		(12,678	)
Maturities and sales of short-term investments		6,750			31,365
Purchase of long-term investments		(500	)		—
Purchase of intangible assets		—			(458	)
Sale of technology and tangible assets		11,351			—
Net cash provided by investing activities		14,257			16,872
Cash flows from financing activities:
Repurchase of common stock		—			(1,609	)
Issuance of common stock under employee stock purchase plan and stock option plans		16			210
Net cash provided (used) in financing activities		16			(1,399	)
Net increase (decrease) in cash and cash equivalents		10,651			(13,523	)
Cash and cash equivalents at beginning of period		33,731			68,630
Cash and cash equivalents at end of period	$	44,382		$	55,107
Supplemental disclosure of cash flow information
Cash paid for income taxes	$	—		$	2,359
Cash refund for income taxes	$	—		$	698

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

5

ESS TECHNOLOGY, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 1. NATURE OF BUSINESS

     We were incorporated in California in 1984 and became a public company in 1995. We have historically operated in two primary business segments, Video and Digital Imaging, both in the semiconductor industry and both serve the consumer electronics and digital media marketplace.

     In our Video business, we design, develop and market highly integrated analog and digital processor chips and digital amplifiers. Our digital processor chips drive digital video and audio devices, including DVD, Video CD (“VCD”), consumer digital audio players and digital media players. We continue to sell certain legacy products we have in inventory including chips for use in recordable DVD players, modems, other communication devices and PC audio products. On September 18, 2006 we announced an ongoing strategic review of our operations and business plan. In connection with this strategic review, on November 3, 2006, we licensed to Hangzhou Silan Microelectronics Co., Ltd. (“Silan”) the development, manufacture and sale of our next generation standard definition DVD chips, the Phoenix II and LMX II, and also granted Silan a non-exclusive license for our standard definition DVD technology. On February 16, 2007, we sold to Silicon Integrated Systems Corporation and its affiliates (“SiS”) our tangible and intangible assets relating to the development of high definition DVD chips based on next generation blue laser technology. Also in connection with this restructuring strategy, during the first quarter of 2007 we substantially terminated the production and sale of our camera phone image sensors. We plan to license our image sensor patents in exchange for royalties, but we will no longer sell imaging sensor semiconductor chips. We continue to design, develop and market highly integrated analog and digital processor chips and digital amplifiers including standard definition DVD products primarily for the Korean market and digital audio players and digital media players for all markets. We are now concentrating on standard definition DVD and evaluating opportunities to develop profitable operations.

     Our strategy is to focus on the design and development of our chip products while outsourcing all of our chip fabrication, assembly, and test operations. All of our products are manufactured, assembled and tested by independent third parties primarily in Asia We market our products worldwide through our direct sales force, distributors and sales representatives. Substantially all of our sales are to distributors, direct customers and end-customers in China, Hong Kong, Taiwan, Japan, Korea, Indonesia and Singapore. We employ sales and support personnel located outside of the United States in China, Hong Kong, Taiwan and Korea to support these international sales efforts. We expect that international sales will continue to represent a significant portion of our net revenues. We also have a 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.

     For the years ended December 31, 2006 and 2005 and the six months ended June 30, 2007, we incurred significant operating losses and negative cash flows. We believe that we have the cash resources to fund our operations for at least the next twelve months. The semiconductor industry in which we operate is characterized by rapid technological advances, short product lives and significant price reductions. If we are unable to meet these challenges, then we will not achieve profitable operations. We may determine that we require additional capital to achieve our current or future business objectives. There can be no assurances that such capital will be available or available on terms that are acceptable to us, which could adversely affect our financial position, results of operations or cash flows.

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, 2006 included in our Annual Report on Form 10-K. Interim financial results are not necessarily indicative of the results that may be expected for a full year.

6

NOTE 3. SALE OF TECHNOLOGY AND TANGIBLE ASSETS

     On February 16, 2007, we entered into asset purchase agreements with SiS, pursuant to which we transferred employees, sold certain tangible assets, and sold and licensed intellectual property related to our HD-DVD and Blu-ray DVD technologies for aggregate proceeds of approximately $13.5 million. Of this amount, $9.5 million was received during the first quarter of 2007, and $2.0 million was received during the second quarter of 2007. The remaining $2.0 million is to be paid on or about August 16, 2008 subject to adjustment upon settlement of any escrow claims by SiS. The gain recognized in the six months ended June 30, 2007 includes the proceeds received, net of the book value of assets sold of $870,000 and certain transaction expenses related to the sale to SiS amounting $149,000. We have not recognized any revenue related to HD-DVD or Blu-ray DVD products in any period.

NOTE 4. STOCK-BASED COMPENSATION

     Stock-based compensation for the three and six months ended June 30, 2007 and 2006 was as follows (in thousands, except per share data):

	Three Months Ended June 30,				Six Months Ended June 30,
	2007		2006		2007		2006
	(In thousands)				(In thousands)
Stock-based compensation expense by type of award:
Employee stock options:
Cost of revenues	$	11	$	57	$	18	$	130
Research and development		94		544		219		1,202
Selling, general and administrative		144		523		326		1,113
Employee stock purchase plan:
Selling, general and administrative		9		47		25		101
Total stock-based compensation	$	258	$	1,171	$	588	$	2,546

     During the six months ended June 30, 2007, we granted approximately 84,000 stock options with an estimated total grant-date fair value of $46,000 No stock options were granted during the three months ended June 30, 2007. During the three and six months ended June 30, 2006, we granted approximately 58,000 stock options with an estimated total grant-date fair value of $95,000 and approximately 142,000 stock options with an estimated total grant-date fair value of $243,000, respectively. As of June 30, 2007, unrecognized stock-based compensation cost related to stock options was $541,000, which will be recorded as compensation expense over an estimated weighted average period of one year.

     No stock-based compensation was capitalized as inventory at June 30, 2007.

Valuation Assumptions

     Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payments,” (“SFAS No. 123(R)”) requires companies to estimate the fair value of stock options on the date of grant using a valuation model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the consolidated statement of operations. Prior to the adoption of SFAS No. 123(R) on January 1, 2006, we accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) as allowed under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). Under the intrinsic value method, no stock-based compensation expense had been recognized in the consolidated statement of operations, other than as related to acquisitions and investments, because the exercise price of the our stock options granted to employees and directors equaled the fair market value of the underlying stock at the date of grant.

     Stock-based compensation expense recognized in the consolidated statement of operations for the three months and six months ended June 30, 2007 and 2006 included compensation expense for stock options granted prior to January 1, 2006, but not yet vested as of January 1, 2006 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS No. 123 and compensation expense for the stock options granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). Stock-based compensation expense recognized in the Condensed Consolidated Statements of Operations for the three months and six months ended June 30, 2007 and 2006 has been

7

reduced for estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The estimated forfeitures rate was determined based upon historical forfeitures.

     We estimate the fair value of stock options using the Black-Scholes valuation model, consistent with the provisions of SFAS No. 123(R), Staff Accounting Bulletin No. 107 (“SAB 107”) and our prior period pro forma disclosures of net earnings, including stock-based compensation. The Black-Scholes valuation model was developed for use in estimating the fair value of short-lived exchange traded options that have no vesting restrictions and are fully transferable. In addition, valuation models require the input of subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. The Black-Scholes valuation model for stock compensation expense requires us to make several assumptions and judgments about the variables to be assumed in the calculation including expected life of the stock option, historical volatility of the underlying security, an assumed risk-free interest rate and estimated forfeitures over the expected life of the option. The dividend yield of zero is based on the fact that we have never paid cash dividends and have no present intention to pay cash dividends. The expected life represents the weighted average period of time that options granted are expected to be outstanding giving consideration to vesting schedules and our historical exercise patterns; expected volatilities are based on historical volatilities of our common stock; the risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the option; and we consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience.

     The fair value of each option grant is estimated on the date of grant using the Black-Scholes option valuation model and the following assumptions:

	Three Months Ended June 30,						Six Months Ended June 30,
	2007			2006			2007			2006
Stock option plans:
Expected life (in years)		—			3.9			3.2			3.4
Expected stock price volatility		—			72	%		67	%		72	%
Risk-free interest rate		—			5.0	%		4.8	%		4.5	%
Expected dividend yield		—			0	%		0	%		0	%
Stock purchase plan:
Expected life (in years)		0.5			0.5			0.5			0.5
Expected stock price volatility		65	%		72	%		65	%		72	%
Risk-free interest rate		5.1	%		5.0	%		5.1	%		5.0	%
Expected dividend yield		0	%		0	%		0	%		0	%

     We have several equity incentive plans that are intended to attract and retain qualified management, technical and other employees, and to align stockholder and employee interests. These equity incentive plans provide that non-employee directors, officers, key employees, consultants and all other employees may be granted options to purchase shares of our stock, restricted stock units and other types of equity awards. Through June 30, 2007, we have only granted stock options under our various plans. These stock options generally have a vesting period of four years, are exercisable for a period not to exceed ten years from the date of issuance and are granted at prices not less than the fair market value of our common stock at the grant date.

Combined Activity

     The following table summarizes the combined activity under the equity incentive plans for the indicated periods:

									Weighted
	Available						Weighted		Average
	for			Options			Average		Contractual
	Grant			Outstanding			Exercise Price		Term
	(In thousands)								(In years)
Balances at January 1, 2006		3,243			9,753		$	5.51
Granted		(293	)		293			2.33
Exercised		—			(6	)		2.66
Forfeited		1,123			(1,123	)		4.82
Expired		1,458			(1,458	)		5.92
Expired — 1995 Plan and Platform Plan		—			(172	)		5.36
Balances at December 31, 2006		5,531			7,287		$	5.40
Granted		(84	)		84			1.12
Forfeited		259			(259	)		5.06
Expired		1,748			(1,748	)		5.23
Expired — 1995 Plan		—			(165	)		7.70
Expired — 1997 Plan		(5,389	)		—			—
Balances at June 30, 2007		2,065			5,199		$	5.33
Fully vested and exercisable at June 30, 2007					4,547		$	5.55		5.67
Expected at June 30, 2007 to vest in the future					616		$	3.86		7.98

8

     The aggregate intrinsic value of options vested and expected at June 30, 2007 to vest in the future, based on our closing stock price of $1.66 as of June 29, 2007, was approximately $85,000.

     The weighted average grant date fair value of options, as determined under SFAS No. 123(R), granted during the three months ended June 30, 2006 was $1.65, and during the six months ended June 30, 2007 and 2006 were $0.55 and $1.71 per share. For the three and six months ended June 30, 2007, there were no options exercised and no tax benefits realized. The total intrinsic value of options exercised during the three and six months ended June 30, 2006 were $2,000 and $7,000 and there were no tax benefits realized.

     We settle employee stock option exercises with newly issued common shares.

NOTE 5. BALANCE SHEET COMPONENTS

	June 30,			December 31,
	2007			2006
	(In thousands)
Cash and cash equivalents:
Cash and money market accounts	$	26,422		$	20,137
U.S. government agency and corporate debt securities		17,960			13,594
	$	44,382		$	33,731
Short-term investments:
U.S. government agency and corporate debt securities	$	6,846		$	10,285
Unrealized gain (loss) on marketable securities, net		(38	)		(21	)
	$	6,808		$	10,264
Accounts receivable, net:
Accounts receivable	$	7,161		$	9,465
Less: Allowance for doubtful accounts		(246	)		(276	)
	$	6,915		$	9,189
Other receivables:
Insurance		4,227			966
Other		207			188
	$	4,434		$	1,154
Inventory:
Raw materials	$	412		$	1,210
Work-in-process		1,954			758
Finished goods		3,376			6,310
	$	5,742		$	8,278

     During the three and six months ended June 30, 2007, there was $2.4 million and $8.6 million of net inventory reserve release from the sale of products that had been previously reserved, respectively. During the three and six months ended June 30, 2006, there was a net inventory reserve charge of $2.8 million and a net inventory reserve release of $0.8 million, respectively.

	June 30,			December 31,
	2007			2006
	(In thousands)
Prepaid expenses and other assets:
Prepaid insurance	$	231		$	527
Prepaid maintenance		306			327
Prepaid royalty		314			713
Other		109			197
	$	960		$	1,764
Property, plant and equipment, net:
Land	$	2,860		$	2,860
Building and building improvements		23,821			24,679
Machinery and equipment		34,903			37,260
Furniture and fixtures		22,310			23,607
		83,894			88,406
Less: Accumulated depreciation and amortization		(70,072	)		(71,410	)
	$	13,822		$	16,996
Other assets:
Investments — Best Elite	$	6,857		$	7,000
Investments — other		1,277			1,344
Other		231			708
	$	8,365		$	9,052
Accounts payable and accrued expenses:
Accounts payable	$	4,339		$	6,167
Accrued compensation costs		2,578			6,057
Accrued legal and professional fees		1,093			1,371
Accrued commission and royalties		364			281
Deferred revenue related to distributor sales, net of deferred cost of goods sold		365			216
Non-cancelable, adverse purchase order commitments		2,042			3,077
Accrued securities litigation settlement		3,700			—
Deposit from SiS		—			1,500
Other accrued liabilities		1,388			1,735
	$	15,869		$	20,404

9

NOTE 6. WARRANTY

     We include warranty in other accrued liabilities. We provide standard warranty coverage for twelve months. We account for the general warranty cost as a charge to cost of product revenues when revenue is recognized. The estimated warranty cost is based on historical product performance and field expenses. In addition to the general warranty accrual, we also provide specific warranty amounts for certain parts if there are potential warranty issues. The following table summarizes the activity in the product warranty accrual for the three months and six months ended June 30, 2007 and 2006:

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2007			2006			2007			2006
	(In thousands)
Beginning balance	$	237		$	372		$	254		$	506
Accruals (releases) for warranties issued during the period		(13	)		133			(28	)		18
Settlements made during the period		(1	)		(146	)		(3	)		(165	)
Ending balance	$	223		$	359		$	223		$	359

NOTE 7. MARKETABLE SECURITIES

			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
June 30, 2007	Cost		Gains		(Loss)			Value
	(In thousands)
Money market accounts	$	9,566	$	—	$	—		$	9,566
Corporate debt securities		22,806		48		(1	)		22,853
Corporate equity securities		1,351		—		(74	)		1,277
U.S. government agency bonds		1,915		—		—			1,915
Total available-for-sale	$	35,638	$	48	$	(75	)	$	35,611
Classified as:
Cash equivalents								$	27,526
Short-term marketable securities									6,808
Long-term marketable securities									1,277
								$	35,611

			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
December 31, 2006	Cost		Gains		(Loss)			Value
			(In thousands)
Money market accounts	$	3,363	$	—	$	—		$	3,363
Corporate debt securities		17,203		2		(3	)		17,202
Corporate equity securities		1,233		111		—			1,344
U.S. government agency bonds		6,676		1		(21	)		6,656
Total available-for-sale	$	28,475	$	114	$	(24	)	$	28,565
Classified as:
Cash equivalents								$	16,957
Short-term marketable securities									10,264
Long-term marketable securities									1,344
								$	28,565

10

     The contractual maturities of our investments in corporate debt securities and U.S. government agency bonds classified as available-for-sale as of June 30, 2007, regardless of the consolidated balance sheet classification are as follows:

June, 2007	Estimated Fair Value
	(In thousands)
Maturing in 90 days or less	$	19,513
Maturing between 90 days and one year		3,493
Maturing in more than one year		1,762
Total available-for-sale debt securities	$	24,768

     Actual maturities may 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.

NOTE 8. OTHER COMPREHENSIVE INCOME (LOSS)

     The following table reconciles net income (loss) to total comprehensive loss for the three months and six months ended June 30, 2007 and 2006:

	Three Months Ended June 30,						Six Months Ended June 30,
	2007			2006			2007			2006
	(In thousands)
Net income (loss)	$	(664	)	$	(15,224	)	$	3,939		$	(29,294	)
Change in unrealized gain (loss) on marketable securities and long-term investments		(116	)		(284	)		(85	)		(404	)
Total comprehensive income (loss)	$	(780	)	$	(15,508	)	$	3,854		$	(29,698	)

NOTE 9. NON-OPERATING INCOME, NET

     The following table lists the major components of non-operating income, net, for the three months and six months ended June 30, 2007 and 2006:

	Three Months Ended June 30,						Six Months Ended June 30,
	2007			2006			2007			2006
	(In thousands)
Interest income	$	489		$	940			920		$	1,697
Impairment of investments		(143	)		(252	)		(643	)		(534	)
Other		234			195			218			196
Total non-operating income, net	$	580		$	883		$	495		$	1,359

11

NOTE 10. INCOME TAXES

     We recorded income tax expense of $0.6 million for the three months ended June 30, 2007 and a $0.2 million tax benefit for the three months ended June 30, 2006. We recorded income tax expense of $1.4 million for the six months ended June 30, 2007 and a $0.9 million tax benefit for the six months ended June 30, 2006. The tax expenses for both three and six months ended June 30, 2007 were higher than the pre-tax income at the federal statutory rate of 35% primarily due to the accrual of interest on uncertain tax balances and foreign taxes.

     Effective January 1, 2007, we adopted Financial Accounting Standards Interpretation No. 48 “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN No. 48”). FIN No. 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of uncertain tax positions taken or expected to be taken in our income tax return, and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.

     The cumulative effect of adopting FIN No. 48 was an increase of $4.1 million as a credit to tax liabilities and an increase to the January 1, 2007 accumulated deficit balance. Upon adoption, the tax liability at January 1, 2007 was $33.6 million, which includes $24.1 million that was reclassified from current to non-current liabilities because payment of cash is not anticipated within one year of the balance sheet.

     The total amount of unrecognized tax benefits as of January 1, 2007 was $81.1 million. If recognized, approximately $27.4 million would be recorded as a component of income tax benefit. These amounts have been increased by $1.1 million during the six months ended June 30, 2007 to $82.2 million and $28.5 million, respectively. We do not believe that the total amounts of unrecognized tax benefits will significantly increase or decrease within 12 months of the reporting date.

     Estimated interest related to the underpayment of income taxes is classified as a component of the provision for income taxes in the Consolidated Statement of Operations and totaled $1.1 million for the six months ended June 30, 2007. Accrued interest was $5.2 million as of June 30, 2007. The Company is not subject to tax penalties.

     Our only major tax jurisdictions are the United States, California, and Hong Kong. The tax years 2003 through 2006 remain open and subject to examination by the appropriate governmental agencies in the U.S., 2002 through 2006 in California, and 1999 through 2006 in Hong Kong.

     In 2005, the Company repatriated cash under the Homeland Investment Act. If the Company is unable to invest the funds in the United States as required by the Act, the Company may be required to pay additional United State federal taxes.

NOTE 11. NET INCOME (LOSS) PER SHARE

     For the six months ended June 30, 2007, all of our stock options were anti-dilutive. As we incurred net losses for the three months ended June 30, 2007 and 2006, the effect of dilutive securities (in-the-money stock options) of approximately 1,400 equivalent shares and 31,000 equivalent shares, respectively, have been excluded from the calculation of dilutive net income (loss) per share because they were anti-dilutive. As we incurred net losses for the six months ended June 30, 2006, the effect of dilutive securities (in-the-money stock options) of approximately 39,000 equivalent shares, respectively, have been excluded from the calculation of dilutive net income (loss) per share because they were anti-dilutive.

     For the three months and six months ended June 30, 2007 and 2006, there were options to purchase approximately 6.2 million and 9.6 million shares of our common stock, respectively, with exercise prices greater than the average market value of such common stock. These options were excluded from the calculation of diluted net income (loss) per share as they were anti-dilutive.

NOTE 12. BUSINESS SEGMENT INFORMATION AND CONCENTRATION OF CERTAIN RISKS

Business Segment

     We have historically operated in two reportable business segments: the Video segment and the Digital Imaging segment. In the Video segment, we primarily develop and market digital processor chips which are the primary processors driving digital video and audio devices, including DVD, VCD, consumer digital audio players, and digital media players. In addition, the Video segment continues to sell certain legacy products we have in inventory including chips for use in recordable DVD players, modems, other communication devices, and PC audio products. Our Digital Imaging segment historically developed and

12

marketed imaging sensor chips for cellular camera phone applications. The method for determining what information to report is based on the way that management organized the operating segments within the Company for making operational decisions and assessments of financial performance. Our chief operating decision maker is considered to be the Chief Executive Officer.

     The following table summarizes the percentages of revenues by major product category for the three months and six months ended June 30, 2007 and 2006:

	Three Months Ended June 30,						Six Months Ended June 30,
	2007			2006			2007			2006
Video Business:
DVD		79	%		66	%		78	%		66	%
VCD		10	%		21	%		8	%		21	%
License & royalty		—			—			2	%		0	%
Other		11	%		6	%		12	%		5	%
Total Video Business		100	%		93	%		100	%		92	%
Digital Imaging Business		—			7	%		—			8	%
Total		100	%		100	%		100	%		100	%

     DVD revenue includes revenue from sales of DVD decoder chips, integrated encoder and decoder chips and non-integrated encoder and decoder chipsets. VCD revenue includes revenue from sales of VCD chips. License and royalty revenue primarily consists of revenue from license of DVD technology to Silan and from license of TV audio technology to NEC. Digital Imaging revenue includes revenue from sales of image sensor chips and image processor chips.

     We evaluate operating segment performance based on net revenues and operating income (loss) of our segments. The accounting policies of the operating segments are the same as those described in the summary of accounting policies in our Annual Report on Form 10-K. Information about reported segments follows:

	Three Months Ended June 30,						Six Months Ended June 30,
	2007			2006			2007			2006
	(In thousands)
Segment net revenues:
Video	$	17,148		$	27,036		$	34,818		$	51,394
Digital Imaging		36			2,030			138			4,558
Total net revenues	$	17,184		$	29,066		$	34,956		$	55,952
Segment operating income (loss):
Video	$	2,161		$	(9,073	)	$	12,592		$	(17,269	)
Digital Imaging		10			(4,305	)		(2,056	)		(7,948	)
Total segment operating income (loss)		2,171			(13,378	)		10,536			(25,217	)
Unallocated corporate expenses		(2,809	)		(2,896	)		(5,712	)		(6,290	)
Operating income (loss)	$	(638	)	$	(16,274	)	$	4,824		$	(31,507	)

Significant Customers and Distributor

     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. FE Global (China) Limited (“FE Global”) is our largest distributor. We work directly with many of our customers in Hong Kong and China on product design and development. Whenever one of these customers buys our products, however, the order is processed through FE Global, which functions much like a trading company. FE Global 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 inventory are transferred to FE Global upon shipment of inventory to FE Global. FE Global is legally responsible to pay our invoices regardless of when the inventories are sold to end-customers. Revenues on sales to FE Global are deferred until FE Global sells the products to end-customers.

     During the three months ended June 30, 2007 and 2006, FE Global accounted for approximately 21% and 36%, respectively, of our net revenues. During the six months ended June 30, 2007 and 2006, FE Global accounted for approximately 30% and 32%, respectively, of our net revenues.

13

     During the three months ended June 30, 2007, in addition to FE Global, Samsung Electronics Company (“Samsung”) and LG International Corporation (“LG”) accounted for approximately 36%, and 13% of our net revenues, respectively. During the three months ended June 30, 2006, in addition to FE Global, LG, SLHK Limited (a subsidiary of Hangzhou Silan Microelectronics Joint-Stock Co. Ltd) (“SLHK”), Universe Electron Corporation (“UEC”) and Samsung accounted for approximately 13%, 12%, 12% and 11% of our net revenues, respectively.

     During the six months ended June 30, 2007, in addition to FE Global, Samsung and LG accounted for approximately 27%, and 14% of our net revenues, respectively. During the six months ended June 30, 2006, in addition to FE Global, LG, SLHK, Samsung and UEC accounted for approximately 15%, 13%, and 11% and 10% of our net revenues, respectively.

     As of June 30, 2007 and December 31, 2006 FE Global accounted for approximately 31% and 27%, respectively, of our gross trade accounts receivable. As of June 30, 2007, in addition to FE Global, Samsung and LG accounted for approximately 19% and 17%, respectively, of our gross trade accounts receivable. In addition to FE Global, LG, Samsung and UEC accounted for 20%, 14% and 11% of our gross trade accounts receivable as of December 31, 2006.

NOTE 13. 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, 2007:

	Payment Due by Period
Contractual Obligations	Total		Less than 1 Year		1-3 Years		3-5 Years		More than 5 Years
	(In thousands)
Operating lease obligations	$	1,059	$	959	$	100		—		—
Purchase obligations		13,145		13,145		—		—		—
Total	$	14,204	$	14,104	$	100		—		—

     As of June 30, 2007, our commitments to purchase inventory from the third-party contractors aggregated approximately $8.8 million of which approximately $2.0 million was non-cancelable purchase order commitments that we have recorded as accrued expenses. Additionally, as of June 30, 2007, commitments for services, license and other operating supplies totaled $4.3 million.

     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.

     The total rent expense under all operating leases was approximately $541,000 and $342,000 for the three months ended June 30, 2007 and 2006, respectively. Rent expense for three months ended June 30, 2007 included $356,000 accrual related to the early lease termination of our Irvine office. The total rent expense under all operating leases was approximately $835,000 and $669,000 for the six months ended ended June 30, 2007 and 2006, respectively.

     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, 2007.

     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. We have, however, a directors and officers’ insurance policy that may reduce our exposure and enable us to recover a portion of any future amounts paid. As a result of this insurance coverage, we believe the estimated fair value of these indemnification agreements is minimal.

     As discussed in Note 10 — Income Taxes, we adopted the provisions of FIN 48 on January 1, 2007. At June 30, 2007 we had a liability for unrecognized tax benefits and accrual for the payment of related interest and penalties totalling $34.5 million of which none is expected to be paid within the next 12 months. The Company is unable to make a reasonable estimate as to when cash settlement with a taxing authority will occur.

14

Legal Proceedings

     On September 12, 2002, following our downward revision of revenue and earnings guidance for the third fiscal quarter of 2002, a series of putative federal class action lawsuits were filed against us in the United States District Court, Northern District of California. The complaints alleged that we and certain of our present and former officers and directors made misleading statements regarding our business and failed to disclose certain allegedly material facts during an alleged class period of January 23, 2002 through September 12, 2002, in violation of federal securities laws. These actions were consolidated and are proceeding under the caption “In re ESS Technology Securities Litigation.” The plaintiffs seek unspecified damages on behalf of the putative class. Plaintiffs amended their consolidated complaint on November 3, 2003, which we then moved to dismiss on December 18, 2003. On December 1, 2004, the Court granted in part and denied in part our motion to dismiss, and struck from the complaint allegations arising prior to February 27, 2002. On December 22, 2004, based on the Court’s order, we moved to strike from the complaint all remaining claims and allegations arising prior to September 10, 2002. On February 22, 2005, the Court granted our motion in part and struck all remaining claims and allegations arising prior to August 1, 2002 from the complaint. In an order filed on February 8, 2006, the Court certified a plaintiff class of all persons and entities who purchased or otherwise acquired the Company’s publicly traded securities during the period beginning August 1, 2002, through and including September 12, 2002 (the “Class Period”), excluding officers and directors of the Company, their families and families of the defendants, and short-sellers of the Company’s securities during the Class Period. On March 24, 2006, plaintiff filed a motion for leave to amend their operative complaint, which the Court denied on May 30, 2006. Trial was tentatively set for January 2008. On November 12, 2006, the parties attended a mediation at which they agreed to settle the litigation for $3.5 million (to be paid by defendants’ insurance carriers), subject to appropriate documentation by the parties and approval by the Court. The Stipulation of Settlement and Release was filed with the Court on April 30, 2007. On May 8, 2007, the Court issued an order preliminarily approving the settlement and providing for class notice. At a fairness hearing on July 27, 2007, having received no objections to the settlement and no requests for exclusion, the Court entered a Final Judgment and Order of Dismissal With Prejudice as to all defendants. The settlement is conditioned on expiration of the time for appeal from the Court’s order approving the settlement. While defendants have denied and continue to deny any and all allegations of wrongdoing in connection with this matter, we believe that given the uncertainties and cost associated with litigation, the settlement is in the best interests of the Company and its stockholders. We recorded a $3.5 million loss for the settlement in the six months ended June 30, 2007, as management has determined this amount probable of payment and reasonably estimable. In addition, because recovery from our insurance carriers is probable, a receivable was also recorded for the same amount, plus recoverable legal fees. Accordingly, there is no impact to the statement of operations because the amount of the settlement, including legal expenses, and the insurance recovery offset each other.

     On September 12, 2002, following the same downward revision of revenue and earnings holders of our common stock, purporting to represent us, filed a series of derivative lawsuits in California state court, County of Alameda, against us as a nominal defendant and against certain of our present and former directors and officers as defendants. The lawsuits allege certain violations of the federal securities laws, including breaches of fiduciary duty and insider trading. These actions have been consolidated and are proceeding as a Consolidated Derivative Action with the caption “ESS Cases.” The derivative plaintiffs seek compensatory and other damages in an unspecified amount, disgorgement of profits, and other relief. On March 24, 2003, we filed a demurrer to the consolidated derivative complaint and moved to stay discovery in the action pending resolution of the initial pleadings in the related federal action, described above. The Court denied the demurrer but stayed discovery. That stay has since been lifted in light of the procedural progress of the federal action. No trial date has been set. The parties have reached an agreement in principle to settle the litigation in exchange for certain minor modifications of the Company’s internal policies and payment of plaintiffs’ attorneys fees not to exceed $200,000 (to be paid by defendants’ insurance carriers). The agreement in principle to settle the litigation is subject to appropriate documentation and finalization by the parties and approval by the Court. There can be no assurance that final settlement will be obtained. While defendants have denied and continue to deny any and all allegations of wrongdoing in connection with this matter, we believe that given the uncertainties and cost associated with litigation, the settlement is in the best interests of the Company and its stockholders. We recorded a $200,000 loss for the proposed settlement in the three months ended June 30, 2007, as management has determined this amount probable of payment and reasonably estimable. This estimate may change as a result of the final settlement arrangement. In addition, because recovery from the insurance carriers is probable, a receivable was also recorded for the same amount. Accordingly, there is no impact to the statement of operations because the amount of the settlement and the insurance recovery offset each other.

     On October 4, 2006, Ali Corporation (“Ali”) filed a lawsuit in Alameda County Superior Court against the company that alleged claims for breach of contract, common counts, quantum meruit, account stated and for an open book account. All of the claims arose from a Joint Development Agreement between the company and Ali, originally entered into on December 14, 2001 and subsequently amended on several occasions. Ali’s complaint sought damages in the amount of $2.5 million. The company answered Ali’s complaint and on April 6, 2007 the parties settled this matter in the course of a formal mediation. A Settlement Agreement has been executed and the matter has been dismissed pursuant to the settlement.

     From time to time, we are subject to various claims and legal proceedings. If management believes that a loss arising from these matters is probable and can reasonably be estimated, we would record the amount of the loss, or the minimum estimated liability when the loss is estimated using a range, and no point within the range is more probable than another. As additional information becomes available, any potential liability related to these matters is assessed and the estimates are revised, if

15

necessary. Based upon consultation with the outside counsel handling our defense in the legal proceedings listed in Part II, Item 1, Legal Proceedings, and an analysis of potential results, we have accrued sufficient amounts for potential losses related to these proceedings. Based on currently available information, management believes that the ultimate outcome of these matters, individually and in the aggregate, will not have a material adverse effect on our financial position, cash flows or overall trends in results of operations. Litigation, however, is subject to inherent uncertainties, and unfavorable rulings could occur. An unfavorable ruling could include monetary damages or an injunction prohibiting us from selling one or more products. If an unfavorable ruling were to occur, a material adverse impact on the results of operations of the period in which the ruling occurs, or future periods, could result.

NOTE 14. RECENT ACCOUNTING PRONOUNCEMENTS

     In September 2006, the FASB issued statement No. 157, “Fair Value Measurements” (“SFAS No. 157”). This standard defines fair value, establishes a framework for measuring fair value in accounting principles generally accepted in the United States of America, and expands disclosure about fair value measurements. This pronouncement applies under other accounting standards that require or permit fair value measurements. Accordingly, this statement does not require any new fair value measurement. This statement is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We will be required to adopt SFAS No. 157 in the first quarter of fiscal year 2008. We are currently evaluating the requirements of SFAS No. 157 and have not yet determined the impact on our consolidated financial statements.

     In February 2007, the FASB issued statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”). SFAS No. 159 permits companies to choose to measure certain financial instruments and certain other items at fair value. The standard requires that unrealized gains and losses on items for which the fair value option has been elected be reported in earnings. SFAS No. 159 is effective for us beginning in the first quarter of fiscal year 2008, although earlier adoption is permitted. We are currently evaluating the impact that SFAS No. 159 may have on our consolidated financial statements.

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

     Certain information contained in or incorporated by reference in the following Management’s Discussion and Analysis of Financial Condition and Results of Operations, in Item 1A, Risk Factors, 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. Actual results may differ materially from those projected in the forward-looking statements as a result of various factors including those discussed in Item 1A, Risk Factors, and elsewhere in this Report. In some cases, these statements can be identified by terminologies such as “may,” “will,” “expect,” “anticipate,” “estimate,” “continue,” other similar terms or the negative of these terms. 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, 2006.

     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

16

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

• Impairment of Long-lived Assets

• Income Tax and Reserves

• Legal Contingencies

• Stock-based Compensation

     Effective January 1, 2007, we adopted Financial Accounting Standards Interpretation, or FIN No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109.” See Note 10, “Income taxes,” to our condensed consolidated financial statements.

     For further discussion of our critical accounting policies and estimates, see 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, 2006.

Recent Accounting Pronouncements

     See Note 14, “Recent Accounting Pronouncements,” to our consolidated financial statements for disclosure of the recently issued accounting pronouncements that may impact our financial statements in the future.

EXECUTIVE OVERVIEW

     We were incorporated in California in 1984 and became a public company in 1995. We have historically operated in two primary business segments, Video and Digital Imaging, both in the semiconductor industry serving the consumer electronics and digital media marketplace.

     In our Video business, we design, develop and market highly integrated analog and digital processor chips and digital amplifiers. Our digital processor chips drive digital video and audio devices, including DVD, Video CD (“VCD”), consumer digital audio players, and digital media players. We continue to sell certain legacy products we have in inventory including chips for use in recordable DVD players, modems, other communication devices, and PC audio products. On September 18, 2006 we announced an ongoing strategic review of our operations and business plan. In connection with this strategic review, on November 3, 2006, we licensed to Hangzhou Silan Microelectronics Co., Ltd. (“Silan”) the development, manufacture and sale of our next generation standard definition DVD chips, the Phoenix II and LMX II, and also granted Silan a non-exclusive license for our standard definition DVD technology. On February 16, 2007, we sold to Silicon Integrated Systems Corporation and its affiliates (“SiS”) our tangible and intangible assets relating to the development of high definition DVD chips based on next generation blue laser technology. Also in connection with this restructuring strategy, during the first quarter of 2007 we substantially terminated the production and sale of our camera phone image sensors. We plan to license our image sensor patents in exchange for royalties, but we will no longer sell imaging sensor semiconductor chips. We continue to design, develop and market highly integrated analog and digital processor chips and digital amplifiers including standard definition DVD products primarily for the Korean market and digital audio players and digital media players for all markets. We are now concentrating on standard definition DVD and evaluating opportunities to develop profitable operations. Our strategy is to focus on the design and development of our chip product while outsourcing all of our chip fabrication, assembly, and test operations.

     We market our products worldwide through our direct sales force, distributors and sales representatives. Substantially all of our sales are to distributors, direct customers and end-customers in China, Hong Kong, Taiwan, Japan, Korea, Indonesia and Singapore. We employ sales and support personnel located outside of the United States in China, Hong Kong, Taiwan and Korea to support these international sales efforts. We expect that international sales will continue to represent a significant portion of our

17

net revenues. In addition, substantially all of our products are manufactured, assembled and tested by independent third parties in Asia. We also have a number of employees engaged in research and development efforts outside of the United States. There are unique risks associated with conducting business outside of the United States.

     For the years ended December 31, 2006 and 2005, we incurred significant operating losses and negative cash flows. We believe that we have the cash resources to fund our operations for at least the next twelve months. The semiconductor industry in which we operate is characterized by rapid technological advances, short product lives and significant price reductions. If we are unable to meet these challenges, then we will not achieve profitable operations. We may determine that we require additional capital to achieve our current or future business objectives. There can be no assurances that such capital will be available or available on terms that are acceptable to us, which could adversely affect our financial position, results of operations or cash flows.

     Effective January 1, 2007, we adopted Financial Accounting Standards Interpretation No. 48 “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN No. 48”). FIN No. 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of uncertain tax positions taken or expected to be taken in our income tax return, and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.

     The cumulative effect of adopting FIN No. 48 was an increase of $4.1 million in interest recorded as a credit to tax liabilities and an increase to the January 1, 2007 accumulated deficit balance. Upon adoption, the tax liability at January 1, 2007 was $33.6 million, which includes $24.1 million that was reclassified from current to non-current liabilities because payment of cash is not anticipated within one year of the balance sheet. The total amount of unrecognized tax benefits as of the January 1, 2007 adoption date was $81.1 million. If recognized, approximately $27.4 million would be recorded as a component of income tax expense. These amounts have been increased by $1.1 million during the six months ended June 30, 2007 to $82.2 million and $28.5 million, respectively.

     On September 18, 2006 we announced an ongoing strategic review of our operations and business plan. In connection with this strategic review, our Board of Directors formed and appointed its Strategic Transaction Committee in April 2007, composed of independent directors, to consider strategic alternatives. The Strategic Transaction Committee has engaged Needham & Company, LLC to act as its investment banker in this process.

Recent Developments

     Our largest distributor, FE Global, recently informed us in a letter dated as of July 31, 2007 that FE Global has decided to terminate its distribution agreement with us on August 31, 2007. FE Global has expressed a desire to make arrangements to clear any remaining inventory and customer and supplier backlogs and settle the outstanding debts, if any, owed to us pursuant to applicable credit terms.

RESULTS OF OPERATIONS

COMPARISON OF THREE MONTHS ENDED JUNE 30, 2007 AND JUNE 30, 2006

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

	Three Months Ended June 30,
	2007					2006
	(In thousands, except percentage data)
Net revenues	$	17,184		100.0	%	$	29,066		100.0	%
Cost of revenues		12,514		72.8			28,354		97.6
Gross profit		4,670		27.2			712		2.4
Operating expenses:
Research and development		2,570		15.0			9,941		34.2
Selling, general and administrative		4,738		27.6			7,045		24.2
Gain on sale of technology and tangible assets		(2,000	)	(11.6	)		—		n/a
Operating loss		(638	)	(3.8	)		(16,274	)	(56.0	)
Non-operating income, net		580		3.4			883		3.0
Loss before income taxes		(58	)	(0.4	)		(15,391	)	(53.0	)
Provision for (benefit from) income taxes		606		3.5			(167	)	(0.6	)
Net loss	$	(664	)	(3.9	)	$	(15,224	)	(52.4	)%

Net Revenues

     Net revenues were $17.2 million for the three months ended June 30, 2007, a decrease of $11.9 million, or 40.9%, compared to $29.1 million for the three months ended June 30, 2006, due to decreased revenues in all product categories in both of our business segments, except sales of legacy video products.

18

     The following table summarizes percentage of net revenues by our two business segments and their major product categories:

	Three Months Ended June 30,
	2007			2006
Video Business:
DVD		79	%		66	%
VCD		10	%		21	%
License & royalty		—			—
Other		11	%		6	%
Total Video Business		100	%		93	%
Digital Imaging Business		—			7	%
Total		100	%		100	%

     Video business revenues included revenues from DVD and VCD products, license and royalty payments for technology, and other products.

     DVD revenue consists of revenue from sales of DVD player chip and recordable chips, which includes integrated encoder and decoder. DVD revenue was $13.5 million for the three months ended June 30, 2007, a decrease of $5.8 million, or 30.1%, from revenue of $19.3 million for the three months ended June 30, 2006, primarily due to lower sales volume and overall average selling price (“ASP”). For the three months ended June 30, 2007, sales volume decreased 17.4% and ASP decreased by 14.0% from the three months ended June 30, 2006. We sold approximately 3.8 million units and 4.6 million units for the three months ended June 30, 2007 and 2006, respectively. Lower DVD revenue was a result of our previously discussed reorganization and competitive pressure. We expect DVD revenue will increase marginally during the remainder of 2007.

     VCD revenue includes revenue from sales of VCD chips. VCD revenue was $1.7 million for the three months ended June 30, 2007, a decrease of $4.4 million, or 72.1%, from revenue of $6.1 million for the three months ended June 30, 2006, primarily due to lower overall sales volume, and partially offset by higher ASP. For the three months ended June 30, 2007, unit sales decreased by 77.6% while ASP increased by 26.1% from the three months ended June 30, 2006. We sold approximately 1.1 million units and 4.9 million units for the three months ended June 30, 2007 and 2006, respectively. Lower VCD revenue was due to the replacement of the VCD market with lower priced DVD units. In addition, in 2006, we licensed to Silan the right to manufacture and market our VCD technology to customers in China and India. Silan recently started shipping a new integrated version, utilizing Silan’s front-end optical controller and ESS’s back-end video processor VCD chip for which they will pay ESS a royalty. Approximately 34% of current VCD revenue are ESS manufactured chips sold to Silan. We expect VCD revenue will continue to decline in 2007 and will shift substantially to royalty payments.

     Other revenue includes revenue from legacy products which includes sales of PC Audio, communication, consumer digital media and miscellaneous chips. Other revenue was $2.0 million for the three months ended June 30, 2007, an increase of $0.3 million, or 14.7%, from revenue of $1.7 million for the three months ended June 30, 2006 primarily due to higher sales volume. For the three months ended June 30, 2007, unit sales increased by 100.0% from the three months ended June 30, 2006. We sold approximately 0.4 million units and 0.2 million units for the three months ended June 30, 2007 and 2006, respectively.

     Digital Imaging revenue includes revenue from sales of image sensor chips and image processor chips. Digital Imaging revenue was $36,000 for the three months ended June 30, 2007, a decrease of approximately $2.0 million, or substantially 100.0%, from revenue of $2.0 million for the three months ended June 30, 2006. During the first quarter of 2007, we reduced operations of our camera phone image sensor business and no longer design, develop and market imaging sensor chips.

     International revenue accounted for almost all of net revenues for the three months ended June 30, 2007 and 2006. Our international sales are denominated in U.S. dollars.

Gross Profit

     Gross profit was $4.7 million, or 27.2% of net revenues, for the three months ended June 30, 2007, compared to $0.7 million, or 2.4% of net revenues, for the three months ended June 30, 2006. The increase in gross margin was due primarily to a $2.4 million net inventory reserve release, from the sale of products that had been previously reserved, compared to a $2.8 million net inventory reserve charge for the three months ended June 30, 2006. Additionally, there was a decrease of $0.8 million in royalty and amortization expenses for the three months ended June 30, 2007 compared to the same period in 2006 due primarily to a decrease in profit sharing royalty expenses related to our older Vibratto II products and the amortization of intangible assets related to prior acquisitions as they became fully amortized during 2006.

19

Research and Development Expenses

     Research and development expenses were $2.6 million, or 15.0% of net revenues, for the three months ended June 30, 2007 compared to $9.9 million, or 34.2% of net revenues, for the three months ended June 30, 2006. The $7.3 million, or 73.7%, decrease in research and development for the three months ended June 30, 2007 was primarily due to the strategic review announced previously and comprised of the following: $3.5 million decrease in salaries and fringe benefits, $0.5 million decrease in stock-based compensation expense under SFAS No. 123(R), $0.9 million decrease in engineering test materials and operating supplies, $0.7 million decrease in mask sets, $0.6 million decrease in depreciation and $0.3 million decrease in hardware and software maintenance, $0.2 million decrease in consulting and outside services, and $0.2 million decrease in facility related expenses.

Selling, General and Administrative Expenses

     Selling, general and administrative expenses were $4.7 million, or 27.6% of net revenues, for the three months ended June 30, 2007 compared to $7.0 million, or 24.2% of net revenues, for the three months ended June 30, 2006. The $2.3 million, or 32.9%, decrease in selling, general and administrative expenses for the three month ended June 30, 2007 was primarily due to the strategic review announced previously and comprised of the following: $2.0 million decrease in salaries and fringe benefits, $0.4 million decrease in stock-based compensation expense under SFAS No. 123(R), $0.4 million decrease in bad debt resulted from a lower past-due balance from one of our distributors, $0.2 million decrease in travel expense and $0.2 million decrease in tax and insurance expense, partially offset by $0.3 million increase in rent expense resulted from an early lease termination of our Irvine facility, $0.2 million increase in fixed asset write-off of our international sales offices, and, and $0.2 million increase in legal and investor relation expenses.

Gain on Sale of Technology and Tangible Assets

     On February 16, 2007, we entered into asset purchase agreements with SiS, pursuant to which we transferred employees, sold certain tangible assets and licensed intellectual property related to our HD-DVD and Blu-ray DVD technologies for aggregate proceeds of approximately $13.5 million. Of this amount, $9.5 million was received during the first quarter of 2007, $2.0 million was received upon SiS’ final certification of all transferred and licensed technology in the second quarter of 2007, with the remaining $2.0 million subject to adjustment upon settlement of any escrow claims by SiS through August 16, 2008. We have not recognized any revenue related to HD-DVD or Blu-ray DVD products in any period.

Non-operating Income, Net

     Net non-operating income was $0.6 million for the three months ended June 30, 2007 compared to net non-operating income of $0.9 million for the three months ended June 30, 2006. For the three months ended June 30, 2007, net non-operating income mainly consisted of interest income of $0.5 million and other miscellaneous gain of $0.2 million, partially offset by the impairment of our investments of $0.1 million. For the three months ended June 30, 2006, net non-operating income mainly consisted of interest income of $0.9 million and other miscellaneous gain of $0.2 million, partially offset by the write-down of our investment in MosChip of $0.3 million.

Provision for (Benefit from) Income Taxes

     Our income tax expense was $0.6 million for the three months ended June 30, 2007 compared to $0.2 million tax benefit for the three months ended June 30, 2006. The tax expense for the current quarter was primarily the result of foreign taxes and interest accrued on uncertain tax balances. The tax provision for the three months ended June 30, 2007 includes interest and penalties on tax liabilities of $0.6 million.

20

COMPARISON OF SIX MONTHS ENDED JUNE 30, 2007 AND JUNE 30, 2006

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

	Six Months Ended June 30,
	2007					2006
	(In thousands, except percentage data)
Net revenues	$	34,956		100.0	%	$	55,952		100.0	%
Cost of revenues		22,915		65.6			52,877		94.5
Gross profit		12,041		34.4			3,075		5.5
Operating expenses:
Research and development		7,161		20.5			19,538		34.9
Selling, general and administrative		9,678		27.7			15,044		26.9
Impairment of property, plant and equipment		859		2.5			—		n/a
Gain on sale of technology and tangible assets		(10,481	)	(30.0	)		—		n/a
Operating income (loss)		4,824		13.7			(31,507	)	(56.3	)
Non-operating income, net		495		1.4			1,359		2.4
Income (loss) before income taxes		5,319		15.1			(30,148	)	(53.9	)
Provision for (benefit from) income taxes		1,380		3.9			(854	)	(1.5	)
Net income ( loss)	$	3,939		11.2	%	$	(29,294	)	(52.4	)%

Net Revenues

     Net revenues were $35.0 million for the six months ended June 30, 2007, a decrease of $21.0 million, or 37.5%, compared to $56.0 million, for the six months ended June 30, 2006, due to decreased revenues in all product categories in both of our business segments; the six months ended June 30, 2007 included $0.8 million in license revenue from Silan for DVD technology.

     The following table summarizes percentage of net revenues by our two business segments and their major product categories:

	Six Months Ended June 30,
	2007			2006
Video Business:
DVD		78	%		66	%
VCD		8	%		21	%
License & royalty		2	%		—
Other		12	%		5	%
Total Video Business		100	%		92	%
Digital Imaging Business		—			8	%
Total		100	%		100	%

     Video business revenues included revenues from DVD and VCD products, license and royalty payments for technology, and other products.

     DVD revenue consists of revenue from sales of DVD player chip and recordable chips, which includes integrated encoder and decoder. DVD revenue was $27.4 million for the six months ended June 30, 2007, a decrease of $9.3 million, or 25.3%, from revenue of $36.7 million for the six months ended June 30, 2006, primarily due to lower overall ASP and sales volume. For the six months ended June 30, 2007, ASP decreased by 21.1% and sales volume decreased by 4.7% from the six months ended June 30, 2006. We sold approximately 8.1 million units and 8.5 million units for the six months ended June 30, 2007 and 2006, respectively. Lower DVD revenue was a result of our previously discussed reorganization and competitive pressure. We expect DVD revenue will increase marginally during the remainder of 2007.

     VCD revenue includes revenue from sales of VCD chips. VCD revenue was $2.8 million for the six months ended June 30, 2007, a decrease of $8.9 million, or 76.1%, from revenue of $11.7 million for the six months ended June 30, 2006, primarily due to lower overall sales volume, and partially offset by higher ASP. For the six months ended June 30, 2007, unit sales decreased by 83.2% while ASP increased by 46.7% from the six months ended June 30, 2006. We sold approximately 1.6 million units and 9.5 million units for the six months ended June 30, 2007 and 2006, respectively. Lower VCD revenue was due to the replacement of the VCD market with lower priced DVD units. In addition, in 2006, we licensed to Silan the right to manufacture and market our VCD technology to customers in China and India. Silan recently started shipping a new integrated version, utilizing Silan’s front-end optical controller and ESS’s back-end video processor VCD chip for which they will pay ESS a royalty. Approximately 22% of current VCD revenue are ESS manufactured chips sold to Silan. We expect VCD revenue will continue to decline in 2007 and will shift substantially to royalty payments.

21

     License and royalty revenue consists of payments from Silan to whom we licensed the right to produce and distribute our next-generation standard definition DVD chips. The license and royalty revenue was $0.8 million for the six months ended June 30, 2007. There was no license or royalty revenue for the six months ended June 30, 2006.

     Other revenue includes revenue from legacy products which includes sales of PC Audio, communication, consumer digital media and miscellaneous chips. Other revenue was $3.9 million for the six months ended June 30, 2007, an increase of $0.8 million, or 26.2%, from revenue of $3.1 million for the six months ended June 30, 2006 primarily due to higher sales volume. For the six months ended June 30, 2007, unit sales increased by 100.0% from the six months ended June 30, 2006. We sold approximately 0.8 million units and 0.4 million units for the six months ended June 30, 2007 and 2006, respectively.

     Digital Imaging revenue includes revenue from sales of image sensor chips and image processor chips. Digital Imaging revenue was $0.1 million for the six months ended June 30, 2007, a decrease of $4.4 million, or 97.8%, from revenue of $4.5 million for the six months ended June 30, 2006. During the first quarter 2007, we reduced operations of our camera phone image sensor business and no longer design, develop and market imaging sensor chips.

     International revenue accounted for almost all of net revenues for the six months ended June 30, 2007 and 2006. Our international sales are denominated in U.S. dollars.

Gross Profit

     Gross profit was $12.0 million, or 34.4% of net revenues, for the six months ended June 30, 2007, compared to $3.1 million, or 5.5% of net revenues, for the six months ended June 30, 2006. Results for the six months ended June 30, 2007 included a net $8.6 million inventory reserve release, compared to $0.6 million for the six months ended June 30, 2006. Additionally, there was a decline of $2.4 million in royalty and amortization expenses for the six months ended June 30, 2007 compared to the same period in 2006 due primarily to a decrease in profit sharing royalty expenses related to our older Vibratto II products and the amortization of intangible assets related to prior acquisitions as they became fully amortized during 2006.

Research and Development Expenses

     Research and development expenses were $7.2 million, or 20.5% of net revenues, for the six months ended June 30, 2007 compared to $19.5 million, or 34.9% of net revenues, for the six months ended June 30, 2006. The $12.3 million, or 63.1%, decrease in research and development for the six months ended June 30, 2007 was primarily due to the strategic review announced previously and comprised of the following: $6.1 million decrease in salaries and fringe benefits, $1.0 million decrease in stock-based compensation expense under SFAS No. 123(R), $1.7 million decrease in engineering test materials and operating supplies, $1.2 million decrease in mask sets, $1.1 million decrease depreciation and $0.4 million decrease in hardware and software maintenance, and $0.3 million in facility related expenses.

Selling, General and Administrative Expenses

     Selling, general and administrative expenses were $9.7 million, or 27.7% of net revenues, for the six months ended June 30, 2007 compared to $15.0 million, or 26.9% of net revenues, for the six months ended June 30, 2006. The $5.3 million, or 35.3%, decrease in selling, general and administrative expenses for the six months ended June 30, 2007 was primarily due to the strategic review announced previously and comprised of the following: $4.4 million decrease in salaries and fringe benefits, $0.9 million decrease in stock-based compensation expense under SFAS No. 123(R), $0.4 million decrease in tax and insurance, $0.3 million decrease in travel expense, and $0.3 million decrease in amortization of intangible assets as they became fully amortized during 2006, partially offset by $0.3 million increase in rent expense resulted from an early lease termination of our Irvine facility, $0.2 million increase in accounting and investor relations, and $0.2 million increase in fixed asset write-off of our international sales offices.

Impairment of Property, Plant and Equipment

     In connection with the strategic review of operations and business plan announced in September 2006, we substantially terminated the operations of our camera phone image sensor business during the first quarter of 2007. As a result, we believe that

22

the carrying amount of property, plant and equipment at our Irvine, California office no longer exceeds its fair value and have recorded a $0.9 million impairment charge during the three months ended March 31, 2007.

Gain on Sale of Technology and Tangible Assets

     On February 16, 2007, we entered into asset purchase agreements with SiS, pursuant to which we transferred employees, sold certain tangible assets and licensed intellectual property related to our HD-DVD and Blu-ray DVD technologies for aggregate proceeds of approximately $13.5 million. Of this amount, $9.5 million was received during the first quarter of 2007, $2.0 million was received during the second quarter upon SiS’ final certification of all transferred and licensed technology, with the remaining $2.0 million subject to adjustment upon settlement of any escrow claims by SiS through August 16, 2008. The gain recognized during the six months ended June 30, 2007 includes the proceeds received, net of the book value of assets sold and certain transaction expenses related to the sale. We have not recognized any revenue related to HD-DVD or Blu-ray DVD products in any period.

Non-operating Income, Net

     Net non-operating income was $0.5 million and $1.4 million for the six months ended June 30, 2007 and 2006, respectively. Non-operating income primarily represents interest and investment income offset by investment losses. For the six months ended June 30, 2007, net non-operating income mainly consisted of interest income of $0.9 million and other miscellaneous income of $0.2 million, partially offset by the impairment of our investments of $0.6 million. For the six months ended June 30, 2006, net non-operating income mainly consisted of interest income of $1.7 million and other miscellaneous income of $0.2 million, partially offset by the impairment of our investments of $0.5 million.

Provision for (Benefit from) Income Taxes

     Our income tax expense was $1.4 million for the six months ended June 30, 2007 compared to a $0.9 million tax benefit for the six months ended June 30, 2006. The tax expense for the six months ended June 30, 2007 was primarily the result of foreign taxes and interest accrued on uncertain tax balances. The tax provision for the six months ended June 30, 2007 includes interest and penalties on tax liabilities of $1.1 million.

LIQUIDITY AND CAPITAL RESOURCES

     Since inception, we have financed our cash requirements from cash generated by operations, the sale of equity securities, and short-term and long-term debt. At June 30, 2007, we had cash, cash equivalents and short-term investments of $44.4 million and working capital of $53.3 million.

     Net cash used in operating activities was $3.6 million and $29.0 million for the six months ended June 30, 2007 and 2006, respectively. After adjusting for net gains and losses of $8.8 million, the net cash used in operating activities for the six months ended June 30, 2007 was primarily attributable to the increase in other receivable of $3.3 million due to the increase in insurance receivable on the securities litigation settlement and decrease in accounts payable and other accrued expenses of $4.5 million, partially offset by net income of $3.9 million, depreciation of $1.9 million, decrease in inventory of $2.5 million and decrease in accounts receivable trade of $2.3 million. The net cash used in operating activities for the six months ended June 30, 2006 was primarily attributable to a net loss of $29.3 million, increases in inventories of $12.9 million, and partially offset by the decreases in other receivables of $4.5 million, depreciation and amortization of $4.1 million and stock-based compensation of $2.5 million. Inventories increased as we were building inventory of our recently introduced Phoenix family of DVD products in anticipation of increasing sales. The decrease in other receivables primarily relates to a decrease in receivables from a vendor to whom we provided raw materials. Net cash used in operating activities for the six months ended June 30, 2007 decreased from the same period in 2006 due to reduced operating expenses primarily from our strategic review of operations and business plan announced in September 2006.

     Net cash provided by investing activities was $14.2 million and $16.9 million for the six months ended June 30, 2007 and 2006, respectively. The net cash provided by investing activities for the six months ended June 30, 2007 was primarily attributable to the proceeds from sale of technology and tangible assets of $11.4 million and the proceeds from sales of short-term investments of $6.8 million, partially offset by the purchase of short-term investments of $3.3 million and during the six months ended June 30, 2007, we made a $0.5 million investment which was subsequently impaired. This impairment was recorded in non-operating income, net. The net cash provided by investing activities for the six months ended June 30, 2006 was primarily attributable to the proceeds from sales of short-term

23

investments of $31.4 million, partially offset by the purchase of short-term investments of $12.7 million and purchase of property, plant and equipment of $1.6 million.

     Net cash provided in financing activities for the six months ended June 30, 2007 was $16,000 received from issuance of common stock under employee stock purchase. The net cash used by financing activities for the six months ended June 30, 2006 was primarily attributable to the repurchase of common stock of $1.6 million, and partially offset by the proceeds from issuance of common stock under employee stock purchase plan of $0.2 million.

     To date, we have not declared or paid cash dividends to our shareholders and do not anticipate paying any dividend in the foreseeable future due to a number of factors, including the volatile nature of the semiconductor industry and the potential requirement to finance working capital in the event of a significant upturn in business. We reevaluate this practice from time to time but are not currently contemplating the payment of a cash dividend.

     We have no long-term debt. Our capital expenditures for the next twelve months are anticipated to be less than $1.0 million. We may also use cash to acquire or invest in other businesses or products or to obtain the right to use complementary technologies. From time to time, in the ordinary course of business, we may evaluate potential acquisitions of, or investment in, such businesses, products or technologies owned by third parties. Also, from time to time the Board of Directors may approve the expenditure of cash resources to repurchase our common stock as market conditions warrant. Based on past performance and current expectations, we believe that our existing cash and short-term investments as of June 30, 2007, together with funds expected to be generated by future operations, sales of assets and other financing options, will be sufficient to satisfy our working capital needs, capital expenditures, mergers and acquisitions, strategic investment requirements, acquisitions of property and equipment, stock repurchases and other potential needs for the next twelve months.

Contractual Obligations, 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, 2007:

	Payment Due by Period
Contractual Obligations	Total		Less than 1 Year		1-3 Years		3-5 Years		More than 5 Years
	(In thousands)
Operating lease obligations	$	1,059	$	959	$	100		—		—
Purchase obligations		13,145		13,145		—		—		—
Total	$	14,204	$	14,104	$	100		—		—

     As of June 30, 2007, our commitments to purchase inventory from the third-party contractors aggregated approximately $8.8 million of which approximately $2.0 million was non-cancelable purchase order commitments that we have recorded as accrued expenses. Additionally, as of June 30, 2007, commitments for services, license and other operating supplies totaled $4.3 million.

     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.

     The total rent expense under all operating leases was approximately $541,000 and $342,000 for the three months ended June 30, 2007 and 2006, respectively. Rent expense for three months ended June 30, 2007 included $356,000 accrual related to the early lease termination of our Irvine office. The total rent expense under all operating leases was approximately $835,000 and $669,000 for the six months ended June 30, 2007 and 2006, respectively.

     From time to time, we are subject to various claims and legal proceedings. If management believes that a loss arising from these matters is probable and can reasonably be estimated, we would record the amount of the loss, or the minimum estimated liability when the loss is estimated using a range, and no point within the range is more probable than another. As additional information becomes available, any potential liability related to these matters is assessed and the estimates are revised, if necessary. Based upon consultation with the outside counsel handling our defense in the legal proceedings listed in Part II, Item 1, Legal Proceedings, and an analysis of potential results, we have accrued sufficient amounts for potential losses related to these proceedings. Based on currently available information, management believes that the ultimate outcome of these matters, individually and in the aggregate, will not have a material adverse effect on our financial position, cash flows or overall trends in results of operations. Litigation, however, is subject to inherent uncertainties, and unfavorable rulings could occur. An unfavorable ruling could include monetary damages or an injunction prohibiting us from selling one or more products. If an

24

unfavorable ruling were to occur, a material adverse impact on the results of operations of the period in which the ruling occurs, or future periods, could result.

     As discussed in Note 10 — Income Taxes, we adopted the provisions of FIN 48 on January 1, 2007. At June 30, 2007 we had a liability for unrecognized tax benefits and accrual for the payment of related interest totalling $34.5 million of which none is expected to be paid within the next 12 months. The Company is unable to make a reasonable estimate as to when cash settlement with a taxing authority will occur.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

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

Foreign Exchange Risks

     We fund our operations with cash generated by operations, the sale of marketable securities and short and long-term debt. Since most of our revenues are international, as we operate primarily in Asia, we are exposed to market risk from changes in foreign exchange rates, which could affect our results of operations and financial condition. In order to reduce the risk from fluctuation in foreign exchange rates, our product sales and all of our arrangements with our foundries and test and assembly vendors are denominated in U.S. dollars. We have operations in China, Taiwan, Hong Kong and Korea. Expenses of our international operations are denominated in each country’s local currency and therefore are subject to foreign currency exchange risk; however, through June 30, 2007 we have not experienced any negative impact on our operations as a result of fluctuations in foreign currency exchange rates. We performed a sensitivity analysis assuming a hypothetical 10% adverse movement in foreign exchange rates to the foreign subsidiaries and the underlying exposures described above. As of June 30, 2007, the analysis indicated that these hypothetical market movements could impact our consolidated financial statements by approximately $0.4 million. We have not entered into any currency hedging activities.

Interest Rate Risks

     We also invest in short-term investments. Consequently, we are exposed to fluctuation in interest rates on these investments. Increases or decreases in interest rates generally translate into decreases and increases in the fair value of these investments. For instance, one percentage point decrease in interest rates would result in approximately a $0.5 million decrease in our annual interest income. In addition, the credit worthiness of the issuer, relative values of alternative investments, the liquidity of the instrument, and other general market conditions may affect the fair values of interest rate sensitive investments. In order to reduce the risk from fluctuation in rates, we invest in highly liquid governmental notes and bonds with contractual maturities of less than two years. All of the investments have been classified as available-for-sale, and on June 30, 2007, the fair market value of our investments approximated their costs.

Investment Risk

     We are exposed to market risk as it relates to changes in the market value of our investments in public companies. We invest in equity instruments of public companies for business and strategic purposes and we have classified these securities as available-for-sale. These available-for-sale equity investments, primarily in technology companies, are subject to significant fluctuations in fair market value due to the volatility of the stock market and the industries in which these companies participate. Our objective in managing our exposure to stock market fluctuations is to minimize the impact of stock market declines to our earnings and cash flows. There are, however, a number of factors beyond our control. Continued market volatility, as well as mergers and acquisitions, have the potential to have a material impact on our results of operations in future periods.

     We are also exposed to changes in the value of our investments in non-public technology companies including start-up companies. These long-term equity investments in technology companies are subject to significant fluctuations in fair value due to the volatility of the industries in which these companies participate and other factors.

Item 4. Controls and Procedures

     Under the direction of our Chief Executive Officer and Chief Financial Officer, we evaluated our disclosure controls and procedures and internal control over financial reporting and concluded that (i) our disclosure controls and procedures were

25

effective as of June 30, 2007, and (ii) no change in internal control over financial reporting occurred during the quarter ended June 30, 2007 that has materially affected or is reasonably likely to materially affect, such internal control over financial reporting.

26

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

     On September 12, 2002, following our downward revision of revenue and earnings guidance for the third fiscal quarter of 2002, a series of putative federal class action lawsuits were filed against us in the United States District Court, Northern District of California. The complaints alleged that we and certain of our present and former officers and directors made misleading statements regarding our business and failed to disclose certain allegedly material facts during an alleged class period of January 23, 2002 through September 12, 2002, in violation of federal securities laws. These actions were consolidated and are proceeding under the caption “In re ESS Technology Securities Litigation.” The plaintiffs seek unspecified damages on behalf of the putative class. Plaintiffs amended their consolidated complaint on November 3, 2003, which we then moved to dismiss on December 18, 2003. On December 1, 2004, the Court granted in part and denied in part our motion to dismiss, and struck from the complaint allegations arising prior to February 27, 2002. On December 22, 2004, based on the Court’s order, we moved to strike from the complaint all remaining claims and allegations arising prior to September 10, 2002. On February 22, 2005, the Court granted our motion in part and struck all remaining claims and allegations arising prior to August 1, 2002 from the complaint. In an order filed on February 8, 2006, the Court certified a plaintiff class of all persons and entities who purchased or otherwise acquired the Company’s publicly traded securities during the period beginning August 1, 2002, through and including September 12, 2002 (the “Class Period”), excluding officers and directors of the Company, their families and families of the defendants, and short-sellers of the Company’s securities during the Class Period. On March 24, 2006, plaintiff filed a motion for leave to amend their operative complaint, which the Court denied on May 30, 2006. Trial was tentatively set for January 2008. On November 12, 2006, the parties attended a mediation at which they agreed to settle the litigation for $3.5 million (to be paid by defendants’ insurance carriers), subject to appropriate documentation by the parties and approval by the Court. The Stipulation of Settlement and Release was filed with the Court on April 30, 2007. On May 8, 2007, the Court issued an order preliminarily approving the settlement and providing for class notice. At a fairness hearing on July 27, 2007, having received no objections to the settlement and no requests for exclusion, the Court entered a Final Judgment and Order of Dismissal With Prejudice as to all defendants. The settlement is conditioned on expiration of the time for appeal from the Court’s order approving the settlement. While defendants have denied and continue to deny any and all allegations of wrongdoing in connection with this matter, we believe that given the uncertainties and cost associated with litigation, the settlement is in the best interests of the Company and its stockholders. We recorded a $3.5 million loss for the settlement in the six months ended June 30, 2007, as management has determined this amount probable of payment and reasonably estimable. In addition, because recovery from our insurance carriers is probable, a receivable was also recorded for the same amount, plus recoverable legal fees. Accordingly, there is no impact to the statement of operations because the amount of the settlement, including legal expenses, and the insurance recovery offset each other.

     On September 12, 2002, following the same downward revision of revenue and earnings holders of our common stock, purporting to represent us, filed a series of derivative lawsuits in California state court, County of Alameda, against us as a nominal defendant and against certain of our present and former directors and officers as defendants. The lawsuits allege certain violations of the federal securities laws, including breaches of fiduciary duty and insider trading. These actions have been consolidated and are proceeding as a Consolidated Derivative Action with the caption “ESS Cases.” The derivative plaintiffs seek compensatory and other damages in an unspecified amount, disgorgement of profits, and other relief. On March 24, 2003, we filed a demurrer to the consolidated derivative complaint and moved to stay discovery in the action pending resolution of the initial pleadings in the related federal action, described above. The Court denied the demurrer but stayed discovery. That stay has since been lifted in light of the procedural progress of the federal action. No trial date has been set. The parties have reached an agreement in principle to settle the litigation in exchange for certain minor modifications of the Company’s internal policies and payment of plaintiffs’ attorneys fees not to exceed $200,000 (to be paid by defendants’ insurance carriers). The agreement in principle to settle the litigation is subject to appropriate documentation and finalization by the parties and approval by the Court. There can be no assurance that final settlement will be obtained. While defendants have denied and continue to deny any and all allegations of wrongdoing in connection with this matter, we believe that given the uncertainties and cost associated with litigation, the settlement is in the best interests of the Company and its stockholders. We recorded a $200,000 loss for the proposed settlement in the three months ended June 30, 2007, as management has determined this amount probable of payment and reasonably estimable. This estimate may change as a result of the final settlement arrangement. In addition, because recovery from the insurance carriers is probable, a receivable was also recorded for the same amount. Accordingly, there is no impact to the statement of operations because the amount of the settlement and the insurance recovery offset each other.

     On October 4, 2006, Ali Corporation (“Ali”) filed a lawsuit in Alameda County Superior Court against the company that alleged claims for breach of contract, common counts, quantum meruit, account stated and for an open book account. All of the claims arose from a Joint Development Agreement between the company and Ali, originally entered into on December 14, 2001 and subsequently amended on several occasions. Ali’s complaint sought damages in the amount of $2.5 million. The company answered Ali’s complaint and on April 6, 2007 the parties settled this matter in the course of a formal mediation. A Settlement Agreement has been executed and the matter has been dismissed pursuant to the settlement.

     From time to time, we are subject to various claims and legal proceedings. If management believes that a loss arising from these matters is probable and can reasonably be estimated, we would record the amount of the loss, or the minimum estimated liability when the loss is estimated using a range, and no point within the range is more probable than another. As additional

27

information becomes available, any potential liability related to these matters is assessed and the estimates are revised, if necessary. Based upon consultation with the outside counsel handling our defense in the legal proceedings listed in Part II, Item 1, Legal Proceedings, and an analysis of potential results, we have accrued sufficient amounts for potential losses related to these proceedings. Based on currently available information, management believes that the ultimate outcome of these matters, individually and in the aggregate, will not have a material adverse effect on our financial position, cash flows or overall trends in results of operations. Litigation, however, is subject to inherent uncertainties, and unfavorable rulings could occur. An unfavorable ruling could include monetary damages or an injunction prohibiting us from selling one or more products. If an unfavorable ruling were to occur, a material adverse impact on the results of operations of the period in which the ruling occurs, or future periods, could result.

Item 1A. Risk Factors

     We have updated the following risk factors which were previously disclosed in Part I Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2006.

  The Strategic Transaction Committee may not be able to identify or recommend strategic alternatives on favorable terms or at all.

     In connection with the ongoing strategic review of our operations and business plan, our Board of Directors appointed its Strategic Transaction Committee, composed of independent directors, to consider strategic alternatives. There can be no assurance that the Strategic Transaction Committee will be able to identify strategic alternatives on favorable terms or at all.

  We have a history of losses and expect to continue to incur net losses in the near-term.

     We have experienced operating losses in each quarterly and annual period since the quarter ended September 30, 2004. We incurred net losses of approximately $44.1 million, $99.6 million, and $35.6 million for the fiscal years ended December 31, 2006, 2005, and 2004, respectively. We had an accumulated deficit of approximately $128.7 million as of June 30, 2007. We will need to generate significant increases in our revenues and margins to achieve and maintain profitability or significantly reduce operating expenses or both. There can be no certainty that our efforts to restructure and reduce its operating expenses will reduce or eliminate these losses; indeed, the reductions and restructuring could increase losses due to reduced revenue levels. There can be no certainty that these operating losses will not continue and consume our working capital.

  Our business strategy is currently going through significant evaluation and change.

     We announced on September 18, 2006 that our business strategy has been going through a significant transition. This transition and our current strategy may fail to stop our operating losses, and we may take alternative measures. As part of this transition, we may not be able to make our current lines of business profitable and therefore may exit them. We may not be able to identify or acquire or transition to new lines of business that may be profitable, and we may not have enough resources to transition to certain alternative lines of business. We are also evaluating alternatives to maximize shareholder value including the sale of the business and/or alternative business models, markets, products, industries and technologies. We may determine it is in the best interests of our shareholders to move us into alternative lines of business, industries and/or markets other than those in which we have historically operated, namely the fabless semiconductor business.

  If our new business strategy is unsuccessful, it could significantly harm our business and operating results.

     On September 18, 2006, we announced an ongoing review of our business strategy. In particular, we announced a business strategy to concentrate our standard DVD business activities on serving a few large customers and to look for business partners or acquirers for our high definition HD DVD and Blu-ray DVD business and our camera phone business. On November 3, 2006 we entered into a DVD Technology License Agreement with Silan for the exclusive license of certain standard definition DVD technologies and also granted Silan a non-exclusive license for our remaining standard definition DVD technology. On February 16, 2007 we entered into Asset Purchase Agreements with SiS to sell our HD-DVD and Blu-ray DVD assets and technologies and on the same date announced we were reducing operations of our camera phone business. In conjunction with this strategic review we are currently maintaining our remaining standard definition DVD business, entering into the business of designing, manufacturing and marketing analog processor chips, and license our image sensor patents. If the market for our licensed VCD and/or DVD businesses, our retained DVD standard definition businesses or our image sensor patent license business or the market for our new product offerings is smaller than we anticipated, our results of operations and business would be adversely affected. In addition, if there is a delay in bringing our new products to market, it would delay our ability to derive revenues from such products and our business and operating results could be significantly harmed. Selling and/or licensing of our standard definition DVD and high definition DVD businesses and reducing operations of our camera phone business may also reduce the scale of our business and income stream, result in our greater reliance on our remaining businesses and result in higher than anticipated expenses such as unforeseen severance costs. Our strategy to expand our digital audio and analog processor chip businesses is still being evaluated, and we may determine it is not attractive for us to pursue any or all of those businesses.

28

Our business is highly dependent on the expansion of the consumer electronics market and our ability to respond to changes in such market.

     Our focus has been developing products primarily for the consumer electronics market. Due to the short life-cycle of the products in this market, we must identify and capitalize on market opportunities in a timely manner to become a leader in these product areas. Historically, we have had to respond to market trends, identify key products and become the market leader for such products in order to succeed. Unfortunately, we have been unable to maintain our market position in recent periods. The DVD market and our role in that market have shifted, and, as a result, we recently granted a license for Silan to take over the design, manufacture and sale of certain of our standard definition DVD products and also sold and licensed our HD-DVD and Blu-ray DVD technologies to SiS. We have historically and we expect to continue to evaluate our strategies in our businesses to ensure that we focus on the technologies and markets that will provide us the best opportunities for the future. Nonetheless, our strategy in potential new markets may not be successful. If the markets for these products and applications decline or fail to develop as expected, or if we are not successful in our efforts to market and sell our products to manufacturers who incorporate our chip into their products, we could exit our historic lines of business and enter other lines of business outside of semiconductors, and it could have a material adverse effect on our business financial conditions and results of operations.

We operate in highly competitive markets.

     The markets in which we operate are intensely competitive and are characterized by rapid technological changes, rapid price reductions and short product life cycles. Competition typically occurs at the design stage, when customers evaluate alternative design approaches requiring integrated circuits. Because of short product life cycles, there are frequent design win competitions for next-generation systems.

     We expect competition to increase in the future from existing competitors and from other companies that may enter our existing or future markets with products that may be provided at lower costs or provide higher levels of integration, higher performance or additional features. In some cases, our competitors have been acquired by even larger organizations, giving them access to even greater resources with which to compete. Advancements in technology can change the competitive environment in ways that may be adverse to us. Unless we are able to develop and deliver highly desirable products in a timely manner continuously and achieve market domination in one or more product lines, we will not be able to achieve long-term sustainable success in this fast consolidating industry. If we are only able to offer commodity products, our results of operations and long-term success will suffer and we will fall prey to stronger competitors. For example, today’s high-performance central processing units in PCs have enough excess computing capacity to perform many of the functions that formerly required a separate chip set, which has reduced demand for our PC audio chips, among other chips. Moreover, our VCD and standard definition DVD products have begun to experience commodity like pricing pressures as new technologies evolve. The announcements and commercial shipments of competitive products could adversely affect sales of our products and may result in increased price competition that would adversely affect the average selling price (“ASP”) and margins of our products.

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

• The timing and success of our new product introductions and those of our customers and competitors;

• The ability to control product cost and produce consistent yield of our products;

• The ability to obtain adequate foundry capacity and sources of raw materials;

• The price, quality and performance of our products and the products of our competitors;

• The emergence of new multimedia standards;

• The development of technical innovations;

• The rate at which our customers integrate our products into their products;

• The number and nature of our competitors in a given market; and

• The protection of our intellectual property rights.

29

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

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

To compete in our industry, we may need to acquire other companies and technologies and/or restructure our businesses, and we may not be successful acquiring key targets, integrating our acquisitions into our businesses or restructuring our businesses effectively.

     We believe the semiconductor industry is experiencing a general industry consolidation. To remain competitive, a semiconductor company must be able to offer high-demand products and renew its product offerings in a timely manner. In order to meet such a high turn over in product offerings, in addition to our own research and development of new products, we regularly consider strategic additions or deletions of our product offerings to enhance our strategic position. To remain competitive in this rapidly changing market, we need to constantly update our product offering and realign our cost structure to bring to the market more sophisticated and cost-effective products. However, we may not be able to identify and consummate suitable acquisitions and investments effectively. Conversely, we may not be able to restructure and realign our businesses effectively. Strategic transactions carry risks that could have a material adverse effect on our business, financial condition and results of operations, including:

• The failure of the acquired products or technology to attain market acceptance, which may result from our inability to leverage such products and technology successfully;

• The failure to integrate acquired products and business with existing products and corporate culture;

• The inability to restructure or realign our businesses effectively and cost-efficiently;

• The inability to retain key employees from the acquired company;

• Diversion of management attention from other business concerns;

• The potential for large write-offs of intangible assets;

• Issuances of equity securities dilutive to our existing shareholders;

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

• Our ability to properly access and maintain an effective internal control environment over an acquired company in order to comply with public reporting requirements.

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

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

• Charges related to the net realizable value of inventories;

30

• Changes in demand or sales forecast for our products;

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

• Changes in the cost of producing our products;

• The timely implementation of customer-specific hardware and software requirements for specific design wins;

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

• Availability and cost of foundry capacity;

• Gain or loss of significant customers;

• Seasonal customer demand;

• The cyclical nature of the semiconductor industry;

• The timing of our and our competitors’ new product announcements and introductions and the market acceptance of new or enhanced versions of our and our customers’ products;

• The timing of significant customer orders and/or design wins;

• Charges related to the impairment of other intangible assets;

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

• The “turns” basis of most of our orders, which makes backlog a poor indicator of the next quarter’s revenue;

• The potential for large adjustments due to resolution of multi-year tax examinations;

• The lead time we normally receive for our orders, which makes it difficult to predict sales until the end of the quarter;

• Availability and cost of raw materials;

• Significant increases in expenses associated with the expansion of operations; and

• A shift in manufacturing of consumer electronic products away from Asia.

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

     We currently place non-cancelable orders to purchase our products from independent foundries and other vendors on an approximately three-month rolling basis, while our customers generally place purchase orders (frequently with short lead times) with us that may be cancelled without significant penalty. Some of these customers may require us to demonstrate our ability to deliver in response to their short lead-time. In order to accommodate such customers, we have to commit to certain inventories before we have a firm commitment from our customers. If anticipated sales and shipments in any quarter are cancelled, do not occur as quickly as expected or become subject to declining ASPs, expense and inventory levels could be disproportionately high and we may be required to record significant inventory charges in our statement of operations in a particular period. In accordance with our accounting policy, we reduce the carrying value of our inventories for estimated slow-moving, excess, obsolete, damaged or otherwise unmarketable products by an amount based on forecasts of future demand and market conditions. As our business grows, we may increasingly rely on distributors, which may further impede our ability to accurately forecast product orders. Additionally, we may venture into new products with different supply chain and logistics requirements which may in turn cause excess or shortage of inventory.

31

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

     We invest a significant amount of time and resources in our research and development activities to enhance and maintain our competitive position. Technical innovations are inherently complex and require long development cycles and the commitment of extensive engineering resources. We incur substantial research and development costs to confirm the technical feasibility and commercial viability of a product that in the end may not be successful. If we are not able to successfully complete our research and development projects on a timely basis, we may face competitive disadvantages. There is no assurance that we will recover the development costs associated with these projects or that we will be able to secure the financial resources necessary to fund future research and development efforts.

     We have recently significantly reduced the size of our research and development workforce and the remaining personnel may not be adequate to enable us to successfully manage existing projects or enter new product markets. Our margins may decrease to a point where we will be unable to sustain the research and development resources necessary to remain competitive.

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

     The semiconductor industry is characterized by rapid technological changes, evolving industry standards and product obsolescence. Our success is highly dependent upon the successful development and timely introduction of new products at competitive prices and performance levels. Recently our financial performance has suffered because we were late with product introductions compared to our competition and we expect this trend in our financial performance to continue until we deliver new product offerings that are competitive and accepted by the market. The success of new products depends on a number of factors, including:

• Anticipation of market trends;

• Timely completion of design, development, and testing of both the hardware and software for each product;

• Timely completion of customer specific design, development and testing of both hardware and software for each design win;

• Market acceptance of our products and the products of our customers;

• Offering new products at competitive prices;

• Meeting performance, quality and functionality requirements of customers and OEMs; and

• Meeting the timing, volume and price requirements of customers and OEMs.

     Our products are designed to conform to current specific industry standards; however, we have no control over future modifications to these standards. Manufacturers may not continue to follow the current standards, which would make our products less desirable to manufacturers and reduce our sales. Our success is highly dependent upon our ability to develop new products in response to these changing industry standards.

Our sales may fluctuate due to seasonality and changes in customer demand.

     Since we are primarily focused on the consumer electronics market, we are likely to be affected both by changes in consumer demand and by seasonality in the sales of our products. Historically, over half of consumer electronics products are sold during the holiday seasons. Consequently, our results during a period that covers a non-holiday season may vary dramatically from a period that covers a holiday season. Consumer electronics product sales have historically been much higher during the holiday shopping seasons than during other times of the year, although the manufacturers’ shipments vary from quarter to quarter depending on a number of factors, including retail levels and retail promotional activities. In addition, consumer demand often varies from one product to another in consecutive holiday seasons and is strongly influenced by the overall state of the economy. Because the consumer electronics market experiences substantial seasonal fluctuations, seasonal trends may cause our quarterly operating results to fluctuate significantly and our inability to forecast these trends may adversely affect the market price of our common stock. For instance, as ASPs for DVD products decline, customer demands for VCD products, from which we enjoy a

32

good product margin, even under our recent arrangement to license our VCD products, may shift to DVD products and ultimately render our VCD products obsolete. In the future, if the market for our products is not as strong during the holiday seasons, whether as a result of changes in consumer tastes, changes in our mix of products or because of an overall reduction in consumer demand due to economic conditions, we may fail to meet expectations of securities analysts and investors which could cause our stock price to fall.

Our products are subject to increasing pricing pressures.

     The markets for most of the applications for our chips are characterized by intense price competition. The willingness of OEMs to design our chips into their products depends, to a significant extent, upon our ability to sell our products at cost-effective prices. We expect the ASP of our existing products (particularly our DVD decoder) to decline significantly over their product lives as the markets for our products mature, new products or technology emerge and competition increases. If we are unable to reduce our costs sufficiently to offset declines in product prices or are unable to introduce more advanced products with higher margins, our gross margins may decline in the future.

We may lose business to competitors who have significant competitive advantages.

     Our existing and potential competitors consist, in part, of large domestic and international companies that have substantially greater financial, manufacturing, technical, marketing, distribution and other resources, greater intellectual property rights, broader product lines and longer-standing relationships with customers than we have. These competitors may have more visibility into market trends, which is critically important in an industry characterized by rapid technological changes, evolving industry standards and product obsolescence. Our competitors also include a number of independent and emerging companies who may be able to better adapt to changing market conditions and customer demand. In addition, some of our current and potential competitors maintain their own semiconductor fabrication facilities and could benefit from certain capacity, cost and technical advantages. We expect that market experience to date and the predicted growth of the market will continue to attract and motivate more and stronger competitors.

     In the Video business, DVD and VCD players face significant competition from video-on-demand, VCRs and other video formats. Further, VCD players, which tend to be viewed as a less expensive alternative, are being replaced by DVD players as DVD players come down in price. We expect that the DVD platform will face competition from other platforms including set-top-boxes, as well as multi-function game boxes being manufactured and sold by large companies. Some of our competitors may be more diversified than us and may supply chips for multiple platforms. Any of these competitive factors could reduce our sales and market share and may force us to lower our prices, adversely affecting our business, financial condition and results of operations.

     As we focus on standard definition DVD technology and move away from HD-DVD and Blu-ray DVD technologies, demand may shift in such a way that we would no longer have the technology to address the market’s changing demand and be unable to remain competitive.

Our business is dependent upon retaining key personnel and attracting new employees.

     Our success depends to a significant degree upon the continued contributions of our top management including Robert L. Blair, our President and Chief Executive Officer (“CEO”). The loss of the services of Mr. Blair or any of our other key executives could adversely affect our business. Fred S.L. Chan, our Chairman of the Board, recently resigned, and James B. Boyd, our Chief Financial Officer, announced his intention to resign. We may not be able to retain our other key personnel and searching for key personnel replacements could divert the attention of other senior management and increase our operating expenses. We currently do not maintain any key person life insurance.

     Additionally, to manage our future operations effectively, we will need to hire and retain additional management personnel, design personnel as well as hardware and software engineers. We may have difficulty recruiting these employees or integrating them into our business. The loss of services of any of our key personnel, the inability to attract and retain qualified personnel in the future, or delays in hiring required personnel, particularly design personnel and software engineers, could make it difficult to implement our key business strategies, such as timely and effective product introductions.

Changes in stock option accounting rules may adversely impact our reported operating results prepared in accordance with generally accepted accounting principles, our stock price and our competitiveness in the employee marketplace.

33

     Our success and competitiveness depend in large part on our ability to attract, retain and motivate key employees. Achieving this objective may be difficult due to many factors, including fluctuations in global economic and industry conditions, changes in our management or leadership, the effectiveness of our compensation programs, including our equity-based programs, and competitors’ hiring practices. In addition, we began recording a charge to earnings for stock options and ESPP shares in our first fiscal quarter of 2006. This requirement reduces the attractiveness of certain equity-based compensation programs as the expense associated with the grants decreases our profitability. We may make certain adjustments to our broad-based equity compensation programs. These changes may reduce the effectiveness of compensation programs. If we do not successfully attract, retain and motivate key employees as a result of these or other factors, our ability to capitalize on our opportunities and our operating results and may be materially and adversely affected.

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

     Sales through our largest distributor FE Global (a Singapore-based company) were approximately 21% and 36% of our net revenues for the three months ended June 30, 2007 and 2006, respectively. FE Global is not subject to any minimum purchase requirements and can discontinue marketing any of our products at any time. In addition, FE Global has rights of return for unsold products and rights to pricing allowances to compensate for rapid, unexpected price changes. Therefore, we do not recognize revenue until FE Global sells through to our end-customers. If our relationship with FE Global deteriorates, our quarterly results could fluctuate significantly as we experience short-term disruption to our sales and collection processes, particularly in light of the fact that we maintain significant accounts receivable from FE Global. We may increasingly rely on distributors, which may reduce our exposure to future sales opportunities. Although we believe that we could replace FE Global as our distributor for the Hong Kong and China markets, there can be no assurance that we could replace FE Global in a timely manner, or even if a replacement were found, that the new distributor would be as effective as FE Global in generating revenue for us. The reduction, delay or cancellation of orders from FE Global or the loss of FE Global as a distributor could materially and adversely affect our business, financial condition and results of operations. In addition, any difficulty in collecting amounts due from FE Global could harm our financial condition.

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

     A substantial portion of our net revenues has been derived from sales to a small number of our customers. During the three months ended June 30, 2007, sales to our top five end-customers across business segments (including end-customers that buy our products from our largest distributor FE Global) accounted for approximately 73% of our net revenues. We expect this concentration of sales to continue along with other changes in the composition of our customer base. The reduction, delay or cancellation of orders from one or more major customers or the loss of one or more major customers could materially and adversely affect our business, financial condition and results of operations. In addition, any difficulty in collecting amounts due from one or more key customers could harm our financial condition.

Because we are dependent upon a limited number of suppliers, we could experience delivery disruptions or unexpected product cost increases.

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

     In addition, we license certain technology from third parties that is incorporated into many of our key products. If we are unable to obtain or license the technology on commercially reasonable terms and on a timely basis, we will not be able to deliver products to our customers on competitive terms and in a timely manner and our relationships with our customers may suffer.

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

     To protect our intellectual property rights we rely on a combination of patents, trademarks, copyrights and trade secret laws and confidentiality procedures. We have numerous patents granted in the United States with some corresponding foreign patents. These patents will expire at various times. We cannot assure you that patents will be issued from any of our pending applications

34

or applications in preparation or that any claims allowed from pending applications or applications in preparation will be of sufficient scope or strength. We may not be able to obtain patent protection in all countries where our products may be sold. Also, our competitors may be able to design around our patents. The laws of some foreign countries may not protect our products or intellectual property rights to the same extent, as do the laws of the United States. We cannot assure you that the actions we have taken to protect our intellectual property will adequately prevent misappropriation of our technology or that our competitors will not independently develop technologies that are substantially equivalent or superior to our technology.

     The semiconductor industry is characterized by vigorous protection and pursuit of intellectual property rights or positions. Litigation by or against us could result in significant expense and divert the efforts of our technical and management personnel, whether or not such litigation results in a favorable determination for us. Any claim, even if without merit, may require us to spend significant resources to develop non-infringing technology or enter into royalty or cross-licensing arrangements, which may not be available to us on acceptable terms, or at all. We may be required to pay substantial damages or cease the use and sale of infringing products, or both. In general, a successful claim of infringement against us in connection with the use of our technologies could adversely affect our business and our results of operations could be significantly harmed. See Part II, Item 1, “Legal Proceedings.” We may initiate claims or litigation against third parties for infringement of our proprietary rights or to establish the validity of our proprietary rights. In the event of an adverse result in any such litigation our business could be materially harmed.

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

     Substantially all of our sales are to customers (including distributors) in China, Hong Kong, Indonesia, Korea, Taiwan, and Japan. During the three months ended June 30, 2007, sales to customers in these territories were approximately 96% of our net revenues. If our sales in one of these countries or territories, such as China, were to fall, our financial condition could be materially impaired. We expect that international sales will continue to represent a significant portion of our net revenues. In addition, substantially all of our products are manufactured, assembled and tested by independent third parties in Asia. There are special risks associated with conducting business outside of the United States, including:

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

• Political, social and economic instability;

• Lack of adequate protection of our intellectual property rights;

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

• Tariffs, quotas and other trade barriers and restrictions;

• Longer payment cycles, greater difficulties in accounts receivable collection and greater difficulties in ascertaining the credit of our customers and potential business partners;

• Potentially adverse tax consequences, including withholding in connection with the repatriation of earnings and restrictions on the repatriation of earnings;

• Difficulties in obtaining export licenses for technologies;

• Language and other cultural differences, which may inhibit our sales and marketing efforts and create internal communication problems among our U.S. and foreign counterparts; and

• Currency exchange risks.

Our products are manufactured by independent third parties.

     We rely on independent foundries to manufacture all of our products. Substantially all of our products are currently manufactured by TSMC, GSMC, and other independent Asian foundries in Asia. Our reliance on these or other independent foundries involves a number of risks, including:

35

• Possibility of an interruption or loss of manufacturing capacity;

• Reduced control over delivery schedules, manufacturing yields and costs; and

• The inability to reduce our costs as rapidly as competitors who perform their own manufacturing and who are not bound by volume commitments to subcontractors at fixed prices.

     Any failure of these third-party foundries to deliver products or otherwise perform as requested could damage our relationships with our customers and harm our sales and financial results.

     To address potential foundry capacity constraints in the future, we may be required to enter into arrangements, including equity investments in or loans to independent wafer manufacturers in exchange for guaranteed production capacity, joint ventures to own and operate foundries, or “take or pay” contracts that commit us to purchase specified quantities of wafers over extended periods. These arrangements could require us to commit substantial capital or to grant licenses to our technology. If we need to commit substantial capital, we may need to obtain additional debt or equity financing, which could result in dilution to our shareholders.

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

     Our potential customers often spend a significant amount of time to evaluate, test and integrate our products. Our sales cycles often last for several months and may last for up to a year or more. These longer sales cycles require us to invest significant resources prior to the generation of revenues and subject us to greater risk that customers may not order our products as anticipated. In addition, orders expected in one quarter could shift to another because of the timing of customers’ purchase decisions. Any cancellation or delay in ordering our products after a lengthy sales cycle could adversely affect our business.

Our products are subject to recall risks.

     The greater integration of functions and complexity of our products increase the risk that our customers or end users could discover latent defects or subtle faults in our products. These discoveries could occur after substantial volumes of product have been shipped, which could result in material recalls and replacement costs. Product recalls could also divert the attention of our engineering personnel from our product development needs and could adversely impact our customer relationships. In addition, we could be subject to product liability claims that could distract management, increase costs and delay the introduction of new products.

The semiconductor industry is subject to cyclical variations in product supply and demand.

     The semiconductor industry is subject to cyclical variations in product supply and demand, the timing, length and volatility of which are difficult to predict. Downturns in the industry have been characterized by abrupt fluctuations in product demand, production over-capacity and accelerated decline of ASP. Upturns in the industry have been characterized by rising costs of goods sold and lack of production capacity at our suppliers. These cyclical changes in demand and capacity, upward and downward, could significantly harm our business. Our quarterly net revenues and gross margin performance could be significantly impacted by these cyclical variations. A prolonged downturn in the semiconductor industry could materially and adversely impact our business, financial condition and results of operations. We cannot assure you that the market will improve from a cyclical downturn or that cyclical performance will stabilize or improve.

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

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

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

• Changes in accounting rules, particularly those related to the expensing of stock options and accounting for uncertainty in income taxes;

36

• The liquidity within the market for our common stock;

• Sales or purchases by us or by our officers, directors, other insiders and large shareholders;

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

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

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

We are incurring additional costs and devoting more management resources to comply with increasing regulation of corporate governance and disclosure.

     We are spending an increased amount of management time and external resources to analyze and comply with changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and NASDAQ Stock Market rules and listing requirements. Devoting the necessary resources to comply with evolving corporate governance and public disclosure standards may result in increased general and administrative expenses and attention to these compliance activities and divert management’s attention from our on-going business operations.

Failure to maintain effective internal controls could have a material adverse effect on our business, operating results and stock price.

     Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we are required to include a report of management’s assessment of the design and effectiveness of our internal controls as part of our Annual Report on Form 10-K. In order to issue our report, our management must document both the design for our internal control over financial reporting and the testing processes, including those related to new systems and programs, that support management’s evaluation and conclusion. During the course of testing our internal controls each year, we may identify deficiencies which we may not be able to remediate, document and retest in time, due to difficulties including those arising from turnover of qualified personnel, to meet the deadline for management to complete its report. Upon the completion of our testing and documentation, certain deficiencies may be discovered that will require remediation, the costs of which could have a material adverse effect on our results of operations. Moreover, our independent registered public accounting firm may not agree with our management’s assessment and may send us a deficiency notice that we are unable to remediate on a timely basis. In addition, if we fail to maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended from time to time we may not be able to ensure that our management can conclude on an ongoing basis that we have effective internal control over financial reporting in accordance with Section 404 and we may not be able to retain our independent registered public accounting firm with sufficient resources to attest to and report on our internal control. In the future, if we are unable to assert that our internal control over financial reporting is effective, we could lose investor confidence in the accuracy and completeness of our financial reports, which in turn could have an adverse effect on our stock price.

37

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

ISSUER PURCHASES OF EQUITY SECURITIES

					Total Number of		Maximum Number
			Weighted		Shares Purchased as		of Shares That may
			Average Price		Part of Publicly		yet be Purchased
	Total Number of		Paid per		Announced		Under the
Period	Shares Purchased		Share		Programs		Programs(1)
April 1, 2007 — April 30, 2007		—	$	—		—		688,000
May 1, 2007 — May 31, 2007		—		—		—		5,688,000
June 1, 2007 — June 30, 2007		—		—		—		5,688,000
Total		—	$	—		—

(1) We announced on April 16, 2003 that our Board of Directors authorized us to repurchase up to 5,000,000 shares of our common stock. During the three months ended June 30, 2007, we did not purchased any shares under this program. As of June 30, 2007, we had approximately 688,000 shares remaining available for repurchase under this program. In addition, we announced on February 16, 2007 that our Board of Directors authorized us to repurchase up to an additional 5,000,000 shares of our common stock with no stated expiration for this program. There is no stated expiration for these programs.

Items 3 and 4 are not applicable for the reporting period and have been omitted.

Item 5. Other Information

     None.

38

Item 6. Exhibits

     (a) Exhibits:

EXHIBIT
NUMBER	DESCRIPTION
3.01	Registrant’s Articles of Incorporation, incorporated herein by reference to Exhibit 3.01 to the Registrant’s Form S-1 registration statement (File No. 33-95388) declared effective by the SEC on October 5, 1995 (the “Form S-1”).
3.02	Registrant’s Bylaws as amended, incorporated herein by reference to Exhibit 3.02 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2006, filed on March 16, 2007.
4.01	Registrant’s Registration Rights Agreement dated May 28, 1993 among the Registrant and certain security holders, incorporated herein by reference to Exhibit 10.07 to the Form S-1.
31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32	Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

39

SIGNATURES

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

	ESS TECHNOLOGY, INC. (Registrant)
Date: August 9, 2007	By:	/s/ Robert L. Blair
		Robert L. Blair
		President and Chief Executive Officer
Date: August 9, 2007	By:	/s/ James B. Boyd
		James B. Boyd
		Chief Financial Officer

40

INDEX TO EXHIBITS

EXHIBIT
NUMBER	DESCRIPTION
3.01	Registrant’s Articles of Incorporation, incorporated herein by reference to Exhibit 3.01 to the Registrant’s Form S-1 registration statement (File No. 33-95388) declared effective by the SEC on October 5, 1995 (the “Form S-1”).
3.02	Registrant’s Bylaws as amended, incorporated herein by reference to Exhibit 3.02 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2006, filed on March 16, 2007.
4.01	Registrant’s Registration Rights Agreement dated May 28, 1993 among the Registrant and certain security holders, incorporated herein by reference to Exhibit 10.07 to the Form S-1.
31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32	Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

41