Ess Technology (ESST) 10-Q 2006 Q3 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 September 30, 2006.

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

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 November 3, 2006 the registrant had 39,222,187 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 September 30, 2006 and December 31, 2005	3
Condensed Consolidated Statements of Operations for the three months ended and nine months ended September 30, 2006 and 2005	4
Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and 2005	5
Notes to Condensed Consolidated Financial Statements	6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	17
Item 3. Quantitative and Qualitative Disclosures About Market Risk	26
Item 4. Controls and Procedures	26
PART II OTHER INFORMATION
Item 1. Legal Proceedings	27
Item 1A. Risk Factors	28
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	37
Item 5. Other Information	37
Item 6. Exhibits	38
SIGNATURES	39
INDEX TO EXHIBITS	40
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)

	September 30,			December 31,
	2006			2005
	(In thousands)
ASSETS
Cash and cash equivalents	$	31,902		$	68,630
Short-term investments		10,970			31,092
Accounts receivable, net		15,289			14,990
Other receivables		2,139			5,795
Inventories		16,732			12,477
Prepaid expenses and other assets		2,307			4,241
Total current assets		79,339			137,225
Property, plant and equipment, net		18,190			21,133
Intangible assets, net		—			795
Investments and other assets		12,116			12,688
Total assets	$	109,645		$	171,841
LIABILITIES AND SHAREHOLDERS’ EQUITY
Accounts payable and accrued expenses	$	23,820		$	35,916
Income tax payable and deferred income taxes		24,385			42,591
Total current liabilities		48,205			78,507
Commitments and contingencies (Note 14)
Shareholders’ equity:
Common stock		179,587			177,545
Accumulated other comprehensive income		11			286
Accumulated deficit		(118,158	)		(84,497	)
Total shareholders’ equity		61,440			93,334
Total liabilities and shareholders’ equity	$	109,645		$	171,841

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 September 30,						Nine months Ended September 30,
	2006			2005			2006			2005
	(In thousands, except per share data)
Net revenues
Product	$	23,190		$	43,588		$	79,142		$	122,842
Royalty		4			5,000			4			15,000
Total net revenues		23,194			48,588			79,146			137,842
Cost of product revenues		27,219			43,047			80,095			132,248
Gross profit (loss)		(4,025	)		5,541			(949	)		5,594
Operating expenses:
Research and development		8,691			8,738			28,229			25,334
Selling, general and administrative		7,567			8,456			22,612			27,161
Operating loss		(20,283	)		(11,653	)		(51,790	)		(46,901	)
Non-operating income, net		505			451			1,863			1,146
Loss before income taxes		(19,778	)		(11,202	)		(49,927	)		(45,755	)
Provision for (benefit from) income taxes		(15,411	)		(106	)		(16,265	)		974
Net loss	$	(4,367	)	$	(11,096	)	$	(33,662	)	$	(46,729	)
Net loss per share — basic and diluted	$	(0.11	)	$	(0.28	)	$	(0.86	)	$	(1.18	)
Shares used in per share calculation — basic and diluted		39,177			39,806			39,150			39,762

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

4

ESS TECHNOLOGY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

	Nine months Ended
	September 30,
	2006			2005
	(In thousands)
Cash flows from operating activities:
Net loss	$	(33,662	)	$	(46,729	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		4,795			4,482
Amortization of intangible assets		795			3,352
Loss on long-term investments		534			678
Loss (gains) on disposal of property, plant and equipment		(241	)		44
Stock-based compensation		3,441			20
Changes in assets and liabilities:
Accounts receivables, net		(299	)		(1,959	)
Other receivables		3,656			(3,670	)
Inventories		(4,255	)		34,447
Prepaid expenses and other assets		1,909			108
Accounts payable and accrued expenses		(12,096	)		(9,377	)
Income tax payable and deferred income taxes		(18,048	)		1,331
Net cash used in operating activities		(53,471	)		(17,273	)
Cash flows from investing activities:
Purchase of property, plant and equipment		(1,852	)		(3,607	)
Sale of property, plant and equipment		241			—
Purchase of short-term investments		(13,154	)		(63,018	)
Sale of short-term investments		33,365			74,356
Purchase of long-term investments		—			(282	)
Purchase of intangible assets		(458	)		—
Refund of acquisition consideration under escrow		—			630
Net cash provided by investing activities		18,142			8,079
Cash flows from financing activities:
Issuance of common stock under employee stock option plans and employee stock purchase plan		210			446
Repurchase of common stock		(1,609	)		—
Net cash provided by (used in) financing activities		(1,399	)		446
Net increase (decrease) in cash and cash equivalents		(36,728	)		(8,748	)
Cash and cash equivalents at beginning of period		68,630			41,527
Cash and cash equivalents at end of period	$	31,902		$	32,779
Supplemental disclosure of cash flow information:
Cash paid for income taxes	$	2,363		$	—
Cash refund for income taxes	$	698		$	491

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 operate in two segments: the Video segment and the Digital Imaging segment.

     In our Video business, we design, develop and market highly integrated analog and digital processor chips and digital amplifiers. Our digital processor chips are the primary processors driving digital video and audio devices, including DVD, Video CD (“VCD”), consumer digital audio players, and digital media players. We continue to sell certain legacy products we have in inventory including chips for use in modems, other communication devices, and PC audio products. In our Digital Imaging business, we design, develop and market highly integrated imaging sensor chips. We focus on our design and development strengths and outsource all of our chip fabrication and assembly as well as the majority of our test operations.

     We market our products worldwide through our direct sales force, distributors and sales representatives. Substantially all of our sales are to distributors, direct customers and end-customers in China, Hong Kong, Taiwan, Japan, Korea, Turkey and Singapore. We employ sales and support personnel located outside of the United States in China, Taiwan, Hong Kong, Korea, Japan and France to support these international sales efforts. We expect that international sales will continue to represent a significant portion of our net revenues. In addition, substantially all of our products are manufactured, assembled and tested by independent third parties in Asia. We also have a 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.

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, 2005 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.

NOTE 3. STOCK-BASED COMPENSATION

     Effective January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”), which requires the measurement and recognition of compensation expense for all stock-based payment awards made to employees and directors, including employee stock options and employee stock purchases related to the Employee Stock Purchase Plan, based on estimated fair values. We had previously applied Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) and related Interpretations and provided the required pro forma disclosures of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) which was superseded by SFAS 123(R). The Company has also applied the provisions of Staff Accounting Bulletin No. 107 (“SAB 107”) in the adoption of SFAS 123(R).

Impact of the Adoption of SFAS 123(R)

     We elected to adopt the modified prospective application transition method as provided by SFAS 123(R). In accordance with the modified prospective transition method, consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Stock-based compensation expense recorded under SFAS 123(R) for the three months ended and nine months ended September 30, 2006 were $0.9 million and $3.4 million, respectively. Stock-based compensation expense recorded during the three months and nine months ended September 30, 2005 was not significant.

6

     The effect of recording stock-based compensation for 2006 was as follows (in thousands, except per share data):

	Three months ended		Nine months ended
	September 30, 2006
	(in thousands)
Stock-based compensation expense by type of award:
Employee stock options:
Cost of product revenues	$	46	$	176
Research and development		444		1,646
Selling, general and administrative		365		1,478
Employee stock purchase plan:
Selling, general and administrative		40		141
Total stock-based compensation		895		3,441
Tax effect on stock-based compensation		—		—
Net effect on net loss	$	895	$	3,441
Effect on earnings per share — basic and diluted	$	0.02	$	0.09

     As of January 1, 2006, we had an unrecorded deferred stock-based compensation cost related to stock options of $6.9 million before estimated forfeitures. In our pro forma disclosures prior to the adoption of SFAS 123(R), we accounted for forfeitures upon occurrence. SFAS 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. Accordingly, as of January 1, 2006, we estimated that the stock-based compensation for the awards not expected to vest was $0.7 million and, therefore, the unrecorded deferred stock-based compensation cost related to stock options was adjusted to $6.2 million after estimated forfeitures.

     During the nine months ended September 30, 2006, we granted approximately 231,000 stock options with an estimated total grant-date fair value of $328,000 after estimated forfeitures. As of September 30, 2006, total unrecognized stock-based compensation cost related to stock options was $3.2 million, which will be recorded as compensation expense over an estimated weighted average period of one year.

     No stock-based compensation cost have been capitalized as inventory at September 30, 2006.

Valuation Assumptions

     SFAS 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 123(R), we accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under SFAS 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 nine months ended September 30, 2006 included compensation expense for stock options granted prior to, 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 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 123(R). Stock-based compensation expense recognized in the Consolidated Statements of Operations for the three months and nine months ended September 30, 2006 has been reduced for estimated forfeitures. SFAS 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. In the pro forma information required under SFAS 123 for the prior periods, the Company accounted for forfeitures as they occurred. 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 123(R), 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.

7

     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 September 30,						Nine months Ended September 30,
	2006			2005			2006			2005
Stock option plans:
Expected life (in years)		4.0			4.0			4.0			4.0
Expected stock price volatility		70	%		83	%		71	%		84	%
Risk-free interest rate		4.8	%		3.8	%		4.6	%		3.7	%
Expected dividend yield		0	%		0	%		0	%		0	%
Stock purchase plan:
Expected life (in years)		0.5			0.5			0.5			0.5
Expected stock price volatility		72	%		83	%		72	%		83	%
Risk-free interest rate		5.0	%		3.0	%		5.0	%		3.0	%
Expected dividend yield		0	%		0	%		0	%		0	%

     The above valuation factors for the stock purchase plan reflect only the factors used to calculate the fair value of shares granted during the three months and nine months ended September 30, 2006 and September 30, 2005. The shares granted during these periods were those granted on the first day of the purchase period beginning May 2006 and the first day of the purchase period beginning May 2005, respectively.

     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 September 30, 2006, 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.

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

									Weighted
	Available						Weighted		Average		Aggregate
	for			Options			Average		Contractual		Intrinsic
	Grant			Outstanding			Exercise Price		Term		Value
	(in thousands)								(in years)		(in thousands)
Balances at December 31, 2003		4,441			8,566		$	9.58
Authorized		400			—			—
Granted		(2,055	)		2,055			12.03
Exercised		—			(275	)		5.76
Forfeited		4,784			(4,784	)		13.53
Balances at December 31, 2004		7,570			5,562		$	7.29
Granted		(5,284	)		5,284			4.06
Exercised		—			(52	)		3.86
Forfeited		1,041			(1,041	)		7.73
Expired		(84	)		—			—
Balances at December 31, 2005		3,243			9,753		$	5.51
Granted		(231	)		231			2.69
Exercised		—			(6	)		2.66
Forfeited		505			(505	)		5.48
Expired		760			(760	)		5.67
Expired — 95 Plan		—			(45	)		4.94
Balances at September 30, 2006		4,277			8,668		$	5.43
Fully vested and exercisable at September 30, 2006					6,585		$	5.63		6.23	$	23
Expected to vest at September 30, 2006					1,960		$	4.82		6.73	$	—

8

     The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value, based on our closing stock price of $0.92 as of September 30, 2006, which would have been received by the option holders had all option holders exercised their options as of that date. The total number of in-the-money options exercisable as of September 30, 2006 was 26,146.

     The weighted average grant date fair value of options, as determined under SFAS 123(R), granted during the three months and nine months ended September 30, 2006 were $0.95 and $1.69 per share. The total intrinsic value of options exercised during the three months and nine months ended September 30, 2006 were $0 and $7,000. The total cash received from employees as a result of employee stock option exercises during the three months and nine months ended September 30, 2006 were $0 and $17,000. In connection with these exercises, we realized no tax benefits for the three months ended September 30, 2006.

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

Employee Stock Purchase Plan

     Our 1995 Employee Stock Purchase Plan provides that eligible employees may contribute up to 10% of their eligible earnings toward the semi-annual purchase our common stock. The employee’s purchase price is the lower of 85% of the fair market value of our common stock at the beginning of the offering period or on the purchase date. The employee stock purchase plan provides a 24-month rolling period beginning on each enrollment date and the purchase price is automatically adjusted to reflect the lower enrollment price. Stock-based compensation expense in connection with the plan for the three months and nine months ended September 30, 2006, were $40,000 and $141,000. There were no shares purchased under the plan during the three months ended September 30, 2006. As of September 30, 2006, 1,425,000 shares were authorized for issuance under the plan and 1,212,877 shares have been issued.

Prior to the Adoption of SFAS 123(R)

     Prior to the adoption of SFAS 123(R), we provided the disclosures required under SFAS 123. The pro forma information for the three months ended and nine months ended September 30, 2005 was as follows (in thousands, except per share data):

	Three months ended			Nine months ended
	September 30, 2005			September 30, 2005
Net loss — as reported	$	(11,096	)	$	(46,729	)
Stock based compensation expense related to non-employees included in reported net loss		—			20
Stock based compensation determined under fair value based method for all awards, net of tax		(1,691	)		(7,170	)
Pro forma net loss	$	(12,787	)	$	(53,879	)
Net loss per share — basic and diluted:
As reported	$	(0.28	)	$	(1.18	)
Pro forma	$	(0.32	)	$	(1.36	)

NOTE 4. INTANGIBLE ASSETS

     The following table summarizes the activities in intangible assets for the nine months ended September 30, 2006.

	December 31,					September 30,
	2005		Amortization			2006
			(in thousands)
Intangible assets	$	795	$	(795	)	$	—

     Acquired intangible assets by categories as of September 30, 2006 and December 31, 2005 consist of the following:

	Gross		Accumulated Amortization
	Carrying		September 30,		December 31,
	Amounts		2006		2005
	(in thousands)
Amortized intangible assets:
Existing technology	$	3,600	$	3,600	$	3,070
Patents and core technology		1,800		1,800		1,535
Customer relationships		1,080		1,080		1,080
Distributor relationships		90		90		90
Foundry agreement		930		930		930
Order backlog		350		350		350
Total identifiable intangible assets	$	7,850	$	7,850	$	7,055

9

     Intangible assets were amortized over estimated useful lives of between 6 months and 3 years. No amortization expense was recorded for the three months ended September 30, 2006 and amortization expense was $1.0 million for the three months ended September 30, 2005. Amortization expense was $0.8 million and $3.4 million for the nine months ended September 30, 2006 and 2005, respectively.

NOTE 5. BALANCE SHEET COMPONENTS

	September 30,			December 31,
	2006			2005
	(In thousands)
Cash and cash equivalents:
Cash and money market accounts	$	17,480		$	39,706
U.S. government and corporate debt securities		14,422			28,924
	$	31,902		$	68,630
Short-term investments:
U.S. government and corporate debt securities	$	11,018		$	31,231
Unrealized gain on marketable securities, net		(48	)		(139	)
	$	10,970		$	31,092
Accounts receivable, net:
Accounts receivable	$	15,678		$	15,439
Less: Allowance for doubtful accounts		(389	)		(449	)
	$	15,289		$	14,990
Other receivables:
Receivable from vendor	$	—		$	4,993
Receivable from Vialta		—			20
Insurance		1,752			581
Other		387			201
	$	2,139		$	5,795
Inventories:
Raw materials	$	3,775		$	3,048
Work-in-process		482			2,527
Finished goods		12,475			6,902
	$	16,732		$	12,477
Prepaid expenses and other assets:
Insurance	$	513		$	724
Maintenance		440			813
Prepaid inventory		—			1,012
Prepaid royalty		687			904
Other		667			788
	$	2,307		$	4,241
Property, plant and equipment, net:
Land	$	2,860		$	2,860
Building and building improvements		24,706			24,640
Machinery and equipment		37,245			36,776
Furniture and fixtures		23,617			23,295
		88,428			87,571
Less: Accumulated depreciation and amortization		(70,238	)		(66,438	)
	$	18,190		$	21,133
Investments and other assets:
Investments — Best Elite	$	10,000		$	10,000
Investments — other		1,333			2,388
Other		783			300
	$	12,116		$	12,688
Accounts payable and accrued expenses:
Accounts payable	$	10,317		$	16,116
Accrued compensation costs		6,276			5,667
Accrued commission and royalties		951			1,740
Deferred revenue related to distributor sales, net of deferred cost of goods sold		645			552
Non-cancelable, adverse purchase order commitments		2,293			8,468
Other accrued liabilities		3,338			3,373
	$	23,820		$	35,916

10

NOTE 6. WARRANTY

     We include warranty reserve 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 reserves, we also provide specific warranty reserves 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 nine months ended September 30, 2006 and 2005:

	Three Months Ended						Nine months Ended
	September 30,						September 30,
	2006			2005			2006			2005
	(In thousands)
Beginning balance	$	359		$	480		$	506		$	324
Accruals(releases) for warranties issued during the period		(28	)		108			(10	)		447
Settlements made during the period		(40	)		(26	)		(205	)		(209	)
Ending balance	$	291		$	562		$	291		$	562

NOTE 7. MARKETABLE SECURITIES

			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
September 30, 2006	Cost		Gains		(Loss)			Value
	(In thousands)
Money market accounts	$	2,673	$	—	$	—		$	2,673
Corporate debt securities		19,553		32		—			19,585
Corporate equity securities		1,233		101		—			1,334
U.S. Government agency bonds		5,868		—		(62	)		5,806
Total available-for-sale	$	29,327	$	133	$	(62	)	$	29,398
Classified as:
Cash equivalents								$	17,094
Short-term marketable securities									10,970
Long-term marketable securities									1,334
								$	29,398

			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
December 31, 2005	Cost		Gains		(Loss)			Value
	(In thousands)
Money market accounts	$	24,016	$	—	$	—		$	24,016
Municipal bonds		21,159		—		—			21,159
Corporate debt securities		28,917		7		—			28,924
Corporate equity securities		1,486		621		—			2,107
U.S. Government agency bonds		10,079		—		(146	)		9,933
Total available-for-sale	$	85,657	$	628	$	(146	)	$	86,139
Classified as:
Cash equivalents								$	52,940
Short-term marketable securities									31,092
Long-term marketable securities									2,107
								$	86,139

     The contractual maturities of debt securities classified as available-for-sale as of September 30, 2006, regardless of the consolidated balance sheet classification are as follows:

September 30, 2006	Estimated Fair Value
	(In thousands)
Maturing 90 days or less from purchase	$	14,421
Maturing between 90 days and one year from purchase		2,550
Maturing more than one year from purchase		8,420
Total available-for-sale debt securities	$	25,391

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     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. Net realized gains and losses for the three months ended and nine months ended September 30, 2006 and 2005 were not material to our financial position or results of operations.

NOTE 8. OTHER COMPREHENSIVE LOSS

     The following table reconciles net loss to total comprehensive loss for the three months ended and nine months ended September 30, 2006 and 2005:

	Three Months Ended September 30,						Nine months Ended September 30,
	2006			2005			2006			2005
	(In thousands)
Net loss	$	(4,367	)	$	(11,096	)	$	(33,662	)	$	(46,729	)
Change in unrealized gain (loss) on marketable securities and long-term investments		130			459			(275	)		699
Total comprehensive loss	$	(4,237	)	$	(10,637	)	$	(33,937	)	$	(46,030	)

NOTE 9. NON-OPERATING INCOME, NET

     The following table lists the major components of non-operating income for the three months ended and nine months ended September 30, 2006 and 2005:

	Three Months Ended September 30,					Nine months Ended September 30,
	2006		2005			2006			2005
	(In thousands)
Interest income	$	499	$	472		$	2,196		$	1,484
Gain (loss) on investments		—		—			(534	)		(576	)
Vialta rental income		—		63			17			315
Other		6		(84	)		184			(77	)
Total non-operating income	$	505	$	451		$	1,863		$	1,146

NOTE 10. INCOME TAXES

     We recorded an income tax benefit of $15.4 million for the three months ended September 30, 2006 and an income tax benefit of $0.1 million for the three months ended September 30, 2005. The tax benefit for the current quarter was higher than the pre-tax loss at the federal statutory rate of 35% primarily due a favorable tax adjustment of $14.9 million from the release of contingencies where there was an expiration of statutes of limitations during the quarter offset, in part, by foreign taxes and losses in jurisdictions for which no tax benefit was recorded.

NOTE 11. NET LOSS PER SHARE

     For all periods presented, the reported net losses were used in the calculation of basic and diluted loss per share. As we incurred net losses for the three months and nine months ended September 30, 2006, the effect of dilutive securities (in-the-money stock options) of approximately 26,000 equivalent shares and 28,000 equivalent shares, respectively, have been excluded from the calculation of dilutive net loss per share because they were anti-dilutive. As we incurred net losses for the three months and nine months ended September 30, 2005, the effect of dilutive securities (in-the-money stock options) of approximately 56,000 equivalent shares and 214,000 equivalent shares, respectively, have been excluded from the calculation of dilutive net loss per share because they were anti-dilutive.

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     For the three months and nine months ended September 30, 2006, there were options to purchase approximately 8.9 million and 9.3 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 loss per share as they were anti-dilutive. For the three months and nine months ended September 30, 2005, there were options to purchase approximately 9.3 million and 5.3 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 loss per share as they were anti-dilutive.

NOTE 12. BUSINESS SEGMENT INFORMATION AND CONCENTRATION OF CERTAIN RISKS

Business Segment

     We operate 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. The Video segment continues to sell certain legacy products we have in inventory including chips for use in digital video recorders, recordable DVD players, modems, other communication devices, and PC audio products. Our Digital Imaging segment develops and markets imaging sensor chips for cellular camera phone applications.

     The following table summarizes the percentages of revenues by major product category for the three months ended and nine months ended September 30, 2006 and 2005:

	Three Months Ended September 30,						Nine months Ended September 30,
	2006			2005			2006			2005
Video Business:
DVD		76	%		50	%		68	%		55	%
VCD		15	%		15	%		19	%		18	%
Recordable products		1	%		3	%		1	%		2	%
Royalty		—			10	%		—			11	%
Other		8	%		3	%		6	%		2	%
Total Video Business		100	%		81	%		94	%		88	%
Digital Imaging Business		0	%		19	%		6	%		12	%
Total		100	%		100	%		100	%		100	%

     DVD revenue includes revenue from sales of DVD decoder chips. VCD revenue includes revenue from sales of VCD and SVCD chips. Recordable revenue includes revenue from sales of integrated encoder and decoder chipsets. Royalty revenue consisted of revenue from license of DVD technology to MediaTek Incorporation (“MediaTek”). Digital Imaging revenue includes revenue from sales of image sensor chips, image processor chips and camera lens modules.

     We evaluate operating segment performance based on net revenues and operating income 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 September 30,						Nine months Ended September 30,
	2006			2005			2006			2005
	(In thousands)
Segment net revenues:
Video	$	23,232		$	39,202		$	74,626		$	120,975
Digital Imaging		(38	)		9,386			4,520			16,867
Total net revenues	$	23,194		$	48,588		$	79,146		$	137,842
Segment operating loss:
Video	$	(14,356	)	$	(3,303	)	$	(31,625	)	$	(15,554	)
Digital Imaging		(2,524	)		(4,199	)		(10,473	)		(19,220	)
Total segment operating loss		(16,880	)		(7,502	)		(42,098	)		(34,774	)
Unallocated corporate expenses		(3,403	)		(4,151	)		(9,692	)		(12,127	)
Operating loss	$	(20,283	)	$	(11,653	)	$	(51,790	)	$	(46,901	)

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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”), formerly known as Dynax Electronics (HK) Ltd., is our largest distributor. We work directly with many of our customers in Hong Kong and China on product design and development. However, whenever one of these customers buys our products, the order is processed through 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 each of the three months ended September 30, 2006 and 2005, FE Global accounted for approximately 30% and 34%, respectively, of our net revenues. During the nine months ended September 30, 2006 and 2005, FE Global accounted for approximately 31% and 39%, respectively, of our net revenues.

     During the three months ended September 30, 2006, in addition to FE Global, LG International Corporation (“LG”), Samsung Electronics Company (“Samsung”) and SLHK Limited (a subsidiary of Hangzhou Silan Microelectronics Joint-Stock Co. Ltd) (“SLHK”) were each 10% or greater customers, accounting for approximately 19%, 17%, and 10% of our net revenue, respectively. During the three months ended September 30, 2005, in addition to FE Global, LG was also a 10% or greater customer, accounting for 23% of net revenue. During the nine months ended September 30, 2006, in addition to FE Global, LG, Samsung, SLHK, and Universe Electron Corporation (“UEC”) accounted for approximately 16%, 13%, 12% and 10% of our net revenue, respectively. During the nine months ended September 30, 2005, in addition to FE Global, LG was also a 10% or greater customer, accounting for 14% of our net revenue.

     As of September 30, 2006 and 2005 FE Global accounted for approximately 38% and 55%, respectively, of our gross trade accounts receivable. In addition to FE Global, LG and UEC each accounted for approximately 21% and 10% of trade accounts receivable, respectively. As of September 30, 2005, in addition to FE Global, LG accounted for approximately 12% of trade accounts receivable.

NOTE 13. RELATED PARTY TRANSACTIONS WITH VIALTA, INC.

     In April 2001, our Board of Directors decided to spin off Vialta, our majority-owned subsidiary. The spin-off transaction, by which Vialta became a public company, was completed in August 2001. On October 7, 2005, Vialta completed its going-private transaction. We do not have any contractual obligations that are expected to have a material impact upon our revenues, operating results or cash flows under any of the spin-off agreements. We leased certain office space to Vialta. In February 2006, Vialta moved out of our building, and we have terminated the lease agreements.

     Our Chairman of the Board of Directors, Fred S.L. Chan, is the chairman of Vialta and acquired Vialta through a going-private transaction in October 2005. In addition to the lease we had with Vialta, we have also sold semiconductor products and provided certain services to Vialta. The following is a summary of major transactions between Vialta and us for the periods presented:

	Three Months Ended					Nine months Ended
	September 30,					September 30,
	2006			2005		2006			2005
	(In thousands)
Product sold to Vialta	$	—		$	—	$	—		$	12
Lease charges to Vialta		—			63		15			315
Other charges, net		(1	)		1		(1	)		5
Total charges to Vialta, net of charges from Vialta	$	(1	)	$	64	$	14		$	332

	As of
	September 30, 2006		December 31, 2005
	(In thousands)
Receivable from Vialta	$	—	$	20

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NOTE 14. COMMITMENTS AND CONTINGENCIES

     The following table sets forth the amounts of payments due under specified contractual obligations, aggregated by category of contractual obligations, as of September 30, 2006:

	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	$	1,735	$	811	$	924	$	—	$	—
Purchase obligations		16,374		16,374		—		—		—
Total	$	18,109	$	17,185	$	924	$	—	$	—

     As of September 30, 2006, our commitments to purchase inventory from the third-party contractors aggregated approximately $8.6 million of which approximately $2.3 million was non-cancelable purchase order commitments that we have recorded as accrued expenses. Under these contractual agreements, we may order inventory from time to time, depending on our needs. There is no termination date to these agreements. Additionally, in the ordinary course of business, we enter into various arrangements with vendors and other business partners, principally for service, license and other operating supplies. As of September 30, 2006, commitments under these arrangements totaled $7.8 million. There are no material commitments for these arrangements extending beyond 2009.

     We are not a party to any off-balance sheet arrangements as defined in Regulation S-K Item 303(a)(4) other than the operating lease obligations listed above.

     The total rent expense under all operating leases was approximately $369,000 and $329,000 for the three months ended September 30, 2006 and 2005, respectively. The total rent expense under all operating leases was approximately $1,038,000 and $709,000 for the nine months ended September 30, 2006 and 2005, 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 September 30, 2006.

     We have agreements whereby our officers and directors are indemnified for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. However, we have a directors and officers’ insurance that may reduce our exposure and enable us to recover a portion of any future amounts paid. As a result of our insurance coverage, we believe the estimated fair value of these indemnification agreements is minimal.

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. The parties have negotiated a revised schedule for continuing discovery and resetting a trial date in this action and are awaiting the Court’s approval of their stipulation.

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     On September 12, 2002, following the same downward revision of revenue and earnings guidance for the third fiscal quarter of 2002, several 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. Discovery is now proceeding in the case. No trial date has been set.

     On October 4, 2006, Ali Corporation (“Ali”) filed a lawsuit in Alameda County Superior Court against us alleging claims for breach of contract, common counts, quantum meruit, account stated and for an open book account. All of the claims arise from a Joint Development Agreement between us and Ali originally entered into on December 14, 2001 and subsequently amended on several occasions. Ali’s complaint seeks damages in the amount of $2.5 million. We have answered Ali’s complaint. Discovery has not yet commenced, and no trial date has been set.

     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 above, 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 the Company’s financial position, cash flows or overall trends in results of operations. However, litigation 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, there exists the possibility of a material adverse impact on the results of operations of the period in which the ruling occurs, or future periods.

NOTE 15. STOCK REPURCHASE

     We did not repurchase any shares during the three months ended September 30, 2006. During the nine months ended September 30, 2006 we repurchased 473,000 shares for approximately $1.6 million. As of September 30, 2006 an aggregate of 4,400,000 shares remain available for repurchase, all of which were authorized under the stock repurchase program announced on April 16, 2003. There is no stated expiration for this program.

NOTE 16. RECENT ACCOUNTING PRONOUNCEMENTS

     In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation Number 48 (FIN 48), “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109.” The interpretation contains a two step approach to recognizing and measuring uncertain tax positions accounted for in accordance with SFAS No. 109. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. The provisions are effective for us beginning in the first quarter of 2007. We are evaluating the impact this statement will have on our consolidated financial statements.

     In March 2006, the Emerging Issues Task Force reached a consensus on Issue No. 06-03 “How Taxes Collected from Customers and Remitted to Government Authorities Should Be Presented in the Income Statement (That Is Gross versus Net Presentation)” (“EITF No. 06-03”). We are required to adopt the provisions of EITF No. 06-03 beginning its fiscal year 2007. We do not expect the provisions of EITF No. 06-03 to have a material impact on the ours consolidated financial position, results of operations or cash flows.

     In September 2006, the SEC issued SAB No. 108 regarding the process of quantifying financial statement misstatements. SAB No. 108 states that registrants should use both a balance sheet approach and an income statement approach when quantifying and evaluating the materiality of a misstatement. The interpretations in SAB No. 108 contain guidance on correcting errors under the dual approach as well as provide transition guidance for correcting errors. This interpretation does not change the requirements within

16

SFAS No. 154, “Accounting Changes and Error Corrections — a replacement of APB No. 20 and FASB Statement No. 3,” for the correction of an error on financial statements. SAB No. 108 is effective for annual financial statements covering the first fiscal year ending after November 15, 2006. We will be required to adopt this interpretation by December 31, 2006. We are currently evaluating the requirements of SAB No. 108 and the impact this interpretation may have on our financial statements.

     In September 2006, the FASB issued statement No. 157, “Fair Value Measurements” (“SFAS 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. Management is currently evaluating the requirements of SFAS No. 157 and has not yet determined the impact on the consolidated financial statements.

NOTE 17. SUBSEQUENT EVENTS

     On September 18, 2006, we announced a plan to reorganize our operations. We will evaluate alternatives to maximize the value of our standard DVD business. In connection with this strategy, on November 3, 2006, we entered into the DVD Technology License Agreement with Hangzhou Silan Microelectronics Co., Ltd. (“Silan”). Pursuant to that agreement, we granted a permanent, irrevocable license to Silan for certain technologies related to our DVD products. In exchange for such a license, Silan agreed to pay initial license fees of $3.75 million over the course of the first year and an ongoing royalty stream based on profits and unit volume of up to a maximum of $20 million or six and one half years, whichever occurs first.

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, 2005.

     CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Use of Estimates

     Our interim condensed consolidated financial statements included herein have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). These accounting principles require us to make certain estimates, judgments and assumptions that affect the amounts reported in our financial statements and accompanying notes. We believe that the estimates, judgments and assumptions upon which we rely are reasonable based upon information available to us at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results,

17

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 Taxes

• Legal Contingencies

• Stock-based Compensation

     Effective January 1, 2006, we adopted the provisions of SFAS 123(R), which requires us to measure all employee stock-based compensation awards using a fair value method and record such expense in our consolidated financial statements. We estimate the fair value of stock options using a Black-Scholes valuation model, consistent with the provisions of SFAS 123(R), SAB 107 and our prior period pro forma disclosures of net earnings, including stock-based compensation (determined under a fair value method as prescribed by SFAS 123). SFAS 123(R) requires the use of valuation models that were not developed for use in valuing employee stock options. 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, the price volatility of the underlying stock, and forfeiture rate.

     For further discussion of our critical accounting policies and estimates other than stock-based compensation, 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, 2005.

Recent Accounting Pronouncements

     See Note 16, “ Recent Accounting Pronouncements,” in Item 1 for disclosure of the recently issued accounting pronouncements that may impact our financial statements in the future.

EXECUTIVE OVERVIEW

     We were incorporated in California in 1984 and became a public company in 1995. We currently operate in two segments: the Video segment and the Digital Imaging segment.

     In our Video business, we design, develop and market highly integrated analog and digital processor chips and digital amplifiers. Our digital processor chips are the primary processors driving digital video and audio devices, including DVD, Video CD (“VCD”), consumer digital audio players, and digital media players. We continue to sell certain legacy products we have in inventory including chips for use in modems, other communication devices, and PC audio products, although we no longer invest in these product lines. In our Digital Imaging business, we design, develop and market highly integrated imaging sensor chips. We focus on our design and development strengths and outsource all of our chip fabrication and assembly as well as the majority of our test operations.

     We market our products worldwide through our direct sales force, distributors and sales representatives. Substantially all of our sales are to customers in China, Hong Kong, Taiwan, Korea, Japan, Turkey and Singapore. We employ sales and support personnel located outside of the United States in China, Taiwan, Hong Kong, Korea, Japan and France to support these international sales efforts. We expect that international sales will continue to represent a significant portion of our net revenues. In addition, substantially all of our products are manufactured, assembled and tested by independent third parties in Asia. We also have a number of employees engaged in research and development efforts outside of the United States. There are special risks associated with conducting business outside of the United States. See Item 1A “Risk Factors — We have significant international sales and operations that are subject to the special risks of doing business outside the United States.”

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     On September 18, 2006, we announced a plan to reorganize our operations. We will evaluate alternatives to maximize the value of our standard DVD business. In connection with this strategy, on November 3, 2006, we entered into a licensing agreement with Hangzhou Silan Microelectronics Co., Ltd. (“Silan”). Pursuant to that agreement, we granted a permanent, irrevocable license to Silan for certain technologies related to our DVD products. In exchange for such a license, Silan agreed to pay initial license fees of $3.75 million over the course of the first year and an ongoing royalty stream based on profits and unit volume of up to a maximum of $20 million or six and one half years, whichever occurs first.

     In addition, on September 18, 2006, we announced that we would begin to look for business partners or acquirers for our high definition BluRay DVD business and our camera phone business. In connection with this reorganization, we announced a reduction in our worldwide headcount of approximately 25% or 101 positions across multiple divisions effective immediately. The total charges for the restructuring were approximately $676,000 for severance payments and other miscellaneous costs, which were paid and expensed in the three months ended September 30, 2006 and resulted in cash expenditures of that amount in the three months ended September 30, 2006.

     On September 18, 2006, we also announced that we had released $14.9 million of our tax reserves which positively impacted earnings through a tax benefit during the three months ended September 30, 2006.

     Effective January 1, 2006, we adopted the provisions of SFAS 123(R), which require us to measure all employee stock-based compensation awards using a fair value method and record such expense in our consolidated financial statements. Prior to January 1, 2006 we accounted for stock-based compensation awards in accordance with APB 25. We have chosen to implement SFAS 123(R) using the modified prospective method. Under this method, periods prior to January 1, 2006 are not restated to reflect stock-based compensation using a fair value method. Stock-based compensation expense recognized under SFAS 123(R) for the three months and nine months ended September 30, 2006 were $0.9 million and $3.4 million, respectively.

RESULTS OF OPERATIONS

COMPARISON OF THREE MONTHS ENDED SEPTEMBER 30, 2006 AND SEPTEMBER 30, 2005

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

	Three Months Ended September 30,
	2006						2005
				(In thousands)
Net revenues	$	23,194			100.0	%	$	48,588		100.0	%
Cost of product revenues		27,219			117.4			43,047		88.6
Gross profit (loss)		(4,025	)		(17.4	)		5,541		11.4
Operating expenses:
Research and development		8,691			37.5			8,738		18.0
Selling, general and administrative		7,567			32.6			8,456		17.4
Operating loss		(20,283	)		(87.5	)		(11,653	)	(24.0	)
Non-operating income, net		505			2.2			451		0.9
Loss before income taxes		(19,778	)		(85.3	)		(11,202	)	(23.1	)
Provision for (benefit from) income taxes		(15,411	)		(66.4	)		(106	)	(0.2	)
Net loss	$	(4,367	)		(18.9	)%	$	(11,096	)	(22.9	)%

Net Revenues

     Net revenues were $23.2 million for the three months ended September 30, 2006, a decrease of $25.4 million, or 52.3%, compared to $48.6 million, for the three months ended September 30, 2005, due to decreased revenues in all product categories of the Video and Digital Imaging businesses. In addition, there was no royalty payment from MediaTek for the three months ended September 30, 2006. Royalty revenue was $5.0 million for the three months ended September 30, 2005.

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

	Three Months Ended September 30,						Q3 06 over Q3 05
	2006			2005			% of Change
Video Business:
DVD		76	%		50	%		(27.6	)%
VCD		15	%		15	%		(52.8	)%
Recordable products		1	%		3	%		(93.3	)%
Royalty		—			10	%		n/a
Other		8	%		3	%		61.5	%
Total Video Business		100	%		81	%		(40.8	)%
Digital Imaging Business		0	%		19	%		(100.0	)%
Total		100	%		100	%		(52.3	)%

     DVD revenue consists of revenue from sales of DVD decoder chips. DVD revenue was $17.6 million for the three months ended September 30, 2006, a decrease of $6.7 million, or 27.6%, from revenue of $24.3 million for the three months ended September 30, 2005, due to lower overall unit sales and average sales price (“ASP”) as a result of weak demand for standard definition DVD business in China. For the three months ended September 30, 2006, unit sales decreased by 17.9% and ASP decreased by 11.6% from the three months ended September 30, 2005. We sold approximately 4.5 million units and 5.4 million units for the three months ended September 30, 2006 and 2005, respectively.

     VCD revenue includes revenue from sales of VCD chips. VCD revenue was $3.4 million for the three months ended September 30, 2006, a decrease of $3.8 million, or 52.8%, from revenue of $7.2 million for the three months ended September 30, 2005, primarily due to lower overall unit sales and ASP. For the three months ended September 30, 2006, unit sales decreased by 36.5% and ASP decreased by 25.7% from the three months ended September 30, 2005. We sold approximately 2.9 million units and 4.6 million units for the three months ended September 30, 2006 and 2005, respectively.

     Recordable revenue includes revenue from sales of integrated encoder and decoder chips and chips sold together as a chipset. Recordable revenue was $0.1 million for the three months ended September 30, 2006, a decrease of $1.4 million, or 93.3%, from revenue of $1.5 million for the three months ended September 30, 2005, primarily due to lower ASP. For the three months ended September 30, 2006, ASP decreased by 41.7% from the three months ended September 30, 2005.

     Royalty revenue consists of royalty payments from MediaTek. Under the settlement agreement between ESS and MediaTek dated June 11, 2003, for a non-exclusive license to our proprietary DVD user interface and other key DVD software, MediaTek was obligated to pay us royalties with a quarterly cap of $5.0 million and lifetime cap of $45.0 million, the last of which was paid in the fourth quarter of 2005. Royalty revenue was $5.0 million for the three months ended September 30, 2005.

     Other revenue includes revenue from legacy products which includes sales of PC Audio, communication, consumer digital media and miscellaneous chips. Other revenue was $2.1 million for the three months ended September 30, 2006, representing an increase of $0.8 million, or 61.5%, from revenue of $1.3 million for the three months ended September 30, 2005, primarily due to higher unit sales and $0.2 million of license fee revenue. For the three months ended September 30, 2006, unit sales increased by 64.1% from the three months ended September 30, 2005. We sold approximately 339,000 units and 207,000 units for the three months ended September 30, 2006 and 2005, respectively.

     Digital Imaging revenue includes revenue from sales of image sensor chips and image processor chips. There was no shipments of Digital Imaging products for the three months ended September 30, 2006 compared to the revenue of $9.4 million for the three months ended September 30, 2005. We have shifted our business strategy to focus on the development of higher resolution products, which bear considerable risk of success because these products are not yet in production and accepted into the market.

     International revenue accounted for almost all of net revenues for both the three months ended September 30, 2006 and 2005. Our international sales are denominated in U.S. dollars.

Gross Profit

     Gross loss was $4.0 million, or (17.4)% of net revenues, for the three months ended September 30, 2006, compared to gross profit of $5.5 million, or 11.4% of net revenues, for the three months ended September 30, 2005. Results for the three months ended September 30, 2006 included a net $3.2 million inventory related charge compared to a net inventory related reserve release of $1.1 million for the three months ended September 30, 2005. The majority of the 2006 charge was related to parts written off on a product that we decided not to bring to market and additional lower of cost or market reserves we took as a result of lower pricing in conjunction with our decision to change the direction of our DVD business. The net release of inventory reserves in 2005 resulted from the sale of products that had previously been fully reserved. Gross loss for the three months ended September 30, 2006 was

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adversely impacted by reduced unit volume of our products. Gross profit for the three months ended September 30, 2005 included $5.0 million of MediaTek royalty revenue at 100% gross margin. No royalty revenue was recognized for the three months ended September 30, 2006.

     For the three months ended September 30, 2006, the net inventory related charge had a negative 13.8% impact on the gross margin. For the three months ended September 30, 2005, royalty revenue and the inventory reserve release had a positive 12.6 % impact on the gross margin.

     As a result of intense competition in our markets, we expect the overall ASP for all of our existing products to decline over their product life. We believe that in order to maintain or increase gross profit during the remainder of 2006, we must achieve higher unit volume in shipments, reduce costs, add new features to our existing products and introduce new products.

Research and Development Expenses

     Research and development expenses were $8.7 million for both the three months ended September 30, 2006 and 2005, or 37.5% and 18.0% of net revenues for the three months ended September 30, 2006 and 2005, respectively. The research and development expense remained steady due to the increase in accrued bonus expense of $0.6 million and the increase in stock-based compensation expense under SFAS 123(R) of $0.4 million partially offset by the $0.9 million decrease in operating supplies and test materials.

Selling, General and Administrative Expenses

     Selling, general and administrative expenses were $7.6 million, or 32.6% of net revenues, for the three months ended September 30, 2006 compared to $8.5 million, or 17.4% of net revenues, for the three months ended September 30, 2005. The $0.9 million, or 10.6%, decrease in selling, general and administrative expenses for the three month ended September 30, 2006 was primarily due to $0.6 million decrease in legal expense, $0.3 million decrease in outside commission expense due to lower revenue, $0.3 million decrease in intangible asset amortization related to prior acquisitions, $0.3 million decrease in salaries and fringe benefits due to lower headcount, and partially offset by $0.4 million increase in stock-based compensation expense under SFAS 123(R) and $0.2 million increase in accrued bonus expense.

Non-operating Income, Net

     Net non-operating income was $0.5 million for each of the three months ended September 30, 2006 and 2005, respectively. For both of the three months ended September 30, 2006 and 2005, net non-operating income mainly consisted of interest income of $0.5 million.

Income Taxes

     Our income tax benefit was $15.4 million for the three months ended September 30, 2006 compared to a $0.1 million tax benefit for the three months ended September 30, 2005. The tax benefit for the current quarter was primarily the result of a favorable tax adjustment of $14.9 million from the release of contingencies where there was an expiration of statutes of limitations during the quarter. An additional $0.5 million of benefit was recorded during the current quarter for benefits received from U.S. net operating losses offset, in part, by foreign taxes.

COMPARISON OF NINE MONTHS ENDED SEPTEMBER 30, 2006 AND SEPTEMBER 30, 2005

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

	Nine months Ended September 30,
	2006					2005
	(In thousands)
Net revenues	$	79,146		100.0	%	$	137,842		100.0	%
Cost of product revenues		80,095		101.2			132,248		95.9
Gross profit		(949	)	(1.2	)		5,594		4.1
Operating expenses:
Research and development		28,229		35.7			25,334		18.4
Selling, general and administrative		22,612		28.6			27,161		19.7
Operating loss		(51,790	)	(65.5	)		(46,901	)	(34.0	)
Non-operating income, net		1,863		2.4			1,146		0.8
Loss before income taxes		(49,927	)	(63.1	)		(45,755	)	(33.2	)
Provision for (benefit from) income taxes		(16,265	)	(20.6	)		974		0.7
Net loss	$	(33,662	)	(42.5	)%	$	(46,729	)	(33.9	)%

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Net Revenues

     Net revenues were $79.1 million for the nine months ended September 30, 2006, a decrease of $58.7 million, or 42.6%, compared to $137.8 million, the nine months ended September 30, 2005, due to decreased revenues in all product categories of the Video and Digital Imaging business. In addition, there was no royalty payment from MediaTek the nine months ended September 30, 2006. Royalty revenue was $15.0 million the nine months ended September 30, 2005.

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

	Nine Months Ended September 30,						Q3 06 over Q3 05
	2006			2005			% of Change
Video Business:
DVD		68	%		55	%		(29.0	)%
VCD		19	%		18	%		(38.7	)%
Recordable products		1	%		2	%		(69.2	)%
Royalty		—			11	%		n/a
Other		6	%		2	%		61.3	%
Total Video Business		94	%		88	%		(38.3	)%
Digital Imaging Business		6	%		12	%		(73.4	)%
Total		100	%		100	%		(42.6	)%

     Video business revenues included revenues from DVD, VCD, Recordable products, Royalty payments for DVD license and Other products.

     DVD revenue consists of revenue from sales of DVD decoder chips. DVD revenue was $53.7 million for the nine months ended September 30, 2006, a decrease of $21.9 million, or 29.0%, from revenue of $75.6 million for the nine months ended September 30, 2005, due to lower overall unit sales and ASP as a result of weak demand for standard definition DVD business in China . For the nine months ended September 30, 2006, unit sales decreased by 19.3% and ASP decreased by 12.1% from the nine months ended September 30, 2005. We sold approximately 12.9 million units and 16.0 million units for the nine months ended September 30, 2006 and 2005, respectively.

     VCD revenue includes revenue from sales of VCD chips. VCD revenue was $15.1 million for nine months ended September 30, 2006, a decrease of $9.5 million, or 38.7%, from revenue of $24.6 million for the nine months ended September 30, 2005, due to lower overall unit sales and ASP. For the nine months ended September 30, 2006, unit sales decreased by 19.4% and ASP decreased by 24.0% from the nine months ended September 30, 2005. We sold approximately 12.4 million units and 15.4 million units for the nine months ended September 30, 2006 and 2005, respectively.

     Recordable revenue includes revenue from sales of integrated encoder and decoder chips and chips sold together as a chipset. Recordable revenue was $0.8 million for the nine months ended September 30, 2006, a decrease of $1.8 million, or 69.2%, from revenue of $2.6 million for the nine months ended September 30, 2005, primarily due to lower overall unit sales and ASP. For the nine months ended September 30, 2006, unit sales decreased by 57.9% and ASP decreased by 23.1% from the nine months ended September 30, 2005. We sold approximately 149,000 units and 354,000 units for the nine months ended September 30, 2006 and 2005, respectively.

     Royalty revenue consists of royalty payments from MediaTek. Under the settlement agreement between ESS and MediaTek dated June 11, 2003, for a non-exclusive license to our proprietary DVD user interface and other key DVD software, MediaTek was obligated to pay us royalties with a quarterly cap of $5.0 million and lifetime cap of $45.0 million, the last of which was paid in the fourth quarter of 2005. Royalty revenue was $15.0 million for the nine months ended September 30, 2005.

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     Other revenue includes revenue from legacy products which includes sales of PC Audio, communication, consumer digital media and miscellaneous chips. Other revenue was $5.0 million for the nine months ended September 30, 2006, representing an increase of $1.9 million, or 61.3%, from revenue of $3.1 million for the nine months ended September 30, 2005, primarily due to higher unit sales. For the nine months ended September 30, 2006, unit sales increased by 38.4% from nine months ended September 30, 2005. We sold approximately 787,00 units and 569,000 units for the nine months ended September 30, 2006 and 2005, respectively.

     Digital Imaging revenue includes revenue from sales of image sensor chips and image processor chips and camera lens modules. Digital Imaging revenue was $4.5 million for the nine months ended September 30, 2006, a decrease of $12.4 million, or 73.4%, from revenue of $16.9 million for the nine months ended September 30, 2005. Lower revenue was primarily due to reduction in volume for our existing lower resolution product. We have shifted our business strategy to focus on the development of higher resolution products, which bear considerable risk of success because these products are not yet in production and accepted into the market.

     International revenue accounted for almost all of net revenues for both the nine months ended September 30, 2006 and 2005. Our international sales are denominated in U.S. dollars.

Gross Profit

     Gross loss was $0.9 million, or (1.2)% of net revenues, for the nine months ended September 30, 2006, compared to gross profit of $5.6 million, or 4.1% of net revenues, for the nine months ended September 30, 2005. Results for the nine months ended September 30, 2006 included a net $2.6 million inventory reserve related charge compared to a net inventory reserve related charge of $5.3 million for the nine months ended September 30, 2005. Gross loss for the nine months ended September 30, 2006 was adversely impacted by reduced unit volume of our products. Gross profit for the nine months ended September 30, 2005 included $15.0 million of MediaTek royalty revenue at 100% gross margin. No royalty revenue was recognized for the nine months ended September 30, 2006.

     For the nine months ended September 30, 2006, the net inventory related charges had a negative 3.3% impact on the gross margin. For the nine months ended September 30, 2005, royalty revenue and the inventory reserve provision had a positive 7.4% impact on the gross margin.

     As a result of intense competition in our markets, we expect the overall ASP for all of our existing products to decline over their product life. We believe that in order to maintain or increase gross profit during the remainder of 2006, we must achieve higher unit volume in shipments, reduce costs, add new features to our existing products and introduce new products.

Research and Development Expenses

     Research and development expenses were $28.2 million, or 35.7% of net revenues, for the nine months ended September 30, 2006 compared to $25.3 million, or 18.4% of net revenues, for the nine months ended September 30, 2005. The $2.9 million, or 11.5%, increase in research and development expenses for the nine months ended September 30, 2006 was primarily due to $1.8 million increase in accrued bonus expense and $1.6 million increase in stock-based compensation expense under SFAS 123(R), and partially offset by the $0.5 million decrease in operating supplies and test materials.

Selling, General and Administrative Expenses

     Selling, general and administrative expenses were $22.6 million, or 28.6% of net revenues, for nine months ended September 30, 2006 compared to $27.2 million, or 19.7% of net revenues, for the nine months ended September 30, 2005. The $4.6 million, or 16.9%, decrease in selling, general and administrative expenses for the nine months ended September 30, 2006 was primarily due to $1.8 million decrease in outside commission due to lower revenue, $1.8 million decrease in legal expenses, $1.2 million decrease in salaries and fringe benefits expense due to lower headcount, $1.0 million decrease in amortization of intangible assets related to prior acquisitions, and partially offset by $1.6 million increase in stock-based compensation expense under SFAS 123(R).

Non-operating Income, Net

     Net non-operating income was $1.9 million for the nine months ended September 30, 2006 compared to net non-operating income of $1.1 million for the nine months ended September 30, 2005. For the nine months ended September 30, 2006, net non-operating income mainly consisted of interest income of $2.2 million and other miscellaneous income of $0.2 million, partially offset by the write-down of our investments of $0.5 million. For the nine months ended September 30, 2005, net non-operating income mainly consisted of interest income of $1.5 million and rental income of $0.3 million from Vialta, partially offset by the $0.6 million investment loss.

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Income Taxes

     Our income tax benefit was $16.3 million for the nine months ended September 30, 2006 compared a $1.0 million tax expense for the nine months ended September 30, 2005. The tax benefit for the nine months ended September 30, 2006 was primarily the result of favorable tax adjustments of $15.3 million related to the expiration of certain statutes of limitations and certain tax refunds. An additional $1.0 million of benefit was recorded during the nine months ended September 30, 2006 for benefits received from U.S. net operating losses offset, in part, by foreign taxes.

STOCK-BASED COMPENSATION

     Effective January 1, 2006, we adopted the provisions of SFAS 123(R). SFAS 123(R) establishes accounting for stock-based awards exchanged for employee services. Under SFAS 123(R), stock-based compensation cost is measured at the grant date, based on the fair value of the award which is computed using the Black-Scholes option valuation model, and is recognized as an expense over the employee requisite service period. We previously applied APB 25 and related interpretations and provided the required pro forma disclosures of SFAS 123.

     We elected to adopt the modified prospective application method as provided by SFAS 123(R), the first day of our fiscal year 2006. In accordance with the modified prospective transition method, consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R).

     During the three months and nine months ended September 30, 2006, we recorded stock-based compensation related to stock options of $0.9 million and $3.4 million, respectively. As of September 30, 2006, total unrecognized stock-based compensation costs related to stock options was $3.2 million, which will be recorded as compensation expense over an estimated weighted average period of one year.

     Compensation expense recorded relating to the employee stock purchase plan for the three months and nine months ended September 30, 2006 was $40,000 and $141,000, respectively. There were no shares purchased under the employee stock purchase plan during the three months ended September 30, 2006. There were 79,887 shares purchased under the employee stock purchase plan during nine months ended September 30, 2006.

     No stock-based compensation cost have been capitalized as inventory at September 30, 2006 due to the immateriality of grants related to manufacturing since the adoption of SFAS 123(R) on January 1, 2006.

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 September 30, 2006, we had cash, cash equivalents and short-term investments of $42.9 million and working capital of $31.1 million.

     Net cash used in operating activities was $53.5 million and $17.3 million for the nine months ended September 30, 2006 and 2005, respectively. The net cash used in operating activities for the nine months ended September 30, 2006 was primarily attributable to a net loss of $33.7 million, decreases in accounts payable and accrued expenses of $12.1 million, decreases in income tax payable and deferred income taxes of $18.0 million, increases in inventory of $4.3 million, and partially offset by the decreases in other receivables of $3.7 million, depreciation and amortization of $5.6 million and stock-based compensation of $3.4 million. Inventories increased as we are 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 provide raw materials. The decrease in income tax payable and deferred income taxes was primarily due to the $14.9 million release of income tax reserve. The net cash used in operating activities for the nine months ended September 30, 2005 was primarily attributable to a net loss of $46.7 million and increases in accounts and other receivables of $5.6 million and decrease in accounts payable and accrued expenses of $9.4 million, partially offset by a decrease in inventories of $34.4 million and depreciation and amortization of $7.8 million. The increases in other receivables were due to the expected insurance reimbursement for expenses related to class action litigation and to a receivable for the acquisition consideration under escrow. The decrease in inventory was due to lower production and the increase in inventory reserves of $2.5 million.

     Net cash provided by investing activities was $18.1 million and $8.1 million for the nine months ended September 30, 2006 and 2005, respectively. The net cash provided by investing activities for the nine months ended September 30, 2006 was primarily attributable to the proceeds from sales of short-term investments of $33.4 million, partially offset by the purchase of short-term investments of $13.2 million and purchase of property, plant and equipment of $1.9 million. The net cash provided by investing activities for the nine months ended September 30, 2005 was primarily attributable to the proceeds from sales of short-term investments of $74.4 million, partially offset by the purchase of short-term investments of $63.0 million and purchase of property, plant and equipment of $3.6 million.

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     Net cash used by financing activities was $1.4 million for the nine months ended September 30, 2006 and net cash provided by financing activities was $0.4 million for the nine months ended September 30, 2005. The net cash used by financing activities for the nine months ended September 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. The net cash provided by financing activities for the nine months ended September 30, 2005 was attributable to the proceeds from the issuance of common stock under stock option plans and employee stock purchase plan of $0.4 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 $2.0 million. We may also use cash to acquire or invest in complementary businesses or products or to obtain the right to use complementary technologies. From time to time, in the ordinary course of business, we may evaluate potential acquisitions of, or investment in, such businesses, products or technologies owned by third parties. Also, from time to time the Board of Directors may approve the expenditure of cash resources to repurchase our common stock as market conditions warrant. Based on past performance and current expectations, we believe that our existing cash and short-term investments as of September 30, 2006, 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 September 30, 2006:

	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	$	1,735	$	811	$	924	$	—	$	—
Purchase obligations		16,374		16,374		—		—		—
Total	$	18,109	$	17,185	$	924	$	—	$	—

     As of September 30, 2006, our commitments to purchase inventory from the third-party contractors aggregated approximately $8.6 million of which approximately $2.3 million was non-cancelable purchase order commitments that we have recorded as accrued expenses. Under these contractual agreements, we may order inventory from time to time, depending on our needs. There is no termination date to these agreements. Additionally, in the ordinary course of business, we enter into various arrangements with vendors and other business partners, principally for service, license and other operating supplies. As of September 30, 2006, commitments under these arrangements totaled $7.8 million. There are no material commitments for these arrangements extending beyond 2009.

     We are not a party to any off-balance sheet arrangements as defined in Regulation S-K Item 303(a)(4) other than the operating lease obligations listed above.

     The total rent expense under all operating leases was approximately $369,000 and $329,000 for the three months ended September 30, 2006 and 2005, respectively. The total rent expense under all operating leases was approximately $1,038,000 and $709,000 for the nine months ended September 30, 2006 and 2005, 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 the Company’s financial position, cash flows or overall trends in results of operations. However, litigation 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, there exists the possibility of a material adverse impact on the results of operations of the period in which the ruling occurs, or future periods.

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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, Europe, 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 September 30, 2006 we have not experienced any material 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 September 30, 2006, the analysis indicated that these hypothetical market movements would not have a material effect. 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 $0.4 million decrease in our interest income on an annual basis. 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 short-term investments have been classified as available-for-sale, and on September 30, 2006, 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 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 effective as of September 30, 2006, and (ii) there were no change in internal control over financial reporting occurred during the quarter ended September 30, 2006 that has materially affected or is reasonably likely to materially affect, such internal control over financial reporting.

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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. The parties have negotiated a revised schedule for continuing discovery and resetting a trial date in this action and are awaiting the Court’s approval of their stipulation.

     On September 12, 2002, following the same downward revision of revenue and earnings guidance for the third fiscal quarter of 2002, several 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. Discovery is now proceeding in the case. No trial date has been set.

     On October 4, 2006, Ali Corporation (“Ali”) filed a lawsuit in Alameda County Superior Court against us alleging claims for breach of contract, common counts, quantum meruit, account stated and for an open book account. All of the claims arise from a Joint Development Agreement between us and Ali originally entered into on December 14, 2001 and subsequently amended on several occasions. Ali’s complaint seeks damages in the amount of $2.5 million. We have answered Ali’s complaint. Discovery has not yet commenced, and no trial date has been set.

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

     We are subject to various other legal proceedings and claims, either asserted or unasserted, that arise in the ordinary course of business. In addition, from time to time, we may receive notification from customers claiming that such customers are entitled to indemnification or other obligations from us related to infringement claims made against the customers by third parties. Although the outcome of claims cannot be predicted with certainty, we do not believe that any of these other existing legal proceedings will have a material adverse effect on our financial condition, results of operations or cash flows.

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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, 2005.

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

     On September 18, 2006, we announced a plan to reorganize our business strategy. In particular, we plan to concentrate our standard DVD business activities on serving a few large customers and also begin to look for business partners or acquirers for our high definition BluRay DVD business and our camera phone business. At the same time, we hope to expand our digital audio and analog processor chips. If the market for our BluRay DVD or camera phone businesses 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. It may take a greater amount of time to locate partners or acquirers for our high definition BluRay DVD and camera phone businesses than we anticipate, and therefore we may incur greater losses. Selling or licensing of our high definition BluRay DVD business and 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 plan to expand our digital audio and analog processor chips businesses may not succeed due to the very competitive nature and the established presence of large competitors in those markets.

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. To succeed in this market, due to the short life-cycle of the products in this market, we need to timely identify market opportunities and capitalize on these opportunities 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 identify all of the next key products in our marketplace or become the market leader for such products. Until recently, our sales of video system processor chips to the DVD and VCD player markets in the Video business accounted for a majority of our revenues. Given the current economic environment, consumer spending on DVD players and cellular camera phones may not increase as expected or may even weaken or fall. Due to declines in the VCD market demand caused by cannibalization by low-price DVD products, we have entered into a certain license arrangement for our VCD products. The DVD market and our role in that market have also shifted, and, as a result, we recently entered into the Silan Agreement to grant a permanent, irrevocable license to Silan for certain technologies related to our DVD products. Lastly, due to reduction in volume demand of our lower resolution products in the second quarter of 2006, we changed our Digital Imaging strategy considerably, dropping lower resolution image sensors to focus on higher resolution opportunities. There can be no assurance this new strategy will be successful, consequently we continue to consider and evaluate alternative strategies for our Digital Imaging, as well as for our other business. 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 these 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, 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 compete are intensely competitive and are characterized by rapid technological changes, 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 with us. 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

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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. 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 timely shipment of new products of our Digital Imaging business, including our new 4T System-on-Chip (“SOC”) 1.3 Megapixel sensor chip, our new 4Ts SOC 3.2 Megapixel sensor chip, and our new VGA SOC sensor chip;

• 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.

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

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

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 restructure 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 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 positions. There may be obsolete technologies that we need to salvage to align our cost structure efficiently and there may be new technologies that we need to acquire or license in order to remain competitive. 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:

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• 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;

• 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;

• Charges related to the impairment of other intangible assets;

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

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• 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 may continue to expand into new businesses and product lines in which there may be a concentrated customer base and for which we may be required to purchase custom inventories to meet our customers’ needs.

     As demonstrated by our entry into the Digital Imaging business through our acquisition of Pictos, Inc., we have in the past and will continue to regularly consider the expansion into new businesses and product lines by acquisition or otherwise. As a result of our prior expansions into new businesses and new product lines, we may continue to sell our products to a highly concentrated customer base. The reduction, delay or cancellation of orders from one or more major customers or the loss of one or more major customers in these new businesses or product lines could render our venture in a new product line, such as digital imaging, unsuccessful, and resulting in a material adverse effect on our business, financial condition and results of operations.

     As a result of our acquisitions such as Pictos, we currently purchase custom inventories for certain of our product lines such as image sensor modules for camera enabled cellular phones. These custom inventories are highly tailored to each customer’s specifications. In the event that these customers reduce or cancel their orders for these products, we may not be able to re-sell the custom inventories to any of our other customers. We may also be forced to write off such custom inventories, which may result in a material adverse effect on our business, financial condition and results of operations.

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 ASP, 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 that is the difference between cost and estimated market value 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.

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.

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     Some of our significant projects include the development of a next generation technology. For the Video business, this includes the next generation of DVD chip that will incorporate BluRay and High-Definition DVD (“HD-DVD”) technology. This family of products will require a new architecture and a complete SOC design, which is extremely complex and may not ultimately be feasible. For the Digital Imaging business, this includes the development of four transistor (4T) and shared four transistor (S4T) technology and the integration of the image sensor with the image processor on a single, integrated chip (SOC or UniMegaxel or UniVGA products). If we are unable to successfully develop these next generation chips, or complete other significant research and development projects, our business, financial condition and results of operations could be materially adversely affected.

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

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

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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 and digital imaging chip products) 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, VCDs are being replaced by cheaper DVDs. We expect that the DVD platform will face competitors 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 supply chips for multiple platforms. In the Digital Imaging business, our digital imaging products face significant competition who may have greater relationships with lens module assemblers and other suppliers that may assist them in attaining design wins with cellular phone manufacturers. Further decreases in DVD, VCD and digital imaging sales will have a disproportionate effect on us as they are currently our most important product lines. Any of these competitive factors could reduce our sales and market share and may force us to lower our prices, adversely affecting our business, financial condition and results of operations.

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

     Our success depends to a significant degree upon the continued contributions of our top management Fred S.L. Chan, our Chairman of the Board, and Robert L. Blair, our President and Chief Executive Officer (“CEO”). In the past, Mr. Chan has served as our President and CEO in addition to being our Chairman of the Board. Mr. Chan is critical to maintaining many of our key relationships with customers, suppliers and foundries in Asia. The loss of the services of Mr. Chan, Mr. Blair, or any of our other key executives including our Chief Financial Officer could adversely affect our business. 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.

     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.

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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 30% and 34% of our net revenues for three months ended September 30, 2006 and 2005, 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. In the future, 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 if a replacement were found that the new distributor would be as effective as FE Global in generating revenue for us.

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

     A substantial portion of our net revenues has been derived from sales to a small number of customers. During the three months ended September 30, 2006, 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 69% of our net revenues. In 2005 we entered into an exclusive license agreement with a third party, pursuant to which our VCD products are distributed in China and India. This risk is also acute in our Digital Imaging business, which currently has few customers and low sales volume. 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 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

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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, Taiwan, Korea, Japan, Indonesia, Turkey and Singapore. During the three months ended September 30, 2006, sales to customers in China, Hong Kong, and Korea were approximately 73% of our net revenues. If our sales in one of these countries or territories, such as Hong Kong, 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 Taiwan Semiconductor Manufacturing Company Ltd. (“TSMC”), United Microelectronics Corporation (“UMC”), and other independent Asian foundries in Asia. Our reliance on these or other independent foundries involves a number of risks, including:

• 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.

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     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;

• The liquidity within the market for our common stock;

• Sales 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.

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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. Our independent registered public accounting firm is required to attest to, and report on, our management’s assessment. 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 and our independent registered public accounting firm may not have sufficient time to retest those remediated deficiencies for its attestation of management’s 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, if our independent registered public accounting firm is unable to attest that our management’s report is fairly stated, if our independent registered public accounting firm is unable to express an opinion on our management’s evaluation or on the effectiveness of the internal control over financial reporting, or if our independent registered public accounting firm expresses an adverse opinion on our internal controls, 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.

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

ISSUER PURCHASES OF EQUITY SECURITIES

					Total Number of		Maximum Number
					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)
July 1, 2006 — July 31, 2006		—	$	—		—		4,400,000
August 1, 2006 — August 31, 2006		—		—		—		4,400,000
September 1, 2006 — September 30, 2006		—		—		—		4,400,000
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 quarter ended September 30, 2006, we did not purchase any shares under this program. As of September 30, 2006, we had approximately 4,400,000 shares remaining available for repurchase under this program. There is no stated expiration for this program.

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

Item 5. Other Information

     None.

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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, 1998, filed on March 31, 1999.
4.01	Registrant’s Registration Rights Agreement dated May 28, 1993 among the Registrant and certain security holders, incorporated herein by reference to Exhibit 10.07 to the Form S-1.
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.

* Indicates a management contract or compensatory plan or agreement.

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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: November 9, 2006	By:	/s/ Robert L. Blair
		Robert L. Blair
		President and Chief Executive Officer

Date: November 9, 2006	By:	/s/ James B. Boyd
		James B. Boyd
		Chief Financial Officer

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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, 1998, filed on March 31, 1999.
4.01	Registrant’s Registration Rights Agreement dated May 28, 1993 among the Registrant and certain security holders, incorporated herein by reference to Exhibit 10.07 to the Form S-1.
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.

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