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FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 1996
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or
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[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
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Commission File Number 0-25580
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DIAMOND MULTIMEDIA SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 77-0390654
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(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
2880 JUNCTION AVENUE, SAN JOSE, CALIFORNIA 95134
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (408) 325-7000
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Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
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The number of shares outstanding of the registrant's common stock
at April 10, 1996 was 34,769,185.
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DIAMOND MULTIMEDIA SYSTEMS, INC.
INDEX TO FORM 10-Q
Page
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PART I - FINANCIAL INFORMATION:
ITEM 1- Financial Statements
Consolidated Condensed Balance Sheets as of March 31, 1996
and December 31, 1995 3
Consolidated Condensed Statements of Operations for the three
months ended March 31, 1996 and 1995 4
Consolidated Condensed Statements of Cash Flows
for the three months ended March 31, 1996 and 1995 5
Notes to Condensed Consolidated Financial Statements 6
ITEM 2 - Management's Discussion and Analysis of
Financial Condition And Results of Operations 6
PART II - OTHER INFORMATION
ITEM 1 - Legal proceedings 16
ITEM 2 - Changes in securities 16
ITEM 3 - Defaults Upon Senior Securities 16
ITEM 4 - Submission of Matters to a Vote of Security Holders 16
ITEM 5 - Other Information 16
ITEM 6 - Exhibits and Reports on Form 8-K 16
SIGNATURE(S) 17
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DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED BALANCE SHEETS
(AMOUNTS IN THOUSANDS)
MARCH 31, 1996 DECEMBER 31, 1995
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(UNAUDITED)
ASSETS
Current assets:
Cash, cash equivalents and short-term investments $ 100,022 $ 106,203
Trade accounts receivable, net of allowance for doubtful accounts
of $1,858 and $1,959 as of March 31, 1996 and
December 31, 1995 92,767 90,640
Other receivables -- 13,129
Inventories 72,764 89,635
Prepaid expenses, other current assets and deferred income taxes 21,969 23,034
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Total current assets 287,522 322,641
Property, plant and equipment, net 10,875 10,152
Other assets 6,511 6,385
Goodwill and other intangibles, net 16,410 12,551
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Total assets $ 321,318 $ 351,729
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LIABILITIES
Current liabilities:
Current portion of long-term debt $ 14,790 $ 18,077
Trade accounts payable 57,997 94,920
Other accrued liabilities 21,104 16,557
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Total current liabilities 93,891 129,554
Long-term debt, net of current portion 6,234 11,705
Deferred income taxes 1,435 1,860
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Total liabilities 101,560 143,119
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STOCKHOLDERS' EQUITY
Preferred stock, par value $.001; Authorized - 8,000 shares at
March 31, 1996 and December 31, 1995; none issued and
outstanding -- --
Common stock, par value $.001; Authorized - 75,000 at March 31,
1996 and December 31, 1995; issued and outstanding - 34,493
at March 31, 1996 and 34,673 at December 31, 1995 34 35
Additional paid-in capital 306,652 306,697
Distributions in excess of net book value (56,775) (56,775)
Accumulated deficit (30,153) (41,347)
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Total stockholders' equity 219,758 208,610
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Total liabilities and stockholders' equity $ 321,318 $ 351,729
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The accompanying notes are an integral part of these consolidated
financial statements.
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DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE MONTHS ENDED
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MARCH 31, 1996 MARCH 31, 1995
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(UNAUDITED)
Net sales $ 187,605 $ 80,276
Cost of sales 147,543 59,591
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Gross profit 40,062 20,685
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Operating expenses:
Research and development 4,803 1,987
Selling, general and administrative 15,983 7,001
Amortization of intangibles 1,207 --
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Total operating expenses 21,993 8,988
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Income from operations 18,069 11,697
Interest income (expense), net 225 (1,467)
Other expense, net (93) --
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Income before provision for income taxes 18,201 10,230
Provision for income taxes 7,007 4,092
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Net income $ 11,194 $ 6,138
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Accretion for dividends on mandatorily
redeemable preferred stock -- (292)
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Net income available for common
stockholders $ 11,194 $ 5,846
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Net income per share $ 0.32 $ 0.28
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Shares used in computing per share amounts 35,342 20,900
The accompanying notes are an integral part of these
consolidated financial statements.
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DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
THREE MONTHS ENDED
MARCH 31, 1996 MARCH 31, 1995
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(UNAUDITED)
Cash flows from operating activities:
Net income $ 11,194 $ 6,138
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization 1,901 244
Provision for doubtful accounts 513 (25)
Provision for excess and obsolete inventories 1,680 (650)
Changes in assets and liabilities:
Trade accounts and other receivables 10,489 (5,339)
Inventories 10,125 (3,371)
Prepaid expenses, deferred income taxes and other assets 939 (704)
Trade accounts payable and other liabilities (32,800) 14,296
Other (35) --
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Net cash provided by operating activities 4,006 10,589
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Cash flows from investing activities:
Purchases of property and equipment (1,417) (350)
Proceeds from sales of short-term investments 6,023 15,758
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Net cash provided by investing activities 4,606 15,408
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Cash flows from financing activities:
Repayments to stockholders (82,664)
Proceeds from issuance of common stock 2 536
Proceeds from long-term debt 3,939 25,000
Payments of long-term debt (12,697) (10,000)
Repurchases of common stock (14) --
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Net cash used in financing activities (8,770) (67,128)
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Net decrease in cash and cash equivalents (158) (41,131)
Cash and cash equivalents at beginning of period 93,971 57,164
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Cash and cash equivalents at end of period $ 93,813 $ 16,033
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Supplemental Disclosure of cash flow information:
Income taxes paid during the period $ 640 $ 350
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Interest paid during the period $ 307 $ 197
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Supplemental disclosure of non-cash financing activities:
Issuance of capital lease obligations for acquisition of
property and equipment -- $ 1,031
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The accompanying notes are an integral part of these consolidated financial
statements
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DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The accompanying consolidated financial statements have been prepared by the
Company without audit in accordance with generally accepted accounting
principles for interim financial information and pursuant to rules and
regulations of the Securities and Exchange Commission. In the opinion of
management, all adjustments (consisting only of normal recurring adjustments)
considered necessary for a fair presentation have been included. These financial
statements should be read in conjunction with the Company's consolidated
financial statements and notes thereto contained in the Company's Form 10-K for
the fiscal year ended December 31, 1995.
The Company operates under a 52-53 week fiscal year with thirteen week quarters
that end on the Sunday closest to calendar quarter end.
Operating results for the quarter ended March 31, 1996 may not necessarily be
indicative of the results to be expected for any other interim period or for the
full year.
2. INVENTORIES
Inventories are stated at the lower of cost (determined on a first-in, first-out
basis) or market. Inventories consisted of (in thousands):
March 31, 1996 December 31, 1995
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(Unaudited)
Raw materials $25,896 $42,194
Work in process 22,597 33,597
Finished goods 24,271 13,844
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$72,764 $89,635
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3. SPEA PURCHASE PRICE ALLOCATION
During the quarter ended March 31, 1996, the Company adjusted the purchase price
related to the Spea acquisition that occurred during November 1995. The
adjustment related to inventory impairments that existed at the data of
acquisition and certain unfavorable purchase commitments. These purchase price
adjustments resulted in an increase of goodwill of $5 million.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The discussion and analysis below contains trend analysis and other
forward-looking statements within the meaning of Section 27A of the Securities
and Exchange Act of 1933 and Section 21E of the Securities Exchange Act of 1934.
Actual results could differ materially from those projected in the
forward-looking statements as a result of the risk factors set forth below and
elsewhere in this report.
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The following discussion should be read in conjunction with the Company's
consolidated financial statements and the notes thereto. All references to years
represent fiscal years unless otherwise noted.
OVERVIEW
The Company develops, manufactures, markets and supports multimedia and
connectivity subsystems for IBM-compatible personal computers ("PCs") and
Macintosh computers. In September 1995, the Company acquired Supra Corporation
("Supra"), a supplier of fax/modem products, including related software, for the
PC and Macintosh markets. In November 1995, the Company acquired SPEA Software
AG ("Spea"), a German corporation. Spea develops, markets and supports add-in
graphics and multimedia accelerator subsystems for PCs and 3D graphics
accelerators for computer-aided design ("CAD") applications. Both acquisitions
have been accounted for as purchase business combinations.
NET SALES
Net sales for the first quarter of 1996 increased by 134% to $187.6 million
from $80.3 million for the first quarter of 1995. The increase in net sales over
the prior year's first fiscal quarter was primarily attributable to the revenues
generated by the growth in demand for the Stealth series of graphics accelerator
cards, sales of the Edge 3D graphics accelerator cards, which were first sold in
significant quantity in the fourth quarter of 1995, and the revenues generated
by the recently acquired subsidiaries of Supra and Spea, which together amounted
to approximately $60.8 million for the first quarter of fiscal 1996. Because the
acquisitions were accounted for as purchases, the results of operations for the
first quarter of 1995 do not include those of Supra or Spea. These increases
were offset, in part, by a decline in sales of the Viper series of graphics
accelerator cards as these products were replaced by the new Stealth product
line. Net sales of fax/modems continued to grow rapidly in the first quarter of
1996 with the IBM-compatible personal computer ("PC") market for fax/modems
growing faster than the Macintosh market.
The increase in sales also reflected significant increase in international
sales, which represented 46% in the first quarter of 1996 compared to 31% in the
first quarter of 1995. During 1995, the Company acquired Spea, increased its
sales to international OEMs, opened offices in the United Kingdom and France,
and launched sales efforts in South America and Korea.
GROSS MARGIN
Gross margin (gross profit as a percentage of sales) was 21.3% in the first
quarter of 1996 compared to 25.8% in the first quarter of 1995. Gross margin
declined primarily due to overall lower unit prices, increased sales to OEM
accounts, and a higher proportion of lower-margin European sales, which
comprised approximately 32% of sales in the first quarter of 1996 versus
approximately 26% of sales in the first quarter of 1995. European sales have
traditionally had lower gross margins than domestic sales primarily due to
competitive pricing pressures and two-tier distribution practices.
During the second fiscal quarter of 1996, declines in prices for DRAMs and
other components are expected to result in lower costs for the Company's
products. As a result, gross margins may improve in the second quarter. The two
immediately preceding sentences contain forward-looking statements which involve
risks and uncertainties and actual results could differ materially from those
anticipated in the forward-looking statements as a result of certain factors,
including those set forth under "Certain Factors That May Affect Future
Performance" and elsewhere in this Form 10-Q.
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RESEARCH AND DEVELOPMENT
Research and development expenses increased $2.8 million (142%) from $2.0
million (2.5% of net sales) in the first quarter of 1995 to $4.8 million (2.6%
of net sales) in the first quarter of 1996. The increase in research and
development expenses for the first quarter in 1996 compared to the first quarter
of 1995 was due primarily to higher personnel-related expenses and, to a lesser
extent, the material and outside service costs associated with new product
development. Additionally, the increase as a percentage of net sales primarily
reflects the significant increase in the Company's engineering staff and
occupancy costs related to its efforts to support the introduction of new
product lines, including those that will offer various combinations of graphics,
digital video, 3D animation, sound, ISDN modem, telephony, television and other
emerging functions. This increase in spending is also attributable to the
acquisitions of Supra and Spea (which were not included in operating results for
the first quarter of 1995), as well as the continued expansion of product
development activities. The Company anticipates that its research and
development expenses will continue to increase in absolute dollars and may
increase as a percentage of sales.
SELLING, GENERAL AND ADMINISTRATIVE
Selling, general and administrative expenses increased to $16.0 million in
the first quarter of 1996 (8.5% of net sales) from $7.0 million in the first
quarter of 1995 (8.7% of net sales). The increase in expenses was due primarily
to higher personnel-related expenses associated with increased staffing to
handle the expansion in the Company's overall level of business, including Supra
and Spea, and to improve its systems and procedures infrastructure, as well as
increased selling and marketing expenses associated with higher sales and
increased promotion of the Company's products, particularly in international
markets. The decrease in expenses as a percentage of net sales resulted
primarily from having a higher proportional increase in net sales. The Company
anticipates that its selling, general and administrative expenses will continue
to increase in absolute dollars, but may vary as a percentage of net sales, as
the Company continues to expand its efforts at penetrating certain sales
channels and regions, and continues to strengthen management information and
telecommunications systems to support its existing and acquired businesses and
the anticipated growth in the scope of its operations, including the recent
acquisitions of Supra and Spea.
AMORTIZATION OF INTANGIBLE ASSETS
The Company incurred amortization expense of $1.2 million in the first
quarter of 1996. This expense relates to amortization of purchased technology
and goodwill from the Supra and Spea acquisitions which occurred in the third
and fourth quarters of 1995, respectively.
INTEREST INCOME (EXPENSE)
Interest income was $225,000 in the first quarter of 1996 compared to
interest expense of $1,467,000 in the first quarter of 1995. Interest income in
the first quarter of 1996 was generated from the Company's cash and short-term
investments, offset in part by interest expense on outstanding borrowings. The
interest expense for the first quarter of 1995 was due primarily to interest on
certain debt that was repaid at the time of the Company's initial public
offering in April 1995.
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PROVISION FOR INCOME TAXES
The Company's effective tax rate was 38.5% for the first quarter of 1996 and
40.0% for the first quarter of 1995. For the first quarter of 1995, the
Company's effective tax rate approximated federal and state statutory rates.
Differences from the statutory rates consisted principally of the effect of
state income taxes and the research and development tax credit. For the first
quarter of 1996, the decrease in the effective tax rate was due primarily to
higher research and development credits, federal tax-exempt interest income and
tax benefits from the Company's foreign sales corporation.
RECENT ACCOUNTING PRONOUNCEMENTS
During March 1995, the Financial Accounting Standards Board issued Statement
No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of," which requires the Company to review for impairment
long-lived assets, certain identifiable intangibles, and goodwill related to
those assets whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. In certain situations, an
impairment loss would be recognized. Statement 121 will be effective for the
Company's fiscal year 1996. The Company has studied the implications of the
statement and, based on its initial evaluation, does not expect it to have a
material impact on the Company's financial condition or results of operations.
During October 1995, the Financial Accounting Standards Board issued
Statement No. 123 (SFAS No. 123), "Accounting for Stock-Based Compensation,"
which establishes a fair value based method of accounting for stock-based
compensation plans. The Company is currently following the requirements of APB
Opinion No. 25, "Accounting for Stock Issued to Employees." The Company plans to
adopt SFAS No. 123 during 1996 utilizing the disclosure alternative.
LIQUIDITY AND CAPITAL RESOURCES
Cash and equivalents decreased by $0.2 million during the quarter ended
March 31, 1996. Operating activities provided $4.0 million in cash. The primary
sources of cash were net income of $11.2 million, a decrease in receivables and
inventories of $10.5 million and $10.1 million, respectively, depreciation and
amortization of $1.9 million, and a decrease of $0.9 million in prepaid
expenses, deferred taxes and other assets. These sources of cash from operating
activities were offset, in part, by a decrease in accounts payable and other
liabilities of $32.8 million.
The Company provided $4.6 million in cash from investing activities
primarily due to proceeds from sales of short-term investments of $6.0 million,
offset in part, by purchases of property and equipment of $1.4 million. Net cash
used in financing activities was $8.8 million primarily due to payments of $12.7
million on long-term debt, offset in part, by $3.9 million of proceeds from term
loans and revolving credit facilities.
At March 31, 1996, the Company had $93.8 million of cash and cash
equivalents and an additional $6.2 million in short-term investments. Further,
as of such date, the Company had lines of credit and bank credit facilities
totaling $55.1 million, of which $38.1 million is unused and available under
these credit facilities.
The Company currently expects to spend approximately $5 million for capital
equipment in 1996, principally relating to computer and office equipment, all or
a portion of which may be financed by equipment lease financing. The Company
believes that its cash balances, short term-investments, and available credit
under existing bank lines will be sufficient to meet anticipated operating and
investing requirements for the foreseeable future. There can be no assurance
that additional capital beyond the amounts currently forecasted by the Company
will not be required nor that any such required additional capital will be
available on reasonable terms, if at all, at such time or times as required by
the Company.
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CERTAIN FACTORS THAT MAY AFFECT FUTURE PERFORMANCE
In addition to other information in this Form 10-Q, the following are
important factors that should be considered carefully in evaluating the Company
and its business.
POTENTIAL FLUCTUATIONS IN FUTURE OPERATING RESULTS; SEASONALITY
The Company's future operating results may vary significantly from period to
period as a result of a number of factors, including the volume and timing of
orders received during the period, the timing of new product introductions by
the Company and its competitors, product line maturation, the impact of price
competition on the Company's average selling prices, the availability and
pricing of components for the Company's products, changes in product or
distribution channel mix and product returns or price protection charges from
customers. Many of these factors are beyond the Company's control. In addition,
due to the short product life cycles that characterize the Company's markets,
the Company's failure to successfully introduce competitive products in a timely
manner would adversely affect operating results for one or more product cycles.
The volume and timing of orders received during a quarter are difficult to
forecast. Customers generally order on an as-needed basis and, accordingly, the
Company has historically operated with a relatively small backlog. Also, during
periods of uncertainty in the personal computer industry's outlook for future
demand or pricing, the Company's customers may choose to draw down their
inventory levels thereby adversely impacting the Company's revenues during the
period of adjustment. Moreover, as often occurs in the personal computer
industry, a disproportionate percentage of the Company's net sales in any
quarter may be generated in the last month of a quarter. As a result, a
shortfall in sales in any quarter as compared to expectations may not be
identifiable until the end of the quarter. In addition, from time to time, a
significant portion of the Company's sales are derived from a limited number of
customers, the loss of one or more of which could adversely impact operating
results.
Notwithstanding the difficulty in forecasting future sales and the
relatively small level of backlog at any given time, the Company generally must
plan production, order components and undertake its development, sales and
marketing activities and other commitments months in advance. Accordingly, any
shortfall in revenues in a given quarter may impact the Company's operating
results due to an inability to adjust expenses or inventory during the quarter
to match the level of revenues for the quarter. Excess inventory could also
result in cash flow difficulties as well as added expenses associated with
inventory write-offs or sell-offs.
The Company's gross margins are impacted by product life cycles, the mix of
products sold, the mix of distribution channels, pricing pressures, the
availability and cost of products and components from the Company's suppliers,
component price inflation or deflation, and general economic conditions. For
example, Diamond has increased its sales to OEMs, which historically have
yielded lower gross margins, and to the retail/mass merchant channel, which
typically provides higher gross margins than OEM sales but requires higher sales
and marketing expenses and carries price protection and stock rotation
liabilities. Individual product lines generally provide higher margins at the
beginning of the typical six-to-twelve-month product life cycle, and lower
margins as the product line matures. Product lines with less value-added,
however, such as multimedia upgrade kits, generally provide lower margins than
product lines with higher value-added. The Company's markets are characterized
by intense ongoing competition and a trend of declining average selling prices.
The decline in selling prices may cause the amount of revenues in any one
quarter to be lower than the preceding quarter even though more units were sold
during the preceding quarter. This trend of declining prices accelerated during
the first quarter of 1996 and is expected to continue in the second quarter of
1996. Accordingly, the Company's average selling prices and margins may decline
in the future from the levels experienced to date. The Company's gross margins
may also be adversely affected by shortages of and higher prices for key
components for the Company's products, including its recently acquired modem and
fax/modem products, which have been impacted from time-to-time by a scarcity in
supply of modem chipsets. In addition, the Company's gross margins may be
adversely affected if the market prices for certain components used by the
Company, such as DRAMs, VRAMs or multimedia controller chips, decline more
rapidly than the Company is able to
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process its component inventory bought earlier at higher prices into finished
products, book and ship the associated orders, and move such products through
third-party distribution channels, some of which may be price protected, to the
final customer.
The Company believes that, due to industry seasonality, demand for its
products is strongest during the fourth calendar quarter of each year. This
seasonality may become more pronounced in the future to the extent that a
greater proportion of the Company's sales consist of sales into the retail/mass
merchant channel or to the extent that PCs become more consumer-oriented
products. Also, to the extent the Company is successful in expanding its
consumer-oriented markets and European operations, both internally and through
its acquisition of Spea, it may experience relatively weak demand in third
calendar quarters due to historically weak summer sales, particularly in Europe.
MANAGEMENT OF GROWTH; INTEGRATION OF SUPRA AND SPEA
In recent years, the Company has experienced a significant expansion in the
overall level of its business and scope of its operations, including research
and development, marketing, technical support, and sales and distribution. In
addition, through its acquisitions of Supra in September 1995 and Spea in
November 1995, the Company increased the scope of its product lines and
multinational operations. This expansion in scope has resulted in a need for
significant investment in infrastructure and systems. Furthermore, this
requirement is relatively more substantial due to the limited systems investment
made by the Company prior to 1995. This requirement includes, without
limitation, securing adequate financial resources to successfully integrate and
manage the acquired businesses, retention of key employees, integration of
management information and telecommunications systems, consolidation of
geographically dispersed manufacturing and distribution facilities, coordination
of suppliers, rationalization of distribution channels, and integration of
various functions and groups of employees, each of which could pose significant
challenges. Moreover, Spea historically has not been profitable and the
Company's management needs to make significant and rapid improvements at Spea
for the merged operation to achieve profit margins comparable to the Company's
historical results. The Company's future operating results will depend in large
measure on its success in implementing operating, manufacturing and financial
procedures and controls, improving communication and coordination among
different operating functions, integrating certain functions such as sales,
procurement and manufacturing, strengthening management information and
telecommunications systems, and continuing to hire additional qualified
personnel in all areas. There can be no assurance that the Company will be able
to manage these activities and implement these additional systems and controls
successfully, and any failure to do so could have a material adverse effect upon
the Company's operating results.
SHORT PRODUCT LIFE CYCLES
The market for the Company's products is characterized by frequent new
product introductions and rapid product obsolescence. These factors typically
result in short product life cycles, frequently ranging from six to twelve
months. The Company must continually monitor industry trends and make difficult
choices in selecting new technologies and features to incorporate into its
products. Each new product cycle presents new opportunities for current or
prospective competitors of the Company to gain market share. If the Company does
not successfully introduce new products within a given product cycle, the
Company's sales will be adversely affected for that cycle and possibly for
subsequent cycles. Any such failure could also impair the Company's brand name
and ability to command retail shelf space in future periods. Moreover, because
of the short product life cycles coupled with the long lead times for many
components used in the Company's products, the Company may not be able, in a
timely manner, to reduce its procurement commitments, production or inventory
levels in response to unexpected shortfalls in sales or declines in prices or,
conversely, to increase production in response to unexpected increases in
demand. This lack of timely forecasting or operations response to changes in
actual or expected demand could result in excess inventory, inventory write
downs and gross margin compression or, conversely, in lost sales due to product
unavailability.
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NEW OPERATING SYSTEMS
The PC industry has recently been characterized by significant operating
system changes, such as the introduction of OS/2 Warp in 1994, Windows 95 in
1995 and the expected introduction of Windows NT 4.0 in 1996. While new
operating systems can provide new market opportunities, such as the growing
market for graphical user interface ("GUI") accelerators that occurred with the
introduction of Windows 3.0 and the expected growth in the PC games market with
the introduction of Windows 95, new operating systems also place a significant
research and development burden on the Company. New drivers, applications and
user interfaces must be developed for the new operating systems in order to
maintain revenue levels. Perhaps more significantly, such drivers, applications
and interfaces customarily are ported to the recently shipped portion of the
Company's installed base. This effort involves a substantial software
engineering, compatibility testing and customer technical support investment
with only a limited near-term incremental revenue return since these driver
updates are usually provided via electronic distribution free to the Company's
customers, and the installation of this software may result in increased
technical support calls. Moreover, during the introductory period of a major new
operating system release such as Windows 95, such installed base support may
reduce the research and development and customer technical support resources
available for launching new products. Furthermore, new operating systems for
which the Company develops driver support may not be successful, and a
reasonable financial return on the corollary research and development investment
may not be achieved.
COMPONENT SHORTAGES; RELIANCE ON SOLE OR LIMITED SOURCE SUPPLIERS
The Company is dependent on sole or limited source suppliers for certain key
components used in its products, particularly application specific integrated
circuit ("ASIC") chipsets that provide graphics, digital video, 3D CAD,
television (TV), sound, 3D animation, telephony and other multimedia functions,
VRAM and DRAM memory, TV tuners and fax/modem chipsets, including voice modem
and simultaneous voice and data ("SVD") modem chipsets. These components are
periodically in short supply and on allocation by semiconductor manufacturers.
The Company's dependence on sole or limited source suppliers, and the risks
associated with any delay or shortfall in supply, can be exacerbated by the
short life cycles that characterize multimedia ASIC chipsets and the Company's
products in general. Although the Company maintains ongoing efforts to obtain
required supplies of components, including working closely with vendors and
qualifying alternative components for inclusion in the Company's products,
component shortages continue to exist from time to time, and there can be no
assurances that the Company can continue to obtain adequate supplies or obtain
such supplies at their historical cost levels. Conversely, in its attempt to
counter actual or perceived component shortages, the Company may overpurchase
certain components, resulting in excess inventory and reducing the Company's
liquidity or, in the event of inventory obsolescence or a decline in the market
value of such inventory, causing inventory write-offs or sell-offs that
adversely affect the Company's gross margin.
From time to time supply-demand conditions for semiconductor components may
change. During periods of oversupply, prices are likely to fall and certain
vendors of such semiconductor chips may liquidate their inventories in a rapid
manner. If such semiconductor vendors are suppliers to the Company's
competitors, then such actions could enable competitors of the Company to enjoy,
at least on a temporary basis, a cost advantage vis-a-vis the Company, and any
resultant price reduction for such competitors' products could require the
Company to reduce its prices, thereby depressing the Company's margins or
revenues in one or more operating periods.
During periods of oversupply and associated price deflation of
semiconductor components, customers of the Company, particularly those
comprising channels that do not receive price protection from the Company, may
seek to draw down the inventory that they hold since such inventory may bear a
price deflation risk. As a consequence, the Company may see its orders and
revenue depressed during such inventory reduction periods, which could adversely
affect revenues or gross margin in the related operating period or periods.
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DEPENDENCE ON GRAPHICS AND MULTIMEDIA ACCELERATOR MARKET
Sales of graphics and multimedia accelerator subsystems accounted for
greater than 75% and 85% of the Company's revenues in the first quarter of 1996
and the same period in 1995, respectively. Although the Company introduced
audio/telecommunications subsystems in mid-1995, and acquired Supra, a supplier
of internal and external fax/modems, in September 1995, graphics and multimedia
accelerator subsystems are expected to continue to account for a substantial
majority of the Company's sales for the foreseeable future. A decline in demand
or average selling prices for graphics or multimedia accelerator subsystems,
whether as a result of new product introductions, price competition, excess
supply, technological change, incorporation of the products' functionality onto
personal computer motherboards or otherwise, would have a material adverse
effect on the Company's sales and operating results.
MIGRATION TO PERSONAL COMPUTER MOTHERBOARDS; OEM RISKS
The Company's graphics and multimedia accelerator subsystems are individual
products which function with personal computers to provide additional multimedia
functionality. Historically, as a given functionality becomes technologically
stable and widely accepted by personal computer users, the cost of providing the
functionality is typically reduced by means of large scale integration onto
semiconductor chips, which can be subsequently incorporated onto personal
computer motherboards. The Company expects that such migration could, in fact,
occur with respect to the functionality provided by the Company's current
products. While the Company believes that a market will continue to exist for
add-in subsystems that provide advanced functions and offer flexibility in
systems configuration, there can be no assurance that the incorporation of new
multimedia functions onto personal computer motherboards or into the CPU
microprocessor will not adversely affect the future market for the Company's
products.
The Company currently has only a limited number of OEM customers. While the
Company is seeking to increase its sales to OEMs, certain OEMs maintain internal
add-in subsystem design and manufacturing capabilities or have existing
relationships with competitors of the Company, and there can be no assurance
that the Company will be successful in its efforts to increase its OEM sales. In
any case, it is expected that OEM revenue will carry a lower gross margin
percentage compared to sales to other channels due to perceived lower expenses
to support such OEM revenue and the buying power exercised by large OEMs.
Furthermore, the Company's products are priced and generally aimed at the higher
performance segment of the market. Therefore, to the extent that OEMs focus on
price rather than performance, an increase in the proportion of the Company's
sales to OEMs may result in an increase in the proportion of the Company's
revenue generated by lower price, lower gross margin products, which could
adversely affect future operating results.
COMPETITION
The market for the Company's products is highly competitive. The Company
competes directly against a large number of suppliers of add-in visual and audio
subsystems and data communications products, and indirectly against OEMs to the
extent they manufacture their own add-in subsystems or incorporate on the
personal computer motherboard the functionality provided by the Company's
products. In addition, the Company's markets are expected to become increasingly
competitive as multimedia functions continue to converge and companies that
previously supplied products providing distinct functions (for example,
companies in the sound, fax/modem, telephony, digital signal processing and
central processing unit markets) emerge as competitors across broader product
categories.
In addition, manufacturers of chipsets or other components used in the
Company's products could become future competitors of the Company to the extent
that such manufacturers elect to integrate forward into the add-in subsystem or
value-added software market. Certain of the Company's current and potential
competitors have significantly greater market presence, name recognition and
financial and technical resources than the Company, and many have long-standing
market positions and established brand names in their respective markets. In
addition, certain of the Company's current and potential competitors also
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have a competitive cost advantage from being located in areas that impose
significantly lower taxes than the United States or provide a substantially
lower cost of labor. Many of the Company's current and potential competitors
design and manufacture their own graphics acceleration, video, sound, fax/modem
or other multimedia processing chipsets. While the Company believes that its
semiconductor vendor flexibility enables it to select from among the most
advanced and price competitive chipsets available, the captive semiconductor
operations of certain of the Company's current and potential competitors could
provide significant advantages, including greater control over component design,
systems design, availability and cost. Also, the Company believes that certain
of its current and potential competitors compete largely on the basis of price,
which may result in significant price competition, lower margins for the
Company's products or otherwise affect the market for the Company's products.
There can be no assurance that the Company will be able to continue to compete
successfully in its markets, or will be able to compete successfully against
current and new competition as the Company's technology, markets and products
continue to evolve.
DISTRIBUTION RISKS; DIVERSIFICATION OF SALES CHANNELS
The Company sells its products to a domestic and international network of
distributors, retailers/mass merchants and OEM customers, and the Company's
success is dependent on the continued viability and financial stability of its
customer base. The computer distribution and retail/mass merchant industries
have historically been characterized by rapid change, including periods of
widespread financial difficulties and consolidations and the emergence of
alternative distribution channels. The loss of, or reduction in sales to,
certain of the Company's key customers could have a material adverse effect on
the Company's operating results, as could the failure of such customers to pay
their accounts receivables to the Company. Likewise, changes in distribution
channel patterns, such as increased commerce on the Internet or increased use of
catalog or consumer-oriented channels for personal computer sales, could affect
the Company in ways not yet known.
The Company frequently grants limited rights to customers to return certain
unsold inventories of the Company's products in exchange for new purchases, as
well as price protection on unsold inventory. The Company estimates returns and
accrues for potential price protection on unsold inventory. However, there can
be no assurance that these estimates or accruals will be sufficient, or that any
future returns or price reductions will not have a material adverse effect on
operating results, particularly in light of the rapid product obsolescence which
often occurs during product transitions. The short product life cycles of the
Company's products, the evolving markets for new multimedia and connectivity
technologies and the difficulty in predicting future sales increase the risk
that new product introductions, price reductions by the Company or its
competitors, or other factors affecting the personal computer and add-in
subsystem industry could result in significant product returns. In addition,
there can be no assurance that new product introductions by competitors or other
market factors will not require the Company to reduce prices in a manner or at a
time that gives rise to significant price protection charges and has a material
adverse impact upon the Company's operating results.
RAPID TECHNOLOGICAL CHANGE
The market for the Company's products is characterized by rapidly changing
technology, evolving industry standards, frequent new product introductions and
rapid product obsolescence. Product life cycles in the Company's markets
frequently range from 6 to 12 months. The Company's success will be
substantially dependent upon its ability to continue to develop and introduce
competitive products and technologies on a timely basis with features and
functionalities that meet changing customer requirements in a cost-effective
manner.
CAPITAL NEEDS; ACQUISITIONS
The financial obligations incurred by the Company as a result of the Supra
and Spea acquisitions are expected to consume a portion of the Company's
available capital. There can be no assurance that
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additional capital beyond the amounts currently forecasted by the Company will
not be required or that any required additional capital will be available on
reasonable terms, if at all, at such time or times as required by the Company.
Any shortfall in capital resources compared to the Company's level of
operations, or any inability to secure additional capital as needed, could
impair the Company's ability to finance inventory, accounts receivable and other
operational needs. Such capital limitations could also impair the Company's
ability to invest in research and development, sales and marketing programs,
customer service and support and other operations, any of which could have a
material adverse effect on the Company's business and operating results.
Moreover, any need to raise additional capital through the issuance of equity
securities may result in additional dilution to earnings per share.
RISKS OF INTERNATIONAL SALES
The Company's international sales are subject to a number of risks generally
associated with international sales, including the effect on demand for the
Company's products in international markets as a result of a strengthening or
weakening U.S. dollar (or German mark, in the case of Spea), the effect of
currency fluctuations on consolidated multi-national financial results,
state-imposed restrictions on the repatriation of funds, import and export
duties and restrictions, the expenses, time and technical resources required to
localize the Company's various products and support local languages, the
logistical difficulties of managing multinational operations and dispersed
product inventory designed or manufactured to meet specific countries'
requirements, and delays and expenses associated with homologating the Company's
telecommunications products and securing necessary governmental approvals for
various countries.
PROPRIETARY RIGHTS
The Company has only a limited number of patents and patent applications
and relies primarily on a combination of copyright and trade secret protection
to establish and protect its proprietary rights. There can be no assurance that
the Company's measures to protect its proprietary rights will deter or prevent
unauthorized use of the Company's technology. In addition, the laws of certain
foreign countries may not protect the Company's proprietary rights to the same
extent as do the laws of the United States. As is typical in its industry, the
Company from time to time is subject to legal claims asserting that the Company
has violated intellectual property rights of third parties. In the event that a
third party was to sustain a valid claim against the Company, and any required
licenses were not available on commercially reasonable terms, the Company's
operating results could be materially and adversely affected. Litigation, which
could result in substantial cost to and diversion of the resources of the
Company, may also be necessary to enforce intellectual property rights of the
Company or to defend the Company against claimed infringement of the rights of
others.
STOCK PRICE VOLATILITY
The trading price of the Common Stock has been subject to fluctuations to
date, and could be subject to wide fluctuations in the future in response to
quarter-to-quarter variations in operating results, announcements of
technological innovations or new products by the Company or its competitors,
general conditions in the markets for the Company's products or the computer
industry, the price and availability of purchased components, general financial
market conditions, market conditions for technology, PC or semiconductor stocks,
changes in earnings estimates by analysts, or other events or factors. In this
regard, the Company does not endorse and accepts no responsibility for the
estimates or recommendations issued by analysts from time to time. In addition,
the public stock markets have experienced extreme price and trading volume
volatility in recent months. This volatility has significantly affected the
market prices of securities of many high technology companies for reasons
frequently unrelated to the operating performance of the specific companies.
These broad market fluctuations may adversely affect the market price of the
Company's Common Stock.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Not applicable.
ITEM 2. CHANGES IN SECURITIES
Not applicable.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
ITEM 5. OTHER INFORMATION
Not applicable.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
11.1 Statement Regarding Computation of Net Income per Share
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SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
DIAMOND MULTIMEDIA SYSTEMS, INC.
Date: May 6, 1996 /s/ William J. Schroeder
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William J. Schroeder
President and Chief Executive Officer
Date: May 6, 1996 /s/ Gary B. Filler
----------------------------
Gary B. Filler
Chief Financial Officer
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