1
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
FORM 10-Q
(Mark One)
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarter ended September 30, 1996 OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________ to __________
Commission file number 0-21126
S3 INCORPORATED
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 77-0204341
---------------------------- ------------------------------------
[State or other jurisdiction [I.R.S. Employer Identification No.]
of incorporation or organization]
2770 San Tomas Expressway
Santa Clara, California 95051-0968
- ---------------------------------------- ----------
[Address of principal executive offices] [Zip Code]
Registrant's telephone number, including area code: (408) 980-5400
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
----- -----
The number of shares of the Registrant's Common Stock, $.0001 par value,
outstanding at November 8, 1996 was 48,083,827.
- --------------------------------------------------------------------------------
2
S3 INCORPORATED
FORM 10-Q
INDEX
PAGE
PART I. CONSOLIDATED CONDENSED FINANCIAL INFORMATION
Item 1. Consolidated Condensed Financial Statements:
Consolidated Condensed Balance Sheets
September 30, 1996 and December 31, 1995 3
Consolidated Condensed Statements of Operations
Three months and nine months ended
September 30, 1996 and 1995 4
Consolidated Condensed Statements of Cash Flows
Nine months ended September 30, 1996 and 1995 5
Notes to Unaudited Consolidated Condensed Financial Statements 6-8
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 9-21
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 22
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 22
Signatures 23
Page 2 of 23
3
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
S3 INCORPORATED
CONSOLIDATED CONDENSED BALANCE SHEETS
(Dollars in thousands, except share data)
(Unaudited)
September 30, December 31,
1996 1995
ASSETS ------------- ------------
Current assets:
Cash and equivalents $ 130,808 $ 69,289
Short-term investments 13,200 24,630
Accounts receivable (net of allowances of $2,026 in 1996
and $1,614 in 1995) 104,831 84,210
Inventories, net 52,865 43,293
Prepaid expenses and other 26,663 14,216
--------- ---------
Total current assets 328,367 235,638
Property and equipment, net 25,896 20,678
Production capacity rights 14,400 24,000
Investment in joint venture 63,346 36,425
Other assets 14,773 4,902
--------- ---------
Total $ 446,782 $ 321,643
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 36,008 $ 62,081
Notes payable 21,314 9,200
Accrued liabilities 15,956 13,461
Income taxes payable 8,640 6,276
--------- ---------
Total current liabilities 81,918 91,018
Notes payable 14,400 24,000
Other liabilities 4,862 761
--------- ---------
Total liabilities 101,180 115,779
--------- ---------
Convertible subordinated notes (Note 5) 103,500 --
Commitments and contingencies (Notes 4 and 6)
Stockholders' equity:
Common stock, $.0001 par value; 70,000,000 shares authorized;
47,802,328 and 46,797,327 shares outstanding in 1996 and 1995 159,865 156,474
Unrealized gain (loss) on short-term investments (27) 14
Retained earnings 82,264 49,376
--------- ---------
Total stockholders' equity 242,102 205,864
--------- ---------
Total $ 446,782 $ 321,643
========= =========
See accompanying notes to consolidated condensed financial statements.
Page 3 of 23
4
S3 INCORPORATED
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)
Three Months Ended Nine Months Ended
September 30, September 30, September 30, September 30,
1996 1995 1996 1995
------------- ------------- ------------- -------------
Net sales $119,440 $ 84,793 $333,337 $212,773
Cost of sales 72,824 50,707 203,691 128,102
-------- -------- -------- --------
Gross margin 46,616 34,086 129,646 84,671
Operating expenses:
Research and development 15,897 11,292 45,675 27,129
Selling, marketing and administrative 12,858 8,785 35,359 23,099
-------- -------- -------- --------
Total operating expenses 28,755 20,077 81,034 50,228
-------- -------- -------- --------
Income from operations 17,861 14,009 48,612 34,443
Other income, net 277 1,643 1,986 3,360
-------- -------- -------- --------
Income before income taxes 18,138 15,652 50,598 37,803
Provision for income taxes 6,350 5,792 17,710 13,888
-------- -------- -------- --------
Net income $ 11,788 $ 9,860 $ 32,888 $ 23,915
======== ======== ======== ========
Net income per share:
Primary $ 0.23 $ 0.20 $ 0.65 $ 0.52
======== ======== ======== ========
Fully diluted $ 0.23 $ 0.20 $ 0.65 $ 0.52
======== ======== ======== ========
Common and equivalent shares used in
computing net income per share:
Primary 51,101 50,496 50,421 45,907
======== ======== ======== ========
Fully diluted 52,932 50,496 51,031 45,907
======== ======== ======== ========
See accompanying notes to consolidated condensed financial statements.
Page 4 of 23
5
S3 INCORPORATED
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
Nine Months Ended
------------------------------
September 30, September 30,
1996 1995
------------- -------------
Operating activities:
Net income $ 32,888 $ 23,915
Adjustments to reconcile net income to net cash provided by
(used for) operating activities:
Deferred income taxes (994) 231
Depreciation and amortization 7,717 4,836
Provision for doubtful accounts receivable 412 458
Deferred rent (115) 27
Changes in assets and liabilities:
Accounts receivable (21,033) (41,869)
Inventories (9,572) (9,752)
Prepaid expenses and other (6,794) (329)
Production capacity rights (7,200) (1,200)
Accounts payable (26,073) 25,436
Accrued liabilities 6,925 7,046
Income taxes payable 2,364 7,726
------------- -------------
Net cash provided by (used for) operating activities (21,475) 16,525
------------- -------------
Investing activities:
Property and equipment purchases, net (12,515) (12,379)
Investment in real estate partnership (2,100) --
Sales/maturities of short-term investments, net 11,389 254
Investment in joint venture (26,921) (37,000)
Other assets -- (2,891)
------------- -------------
Net cash used for investing activities (30,147) (52,016)
------------- -------------
Financing activities:
Sale of common stock, net 3,391 92,694
Sale of convertible subordinated notes 103,500 --
Debt issuance costs (3,250) --
Borrowings on equipment financing 6,500 --
Borrowings of notes payable, net 3,000 --
------------- -------------
Net cash provided by financing activities 113,141 92,694
------------- -------------
Net increase in cash and equivalents 61,519 57,203
Cash and equivalents at beginning of period 69,289 25,772
------------- -------------
Cash and equivalents at end of period $ 130,808 $ 82,975
============= =============
See accompanying notes to consolidated condensed financial statements.
Page 5 of 23
6
S3 INCORPORATED
NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
1. Basis of Presentation:
The consolidated condensed financial statements have been prepared by
S3 Incorporated, without audit, pursuant to the rules and regulations of the
Securities and Exchange Commission and include the accounts of S3 Incorporated
and its wholly owned subsidiaries ("S3" or collectively the "Company"). Certain
information and footnote disclosures, normally included in financial statements
prepared in accordance with generally accepted accounting principles, have been
condensed or omitted pursuant to such rules and regulations. In the opinion of
the Company, the financial statements reflect all adjustments, consisting only
of normal recurring adjustments, necessary for a fair presentation of the
financial position at September 30, 1996 and December 31, 1995, and the
operating results and cash flows for the three and nine months ended September
30, 1996 and 1995. These financial statements and notes should be read in
conjunction with the Company's audited financial statements and notes thereto
for the year ended December 31, 1995, included in the Company's Form 10-K filed
with the Securities and Exchange Commission.
The results of operations for the three months and nine months ended
September 30, 1996 are not necessarily indicative of the results that may be
expected for the year ending December 31, 1996.
2. Inventories:
Inventories consist of work in process and finished goods and are
stated at the lower of cost (first-in, first out) or market.
September 30, December 31,
Inventories consist of: 1996 1995
-------------------------------
(in thousands)
Work in process $25,066 $23,469
Finished goods 27,799 19,824
-------------------------------
Total $52,865 $43,293
===============================
3. Net Income Per Share:
Net income per share is computed using the weighted average number of
common shares and dilutive common equivalent shares outstanding. For primary
earnings per share, common equivalent shares include stock options and shares
subscribed under the employee stock purchase plan (computed using the treasury
stock method). Fully diluted earnings per share also include, if dilutive, the
effect of incremental shares issuable upon the conversion of the convertible
subordinated notes and an adjustment to net income for the interest expense (net
of income taxes) related to the notes.
Page 6 of 23
7
4. Wafer Supply Agreements and Commitments
In the third quarter of 1995, the Company entered into two long-term
manufacturing capacity arrangements. The Company entered into an agreement with
United Microelectronics Corporation (UMC) and Alliance Semiconductor (Alliance)
to form USC, a separate Taiwanese company, for the purpose of building and
managing a semiconductor manufacturing facility in the Science-Based Industrial
Park in Hsin Chu City, Taiwan. Pursuant to the agreement, as initially executed,
the Company invested $36.4 million in 1995 and committed to invest New Taiwanese
Dollars (NTD) 1,500,000,000 (approximately $56.2 million) in the second half of
1996 for a 25% equity interest in USC. In June 1996, the Company amended its
agreement with UMC and Alliance to provide that the Company would pay NTD
688,000,000 (approximately $26.1 million) in July 1996 and would have the
option, exercisable no later than December 31, 1996 to pay NTD 687,000,000, plus
8.5% of such amount from July 4, 1996, for a revised equity interest of 23.75%
if the option was exercised. The first installment of NTD 688,000,000
(approximately $26.1 million) was paid at the beginning of July 1996. The
Company intends to pay the remaining balance of NTD 687,000,000 plus interest
prior to December 31, 1996. The facility began production utilizing advanced
submicron semiconductor manufacturing processes in September 1996, although
there can be no assurance that production will ramp to planned capacity. The
Company has the right to purchase up to 31.25% of the output from USC.
Operations through September 30, 1996 consisted primarily of construction and
other capitalizable preproduction activities and, therefore, results of
operations for the entity have been immaterial. To the extent USC experiences
operating losses during the ramp up of production or thereafter, the Company
will recognize its proportionate share of such losses. There can be no assurance
that such operating losses will not continue after ramp up of production or that
such losses will not have a material adverse effect on the Company's
consolidated results of operations.
In June 1995, the Company expanded and formalized its relationship with
Taiwan Semiconductor Manufacturing Company (TSMC) to provide additional capacity
over the 1996 to 2000 timeframe. The agreement with TSMC requires the Company to
make certain annual advance payments to be applied against the following year's
capacity. The Company has signed promissory notes to secure these payments over
the term of the agreement. On July 1, 1996, the Company paid $7.2 million to
TSMC. At September 30, 1996 the remaining advance payments (and corresponding
promissory notes to be paid through 2000) totaled $24.0 million ($9.6 million in
prepaid expenses and $14.4 million in production capacity rights).
In the ordinary course of business, the Company places orders with its
wafer suppliers based on its existing and anticipated customer orders for its
products. Should the Company experience a substantial unanticipated decline in
the selling price of its products and/or demand thereof, it could result in a
material loss on such purchase commitments.
During December 1995, the Company entered into a limited partnership
arrangement with a developer to obtain a ground lease and develop and operate
the Company's future Santa Clara facilities. At September 30, 1996, the Company
had invested $2.1 million in the limited partnership. In connection with the
Company's investment in the real estate partnership, the Company (together with
the developer) is subject to recourse provisions for the construction financing
loan for up to $12.0 million. At September 30, 1996, the Company was a guarantor
with respect to $7.2 million incurred under the construction financing loan
agreement. Permanent nonrecourse financing has been obtained, conditioned upon
completion of the construction and satisfaction of certain criteria of the
lender. The Company is not a guarantor on the permanent financing. The
facilities are currently scheduled to be ready for occupancy in the first half
of 1997.
5. Convertible Subordinated Notes
In September 1996, the Company completed a private placement of
$103,500,000 aggregate principal amount of convertible subordinated notes. The
notes mature in 2003. Interest is payable semi-annually at 5 3/4% per annum.
Page 7 of 23
8
The notes are convertible at the option of the note holders into the Company's
common stock at an initial conversion price of $19.22 per share, subject to
adjustment. Beginning in October 1999, the notes are redeemable at the option of
the Company at an initial redemption price of 102% of the principal amount. The
Company has reserved 5,385,016 shares of common stock (plus such additional
number of shares that may be required pursuant to the operation of anti-dilution
provisions) for the conversion of these notes. Offering costs of $3,250,000 are
included in other assets and are amortized on a straight-line basis over the
term of the notes.
6. Contingencies:
In October 1995, Brooktree Corporation ("Brooktree") filed a complaint
against the Company in the United States District Court for the Southern
District of California, alleging that most of the Company's current products
infringe a Brooktree patent. Such lawsuit resulted in substantial expense to the
Company to defend the action and diverted the efforts of the Company's technical
and management personnel. In August 1996, the Company and Brooktree entered into
a settlement and license agreement pursuant to which all claims and
counterclaims between the parties were dismissed. S3 made no admission of
infringement or any other wrongdoing. The settlement requires S3 to pay to
Brooktree a license fee and royalties over a five-year period, and each company
has agreed not to sue the other with respect to video and graphics products over
such five-year period.
The semiconductor and software industries are characterized by frequent
litigation regarding patent and other intellectual property rights. The Company
is party to various claims of this nature. Although the ultimate outcome of
these matters is not presently determinable, management currently believes that
the resolution of all such pending matters will not have a material adverse
effect on the Company's financial position or results of operations.
Accordingly, no liability that may occur has been provided for in the
accompanying financial statements.
Page 8 of 23
9
PART I. FINANCIAL INFORMATION
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations
When used in this discussion, the word "expects", "anticipates" and
similar expressions are intended to identify forward-looking statements. Such
statements, which include statements concerning the timing of availability and
functionality of products under development, product mix, trends in average
selling prices, the growth rate of the market for PCs, the percentage of export
sales and sales to strategic customers, the adoption or retention of industry
standards, the availability and cost of products from the Company's suppliers,
and the initial operating results for the Company's joint venture foundry, are
subject to risks and uncertainties, including those set forth below under
"Factors that May Affect Results," that could cause actual results to differ
materially from those projected. These forward-looking statements speak only as
of the date hereof. The Company expressly disclaims any obligation or
undertaking to release publicly any updates or revisions to any forward-looking
statement contained herein to reflect any change in the Company's expectations
with regard thereto or any change in events, conditions or circumstances on
which any such statement is based.
OVERVIEW
The Company is a leading supplier of high performance multimedia
accelerator solutions for the PC market. The Company's accelerators are designed
to work cooperatively with a PC's central processing unit ("CPU"), implementing
functions best suited for a dedicated accelerator while allowing the CPU to
perform the more general purpose computing functions of today's advanced
graphical user interface ("GUI") environments and applications.
The following information should be read in conjunction with the
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" on pages 20 through 23 of the Company's 1995 Annual Report to
Stockholders.
RESULTS OF OPERATIONS
The following table sets forth for the periods indicated certain
financial data as a percentage of net sales:
Three Months Ended Nine Months Ended
Sept. 30, Sept. 30, Sept. 30, Sept. 30,
1996 1995 1996 1995
--------- --------- --------- ---------
Net sales 100.0% 100.0% 100.0% 100.0%
Cost of sales 61.0 59.8 61.1 60.2
--------- --------- --------- ---------
Gross margin 39.0 40.2 38.9 39.8
--------- --------- --------- ---------
Operating expenses:
Research and development 13.3 13.3 13.7 12.7
Selling, marketing and administrative 10.7 10.4 10.6 10.9
--------- --------- --------- ---------
Total operating expenses 24.0 23.7 24.3 23.6
--------- --------- --------- ---------
Income from operations 15.0 16.5 14.6 16.2
Other income, net 0.2 1.9 0.6 1.5
--------- --------- --------- ---------
Income before income taxes 15.2 18.4 15.2 17.7
Provision for income taxes 5.3 6.8 5.3 6.5
--------- --------- --------- ---------
Net income 9.9% 11.6% 9.9% 11.2%
========= ========= ========= =========
Page 9 of 23
10
NET SALES
The Company's net sales to date have been generated from the sale of
its graphic and multimedia accelerators. The Company's products are used in, and
its business is dependent on, the personal computer industry with sales
primarily in the U.S., Asia, and Europe. Net sales were $119.4 million for the
three months ended September 30, 1996, a 41% increase above the $84.8 million of
net sales for the three months ended September 30, 1995. Net sales were $333.3
million for the nine months ended September 30, 1996 or 57% above the $212.8
million of net sales for the nine months ended September 30, 1995. Net sales
increased primarily as a result of strong demand for the Company's 64-bit Trio
and ViRGE products that resulted in increased unit shipments. The increase in
unit shipments was partially offset by lower overall average selling prices.
Sales for the three and nine months ended September 30, 1996 consisted primarily
of the Trio family of integrated accelerators and ViRGE family of multimedia
accelerators, which commenced shipment in volume in the second quarter of the
year. Sales for the three and nine months ended September 30, 1995 consisted
primarily of the 64-bit Vision family and Trio family of integrated
accelerators. The Company expects that the percentage of its net sales
represented by any one product or type of product may change significantly from
period to period as new products are introduced and existing products reach the
end of their product life cycles. Due to competitive price pressures, the
Company's products experience declining unit average selling prices over time,
which at times can be substantial.
The pricing environment for 2D graphics accelerators, which accounted
for a majority of the Company's net sales for the nine months ended September
30, 1996, has recently experienced and is expected to continue to experience
increasing pricing pressures due in part to the alleviation of supply
constraints that contributed to more stable pricing in 1995 and to aggressive
pricing from certain of the Company's competitors. In particular, the Company's
Trio family of integrated 2D accelerators has experienced significant decreases
in average selling prices in 1996. The Company expects that the graphics
accelerator market will transition from 2D acceleration to 3D acceleration, and
the Company has introduced the initial member of its ViRGE family of 3D
accelerators in the first quarter of 1996 in response to this expected
transition. As a result of the entry of competitors into the 3D acceleration
market, the Company anticipates that it may experience increased pricing
pressures on average selling prices for the ViRGE family of 3D accelerators. If
the transition occurs slower than expected, if the Company's 3D products do not
achieve market acceptance or if the pricing pressures increase, the Company's
operating results could be adversely affected.
Export sales accounted for 62% and 46% of net sales in the three months
ended September 30, 1996 and 1995, respectively. Export sales accounted for 58%
and 43% of net sales in the nine months ended September 30, 1996 and 1995,
respectively. Approximately 33% and 34% of export sales for the three months and
nine months ended September 30, 1996, respectively were to affiliates of United
States customers. The Company expects that export sales will continue to
represent a significant portion of net sales, although there can be no assurance
that export sales as a percentage of net sales will remain at current levels.
All sale transactions were denominated in U.S. dollars.
Two customers accounted for 13% and 11% of net sales for the three
months ended September 30, 1996. Three customers accounted for 16%, 15% and 11%
of net sales for the three months ended September 30, 1995. One customer
accounted for 15% of net sales for the nine months ended September 30, 1996. Two
customers accounted for 18% and 11% of net sales for the nine months ended
September 30, 1995. The Company expects a significant portion of its future
sales to remain concentrated within a limited number of strategic customers.
There can be no assurance that the Company will be able to retain its strategic
customers or that such customers will not cancel or reschedule orders or, in the
event orders are canceled, that such orders will be replaced by other sales. In
addition, sales to any particular customer may fluctuate significantly from
quarter to quarter. The occurrence of any such events or the loss of a strategic
customer could have a material adverse effect on the Company's operating
results.
Page 10 of 23
11
GROSS MARGIN
Gross margin percentage decreased to 39% for the three months and nine
months ended September 30, 1996 from 40% in the three months and nine months
ended September 30, 1995. The decrease resulted from the continuing decrease in
overall average selling prices of the 64-bit Trio family, partially offset by
the decrease in the unit average costs resulting from the Company's foundries'
conversion to 8-inch wafers and 0.5 micron technology, and from initial volume
sales of ViRGE products.
In the future, the Company's gross margin percentages may be affected
by increased competition and related decreases in the unit average selling
prices (particularly with respect to older generation products), timing of
volume shipments of new products, the availability and cost of products from the
Company's suppliers, changes in the mix of products sold, and future shifts in
the mix of sales to add-in card manufacturers and systems OEMs.
RESEARCH AND DEVELOPMENT EXPENSES
The Company has made and intends to continue to make significant
investments in research and development to remain competitive by developing new
and enhanced products, which include products focused on the acceleration of
personal computer audio and communication functions and 3D multimedia
accelerators with enhanced features. Research and development expenses were
$15.9 million for the three months ended September 30, 1996, an increase of $4.6
million from $11.3 million for the three months ended September 30, 1995.
Research and development expenses were $45.6 million for the nine months ended
September 30, 1995, an increase of $18.5 million from $27.1 million for the nine
months ended September 30, 1995. Research and development spending increases
reflect additions to the Company's engineering staff and nonrecurring
engineering expenses related to the introduction of new products and initial
product verification. Research and development spending is expected to increase
in absolute dollars in 1996 as a result of product development activities
currently underway for the desktop, mobile, and home PC markets with a focus on
video, 3D, audio and communications.
SELLING, MARKETING AND ADMINISTRATIVE EXPENSES
Selling, marketing and administrative expenses were $12.9 million in
the three months ending September 30, 1996, an increase of $4.0 million from
$8.8 million in the three months ending September 30, 1995. Selling, marketing
and administrative expenses were $35.3 million in the nine months ended
September 30, 1996, an increase of $12.2 million from $23.1 million in the nine
months ending September 30, 1995. Selling and marketing costs increased as a
result of additional personnel, increased commissions associated with higher
sales levels and increased marketing costs associated with the introduction of
new products, including consumer software licensing costs for the ViRGE 3D
software. Administrative costs have increased due to the hiring of additional
personnel necessary to support the increased level of operations and the
litigation costs in defending the Brooktree lawsuit. The Company anticipates
that selling, marketing and administrative expenses will increase in absolute
dollars in 1996.
OTHER INCOME, NET
Other income, net decreased to $0.3 million in the three months ended
September 30, 1996 from $1.6 million in the three months ended September 30,
1995. Other income, net decreased to $2.0 million in the nine months ended
September 30, 1996 from $3.4 million in the nine months ended September 30,
1995. The current year decrease is due to the lower average amounts of cash and
short-term investments in the three and nine months ended September 30, 1996
compared to the same period in 1995.
Page 11 of 23
12
INCOME TAXES
The Company's effective tax rate for the three and nine months ended
September 30, 1996 was 35%, compared to the effective tax rate for the three and
nine months ended September 30, 1995 of 37% due principally to increased tax
credits.
Page 12 of 23
13
LIQUIDITY AND CAPITAL RESOURCES
Cash used for operating activities for the nine months ended September
30, 1996 was $21.5 million. The Company experienced an increase from December
31, 1995 in accounts receivable, inventory, prepaid expenses and other,
production capacity rights, income taxes payable and accrued liabilities. These
increases were partially offset by decreases in accounts payable. The Company
experienced an increase in accounts receivable from the level at December 31,
1995 due to the substantial concentration of sales in September 1996 resulting
from the delivery schedules of the Company's suppliers and increased shipments
in the third month of that quarter over either of the first two months of the
quarter relative to what the Company experienced in previous quarters. Inventory
increased due to the absence of capacity constraints and an increase in finished
goods inventory to support sales levels. During the nine months ended September
30, 1996, the Company sold its remaining inventory of its Vision family of
integrated accelerators.
Investing activities for the nine months ended September 30, 1996 and
1995 reflected property and equipment purchases of $12.5 million and $12.4
million, respectively, sales and maturities of short-term investments, the 1996
investment in a real estate partnership for the Company's new headquarters
facility of $2.1 million and the first 1996 installment of $26.9 million for the
Company's 23.75% equity interest in USC. Continued expansion of the Company's
business is likely to require higher levels of capital equipment purchases,
foundry investments and other payments to secure manufacturing capacity.
Financing activities provided cash of $113.1 million principally as a
result of the convertible subordinated note offering of $103,500,000 aggregate
principal amount completed in September 1996. Net proceeds from the sale of the
notes were approximately $100.2 million. The notes mature in 2003. Interest is
payable semi-annually at 5 3/4% per annum. The notes are convertible at the
option of the note holders into the Company's common stock at an initial
conversion price of $19.22 per share, subject to adjustment. Beginning in
October 1999, the notes are redeemable at the option of the Company at an
initial redemption price of 102% of the principal amount. The Company has
reserved 5,385,016 shares of common stock (plus such additional number of shares
that may be required pursuant to the operation of anti-dilution provisions) for
the conversion of these notes. Equipment financing and proceeds from the
issuance of common stock resulting from the exercise of stock options also
generated cash in that period.
Working capital at September 30, 1996 and December 31, 1995 was $246.4
million and $144.6 million, respectively. At September 30, 1996 the Company's
principal sources of liquidity included cash and equivalents of $130.8 million
and $13.2 million in short-term investments. In addition, the Company has
available $25.0 million under an unsecured revolving line of credit that expires
June 1, 1997. The Company had $5.0 million outstanding under this line of credit
as of September 30, 1996. The line of credit requires the Company to comply with
certain financial covenants, and the Company was in compliance with all of the
covenants at September 30, 1996. In addition, the Company has available two
separate secured equipment lines of credit totaling $10.0 million. The Company
had $6.5 million outstanding under these secured equipment lines of credit at
September 30, 1996. The Company believes these available funds and anticipated
funds from operations will satisfy the Company's projected working capital,
existing foundry supply agreement and capital expenditure requirements through
1997, other than future potential manufacturing agreements.
During December 1995, the Company entered into a limited partnership
arrangement with a developer to obtain a ground lease and develop and operate
the Company's future Santa Clara facilities. At September 30, 1996, the Company
had invested $2.1 million in the limited partnership. In connection with the
Company's investment in the real estate partnership, the Company (together with
the developer) is subject to recourse provisions for the construction financing
loan for up to $12.0 million. At September 30, 1996, the Company
Page 13 of 23
14
was a guarantor with respect to $7.2 million incurred under the construction
financing loan agreement. Permanent nonrecourse financing has been obtained,
conditioned upon completion of the construction and satisfaction of certain
criteria of the lender. The Company is not a guarantor on the permanent
financing. The facilities are currently scheduled to be ready for occupancy in
the first half of 1997.
In order to obtain an adequate supply of wafers, especially wafers
manufactured using advanced process technologies, the Company has entered into
and will continue to consider various possible transactions. See "Factors That
May Affect Results - Transactions to Obtain Manufacturing Capacity; Future
Capital Needs."
In the third quarter of 1995, the Company entered into two long-term
manufacturing capacity arrangements. The Company entered into an agreement with
United Microelectronics Corporation (UMC) and Alliance Semiconductor (Alliance)
to form USC, a separate Taiwanese company, for the purpose of building and
managing a semiconductor manufacturing facility in the Science-Based Industrial
Park in Hsin Chu City, Taiwan. Pursuant to the agreement, as initially executed,
the Company invested $36.4 million in 1995 and committed to invest New Taiwanese
Dollars (NTD) 1,500,000,000 (approximately $56.2 million) in the second half of
1996 for a 25% equity interest in USC. In June 1996, the Company amended its
agreement with UMC and Alliance to provide that the Company would pay NTD
688,000,000 (approximately $26.1 million) in July 1996 and would have the
option, exercisable no later than December 31, 1996 to pay NTD 687,000,000, plus
8.5% of such amount from July 4, 1996, for a revised equity interest of 23.75%
if the option was exercised. The first installment of NTD 688,000,000
(approximately $26.1 million) was paid at the beginning of July 1996. The
Company intends to pay the remaining balance of NTD 687,000,000 plus interest
prior to December 31, 1996. The facility began production utilizing advanced
submicron semiconductor manufacturing processes in September 1996, although
there can be no assurance that production will ramp to planned capacity. The
Company has the right to purchase up to 31.25% of the output from USC.
Operations through September 30, 1996 consisted primarily of construction and
other capitalizable preproduction activities and, therefore, results of
operations for the entity have been immaterial. To the extent USC experiences
operating losses during the ramp up of production or thereafter, the Company
will recognize its proportionate share of such losses. There can be no assurance
that such operating losses will not continue after ramp up of production or that
such losses will not have a material adverse effect on the Company's
consolidated results of operations.
In June 1995, the Company expanded and formalized its relationship with
Taiwan Semiconductor Manufacturing Company (TSMC) to provide additional capacity
over the 1996 to 2000 timeframe. The agreement with TSMC requires the Company to
make certain annual advance payments to be applied against the following year's
capacity. The Company has signed promissory notes to secure these payments over
the term of the agreement. On July 1, 1996, the Company paid $7.2 million to
TSMC. At September 30, 1996 the remaining advance payments (and corresponding
promissory notes to be paid through 2000) totaled $24.0 million ($9.6 million in
prepaid expenses and $14.4 million in production capacity rights).
The cyclical nature of the semiconductor industry periodically results
in shortages of advanced process wafer fabrication capacity such as the Company
experiences from time to time. The Company's ability to maintain adequate levels
of inventory is primarily dependent upon the Company obtaining sufficient supply
of products to meet future demand, and any inability of the Company to maintain
adequate inventory levels may adversely affect its relations with its customers.
In addition, because the Company must order products and build inventory
substantially in advance of product shipments and because the Company's products
are volatile and subject to rapid technology and price change, there is a risk
that the Company will forecast incorrectly and produce excess or insufficient
inventories of particular products. This inventory risk is heightened because
certain of the Company's key customers place orders with short lead times. The
Company's customers' ability to reschedule or cancel orders without significant
penalty could adversely affect the Company's liquidity, as the Company may be
unable to adjust its purchases from its independent foundries to match such
customer changes and cancellations. To the extent the Company purchases excess
or insufficient inventories of particular products, the Company's operating
results could be adversely affected.
Page 14 of 23
15
In October 1995, Brooktree Corporation ("Brooktree") filed a complaint
against the Company in the United States District Court for the Southern
District of California, alleging that the Company's current products infringe a
Brooktree patent. Such lawsuit resulted in substantial expense to the Company to
defend the action and diverted the efforts of the Company's technical and
management personnel. In August 1996, the Company and Brooktree entered into a
settlement and license agreement pursuant to which all claims and counterclaims
between the parties were dismissed and the Company agreed to pay to Brooktree a
license fee and royalties over a five-year period.
FACTORS THAT MAY AFFECT RESULTS
FLUCTUATIONS IN QUARTERLY OPERATING RESULTS
The Company's operating results have historically been, and will
continue to be, subject to quarterly and other fluctuations due to a variety of
factors, including changes in pricing policies by the Company, its competitors
or its suppliers, anticipated and unanticipated decreases in unit average
selling prices of the Company's products, availability and cost of products from
the Company's suppliers, changes in the mix of products sold and in the mix of
sales by distribution channels, the gain or loss of significant customers, new
product introductions by the Company or its competitors, market acceptance of
new or enhanced versions of the Company's products, seasonal customer demand,
and the timing of significant orders. Operating results could also be adversely
affected by general economic and other conditions affecting the timing of
customer orders and capital spending, a downturn in the market for PCs, and
order cancellations or rescheduling. Any shortfall in net sales or net income
from levels expected by securities analysts could have an immediate and
significant adverse effect on the trading price of the Company's Common Stock.
In particular, the market for PCs in 1996 has experienced a weakening in the
trends for demand as compared with the comparable period in 1995 and is expected
to grow at a lower rate for the entire year as compared with 1995. These factors
could adversely affect demand for the Company's products. In addition, the
pricing environment for graphics accelerators has recently experienced and is
expected to continue to experience increasing pricing pressures due in part to
the alleviation of supply constraints that contributed to more stable pricing in
1995 and to aggressive pricing from certain of the Company's competitors. In
particular, the Company's Trio family of integrated 2D accelerators, which
accounted for a majority of the Company's revenues in the first nine months of
1996, has experienced significant decreases in average selling prices in 1996.
The Company expects that the graphics accelerator market will transition from 2D
acceleration to 3D acceleration, and the Company has introduced its ViRGE family
of 3D accelerators in response to this expected transition. As a result of the
entry of competitors into the 3D acceleration market, the Company anticipates
that it may experience increased pricing pressures on average selling prices for
the ViRGE family of 3D accelerators. If the transition occurs slower than
expected, if the Company's 3D products do not achieve market acceptance or if
pricing pressures increase, the Company's operating results could be adversely
affected. Further, because the Company is continuing to increase its operating
expenses for personnel and new product development, the Company's operating
results would be adversely affected if budgeted sales levels were not achieved.
PC graphics and multimedia subsystems include, in addition to the Company's
products, a number of other components, which are supplied by third-party
manufacturers. Any shortage of such components in the future could adversely
affect the Company's business and operating results. Furthermore, it is possible
that the Company's products may be found to be defective after the Company has
already shipped significant volume production. There can be no assurance that
the Company would be able to successfully correct such defects or that such
corrections would be acceptable to customers, and the occurrence of such events
could have a material adverse effect on the Company's business and operating
results.
Page 15 of 23
16
Because the Company must order products and build inventory
substantially in advance of product shipments, and because the markets for the
Company's products are volatile and subject to rapid technological and price
changes, there is a risk that the Company will forecast incorrectly and produce
excess or insufficient inventories of particular products. In addition, the
Company's customers may change delivery schedules or cancel orders without
significant penalty. To the extent the Company produces excess or insufficient
inventories of particular products, the Company's operating results could be
adversely affected.
The Company ships more product in the third month of each quarter than
in either of the first two months of the quarter, with shipments in the third
month higher at the end of the month. This pattern, which is common in the
semiconductor industry, is likely to continue. The concentration of sales in the
last month of the quarter may cause the Company's quarterly results of
operations to be more difficult to predict. Moreover, a disruption in the
Company's production or shipping near the end of a quarter could materially
reduce the Company's net sales for that quarter. The Company's reliance on
outside foundries and independent assembly and testing houses reduces the
Company's ability to control, among other things, delivery schedules.
IMPORTANCE OF NEW PRODUCTS; RAPID TECHNOLOGICAL CHANGE
The PC industry in general, and the market for the Company's products
in particular, is characterized by rapidly changing technology, evolving
industry standards, frequent new product introductions and significant price
competition, resulting in short product life cycles and regular reductions of
unit average selling prices over the life of a specific product. Products in the
Company's market typically have a life cycle of 12 to 24 months, with regular
reductions of unit average selling prices over the life of a specific product.
The successful development and commercialization of new products required to
replace or supplement existing products involve many risks, including the
identification of new product opportunities, the successful and timely
completion of the development process, and the selection of the Company's
products by leading systems suppliers and board manufacturers for design into
their products. There can be no assurance that the Company will successfully
identify new product opportunities and develop and bring to market in a timely
manner successful new products, that products or technologies developed by
others will not render the Company's products or technologies noncompetitive, or
that the Company's products will be selected for design into its customers'
products.
The Company is continually developing new products to address changing
market needs, and its operating results may fluctuate from those in prior
quarters or may be adversely affected in quarters in which it is undergoing a
product transition or in which existing products are under price pressures due
to competitive factors. The Company also intends to add increased functionality
to its products, such as system logic, audio, communications or other additional
functions. Market acceptance of the Company's products will also depend upon
acceptance of other components, such as memory, that the Company's products are
designed to work with. For example, if performance of synchronous graphics RAM
("SGRAM") and/or synchronous DRAM ("SDRAM") improves relative to the performance
of more expensive video RAM ("VRAM"), market demand for higher performance
multimedia accelerators may shift away from VRAM-based accelerators toward SGRAM
or SDRAM-based accelerators. If new products are not brought to market in a
timely manner or do not address market needs or achieve market acceptance, then
the Company's operating results will be adversely affected. The Company's 1994
operating results were adversely affected in part because the Company had made a
strategic decision to transition its product offerings from 32-bit to 64-bit
accelerators during the first half of 1994, but due to a lack of PC system logic
chipsets based on the PCI bus standard and a slower than anticipated shift from
32- to 64-bit graphics, sales of S3's PCI-based Vision64 family of accelerators
were less than expected. During the same period of time, competitors' 32-bit
integrated accelerator products offered a more competitive solution to the
Company's customers and ultimately necessitated an adjustment in the valuation
of the Company's 32-bit non-integrated inventory. In
Page 16 of 23
17
anticipation of a shift in demand from 2D to 3D technology, the Company has
recently introduced the initial products from its ViRGE family of 3D multimedia
accelerators. If the transition from 2D to 3D in the PC market is slower than
the Company expects or if these products are not brought to market in a timely
manner or do not address market needs or achieve market acceptance, the
Company's operating results could be adversely affected.
DEPENDENCE ON FOUNDRIES AND OTHER THIRD PARTIES
The Company currently relies on several independent foundries to
manufacture its products either in finished form or wafer form. The Company
currently has a long-term supply agreement with only one of its foundries, TSMC,
which is a "take or pay" contract, and has invested in a joint venture foundry,
USC. The Company conducts business with its other current foundries by
delivering written purchase orders specifying the particular product ordered,
quantity, price, delivery date and shipping terms and, therefore, such foundries
are generally not obligated to supply products to the Company for any specific
period, in any specific quantity or at any specified price, except as may be
provided in a particular purchase order. To the extent a foundry terminates its
relationship with the Company or should the Company's supply from a foundry be
interrupted or terminated for any other reason, such as a natural disaster, the
Company may not have a sufficient amount of time to replace the supply of
products manufactured by that foundry. From time to time, the Company is unable
to obtain a sufficient supply of products to enable it to meet demand and is
required to allocate available supply of its products among its customers. Until
recently, there has been a worldwide shortage of advanced process technology
foundry capacity and there can be no assurance that the Company will obtain
sufficient foundry capacity to meet customer demand in the future, particularly
if that demand should increase. The Company is continuously evaluating potential
new sources of supply. However, the qualification process and the production
ramp-up for additional foundries has in the past taken, and could in the future
take, longer than anticipated, and there can be no assurance that such sources
will be able or willing to satisfy the Company's requirements on a timely basis
or at acceptable quality or per unit prices.
In the third quarter of 1995, the Company entered into an agreement
with UMC and Alliance to form a separate Taiwanese company, USC, for the purpose
of building and managing a semiconductor manufacturing facility in the
Science-Based Industrial Park in Hsin Chu City, Taiwan. To the extent USC
experiences operating losses during the ramp up of production or thereafter, the
Company will recognize its proportionate share of such losses and may be
required to contribute additional capital. There can be no assurance that USC
will ramp to planned capacity, that such operating losses will not continue
after the ramp up of production or that such losses will not have a material
adverse effect on the Company's consolidated results of operations.
The Company's foundry agreement with TSMC requires the Company, under
certain circumstances, to purchase certain committed capacity amounts or forfeit
advance payments against such amounts. To the extent the Company purchases
excess inventories of particular products or chooses to forfeit advance
payments, the Company's operating results could be adversely affected.
Two of the Company's principal foundries, TSMC and UMC, and the
Company's foundry joint venture, USC, are located in the Science-Based
Industrial Park in Hsin Chu City, Taiwan. Disruption of operations at these
foundries for any reason, including work stoppages, fire, earthquakes or other
natural disasters, would cause delays in shipments of the Company's products,
and could have a material adverse effect on the Company's results of operations.
In addition, as a result of the rapid growth of the semiconductor industry based
in the Science-Based Industrial Park, severe constraints have been placed on the
water and electricity supply in that region. Any shortages of water or
electricity could adversely affect the Company's foundries' ability to supply
the Company's products, which could have a material adverse effect on the
Company's results of operations.
Page 17 of 23
18
The Company is using multiple sources of supply for certain of its
products, which may require the Company's customers to perform separate product
qualifications. The Company has not, however, developed alternate sources of
supply for certain other products, and its newly introduced products are
typically produced initially by a single foundry until alternate sources can be
qualified. The requirement that a customer perform separate product
qualifications or a customer's inability to obtain a sufficient supply of
products from the Company may cause that customer to satisfy its product
requirements from the Company's competitors, which would adversely affect the
Company's results of operations.
The Company's products are assembled and tested by a variety of
independent subcontractors. The Company's reliance on independent assembly and
testing houses to provide these services involves a number of risks, including
the absence of guaranteed capacity and reduced control over delivery schedules,
quality assurance and costs. The Company also is subject to the risks of
shortages and increases in the cost of raw materials used in the manufacture or
assembly of the Company's products.
Constraints or delays in the supply of the Company's products, whether
because of capacity constraints, unexpected disruptions at the foundries or
assembly or testing houses, delays in obtaining additional production at
existing foundries or in obtaining production from new foundries, shortages of
raw materials, or other reasons, could result in the loss of customers and other
material adverse effects on the Company's operating results, including effects
that may result should the Company be forced to purchase products from higher
cost foundries or pay expediting charges to obtain additional supply.
TRANSACTIONS TO OBTAIN MANUFACTURING CAPACITY; FUTURE CAPITAL NEEDS
In order to obtain an adequate supply of wafers, especially wafers
manufactured using advanced process technologies, the Company has entered into
and will continue to consider various possible transactions, including the use
of "take or pay" contracts that commit the Company to purchase specified
quantities of wafers over extended periods, equity investments in or advances or
issuances of equity securities to wafer manufacturing companies in exchange for
guaranteed production capacity, or the formation of joint ventures to own and
operate or construct foundries or to develop certain products. Any of these
transactions would involve financial risk to the Company and could require the
Company to commit substantial capital or provide technology licenses in return
for guaranteed production capacity. In particular, the Company has entered into
a "take or pay" contract with TSMC and a joint venture with UMC and another
semiconductor company. The need to commit substantial capital may require the
Company to seek additional equity or debt financing. The sale or issuance of
additional equity or convertible debt securities could result in additional
dilution to the Company's stockholders. There can be no assurance that such
additional financing, if required, will be available when needed or, if
available, will be on terms acceptable to the Company.
DEPENDENCE ON ACCELERATOR PRODUCT LINE
S3's products are designed to improve the graphics and multimedia
performance of x86-based PCs and Microsoft Windows, Windows NT and IBM OS/2
operating systems, the predominant standards in today's PC market. Any shift
away from such standards would require the Company to develop new products. The
Company expects that additional specialized graphics and multimedia processing
and general purpose computing capabilities will be integrated into future
versions of Intel and other x86-based microprocessors and that standard
multimedia accelerators in the future will likely integrate memory, system
logic, audio, communications or other additional functions. The Company has not
previously offered either single function or integrated accelerator products
that provide these functions, which have traditionally been provided by separate
single function chips or chipsets. The
Page 18 of 23
19
Company has been and will continue to be required to expand the scope of its
research and development efforts to provide these functions, which will require
the hiring of engineers skilled in the respective areas and additional
management and coordination among the Company's design and engineering groups.
Alternatively, the Company may find it necessary or desirable to license or
acquire technology to enable the Company to provide these functions, and there
can be no assurance that any such technology will be available for license or
purchase on terms acceptable to the Company. Furthermore, there is a limited
amount of space on PC motherboards, and companies that offer solutions that
provide the greatest amount of functionality within this limited space may have
a competitive advantage. While the Company's strategy is to develop new and
enhanced graphics and multimedia accelerator products that will be complementary
to present and future versions of Intel and other x86-based microprocessors and
integrate significant additional functionality, there can be no assurance that
the Company will be able to develop such new or enhanced products or correctly
anticipate the additional functionality that will be required to compete
effectively in this market. There can be no assurance that, if developed, the
Company's new or enhanced products that incorporate these functions will achieve
market acceptance. There also can be no assurance that the market for graphics
and multimedia accelerators will continue to grow in the future or that new
technological developments or changes in standards will not result in decreased
demand for graphics and multimedia accelerators or for the Company's products
that are not compatible with such changed standards. While the PC industry in
recent periods has been characterized by substantial demand, such demand has
historically been cyclical, and there can be no assurance that this demand will
continue in future periods or that demand for the Company's products will
continue. The occurrence of any such events would have a material adverse effect
on the Company's operating results.
SUBSTANTIAL COMPETITION
The market for the Company's products is extremely competitive and is
characterized by declining selling prices over the life of a particular product
and rapid technological changes. The Company's principal competitors for
graphics accelerators include ATI Technologies, Inc., Cirrus Logic, Inc., Matrox
Graphics Inc., and Trident Microsystems, Inc. The Company's principal
competitors in the multimedia market include the companies named in the
preceding sentence and a number of small, privately-held companies which may
have greater flexibility to address specific market needs. Potential competitors
in these markets include both large and emerging domestic and foreign
semiconductor companies. In particular, there is a significant number of
established and emerging companies that have announced plans to develop 3D
graphics chips, including Intel Corporation and Lockheed Martin Corporation,
which have announced a joint venture to develop such chips, and Texas
Instruments Incorporated, which has announced a development and marketing
agreement with 3Dlabs Inc. To the extent the Company expands its product line to
add products with additional functionality, such as audio, communications and
system logic functions, it will encounter substantial competition from
established semiconductor companies and may experience competition from
companies designing chips based on different technologies, such as
software-centric multimedia processors. Further, the need of PC manufacturers to
rapidly introduce a variety of products aimed at different segments of the PC
market may lead to the shift by such system OEMs to the purchase of graphics and
multimedia add-in cards provided by others. Certain of the Company's competitors
supply both add-in cards and accelerator chips, which may provide those
competitors with an advantage over suppliers such as the Company that supply
only accelerator chips. Certain of the Company's current and potential
competitors have greater technical, manufacturing, financial and marketing
resources than the Company. The Company believes that its ability to compete
successfully depends upon a number of factors both within and outside of its
control, including product performance, product features, product availability,
price, quality, timing of new product introductions by the Company and its
competitors, the emergence of new graphics and PC standards, customer support,
and industry and general economic trends. There can be no assurance that the
Company will have the financial resources, technical expertise, or marketing,
distribution and support capabilities to compete successfully. The Company's
future success will be highly dependent upon the successful development and
introduction of new products that are responsive to market needs. There can be
no assurance that the Company will be able to successfully develop or market any
such products.
Page 19 of 23
20
CUSTOMER CONCENTRATION
The Company's sales are concentrated within a limited customer base.
The Company expects a significant portion of its future sales to remain
concentrated within a limited number of strategic customers. There can be no
assurance that the Company will be able to retain its strategic customers or
that such customers will not otherwise cancel or reschedule orders, or in the
event of canceled orders, that such orders will be replaced by other sales. In
addition, sales to any particular customer may fluctuate significantly from
quarter to quarter. The occurrence of any such events could have a material
adverse effect on the Company's operating results.
MANAGEMENT OF GROWTH; DEPENDENCE ON KEY PERSONNEL
Since its inception, the Company has experienced significant growth in
the number of its employees and in the scope of its operating and financial
systems, resulting in increased responsibilities for the Company's management.
To manage future growth effectively, the Company will need to continue to
improve its operational, financial and management information systems,
procedures and controls, and expand, train, motivate, retain and manage its
employee base. The Company is in the process of implementing a new management
information system. Any problems encountered in the implementation of such
system could adversely affect the Company's operations. There can be no
assurance that the Company will be able to manage its growth effectively, and
failure to do so could have a material adverse effect on the Company's operating
results.
The Company's future success depends in part on the continued service
of its key engineering, sales, marketing and executive personnel, including
highly skilled semiconductor design personnel and software developers, and its
ability to identify and hire additional personnel. In August 1996, the Company
appointed a new President and Chief Executive Officer to replace Terry N. Holdt,
who retired, and there can be no assurance as to the effects of this management
transition on the Company's business and operating results. Competition for such
personnel is intense and there can be no assurance that the Company can retain
and recruit adequate personnel to operate its business. The loss of key
personnel could have a material adverse effect on the Company's business and
operating results. The Company does not maintain key man insurance on any of its
employees.
IMPORTANCE OF INTELLECTUAL PROPERTY; LITIGATION INVOLVING INTELLECTUAL PROPERTY
The Company's ability to compete will be affected by its ability to
protect its proprietary information. The Company has filed several United States
and foreign patent applications and to date has four issued United States
patents. The Company relies primarily on its trade secrets and technological
know-how in the conduct of its business. There can be no assurance that the
steps taken by the Company to protect its intellectual property will be adequate
to prevent misappropriation of its technology or that the Company's competitors
will not independently develop technologies that are substantially equivalent or
superior to the Company's technology. The semiconductor and software industries
are characterized by frequent claims and related litigation regarding patent and
other intellectual property rights. The Company is party to various claims of
this nature. Although the ultimate outcome of these matters is not presently
determinable, management presently believes that the resolution of all such
pending matters will not have a material adverse effect on the Company's
operating results. There can be no assurance that third parties will not assert
additional claims or initiate litigation against the Company, its foundries or
its customers with respect to existing or future products. In addition, the
Company may initiate claims or litigation against third parties for infringement
of the Company's proprietary rights or to determine the scope and validity of
the proprietary rights of the Company or others. Litigation by or against the
Company has in the past, in the case of the Brooktree litigation, resulted and
could in the future result in significant expense to the Company and diversion
of the efforts of the Company's technical and management personnel, whether or
not litigation is determined in favor of the Company. In the event of an adverse
result in any such litigation, the Company could be required to pay
Page 20 of 23
21
substantial damages, cease the manufacture, use, sale, offer for sale and
importation of infringing products, expend significant resources to develop or
obtain non-infringing technology, discontinue the use of certain processes, or
obtain licenses to the technology which is the subject of the litigation. There
can be no assurance that the Company would be successful in such development or
acquisition or that any such licenses, if available, would be available on
commercially reasonable terms, and any such development or acquisition could
require expenditures by the Company of substantial time and other resources. Any
such litigation or adverse result therefrom could have a material adverse effect
on the Company's operating results.
INTERNATIONAL OPERATIONS
The Company expects that export sales will continue to represent a
significant portion of net sales, although there can be no assurance that export
sales, as a percentage of net sales, will remain at current levels. In addition,
a substantial proportion of the Company's products are manufactured, assembled
and tested by independent third parties in Asia. Due to its export sales and
independent third party manufacturing, assembly and testing operations and its
joint venture foundry, and to the extent the Company qualifies an additional
foundry or foundries in Asia to manufacture its products, the Company is subject
to the risks of conducting business internationally, including unexpected
changes in, or impositions of, legislative or regulatory requirements,
fluctuations in the U.S. dollar, which could increase the sales price in local
currencies of the Company's products in foreign markets or increase the cost of
wafers purchased by the Company, delays resulting from difficulty in obtaining
export licenses for certain technology, tariffs and other barriers and
restrictions, potentially longer payment cycles, greater difficulty in accounts
receivable collection, potentially adverse taxes, and the burdens of complying
with a variety of foreign laws. In addition, the Company is subject to general
geopolitical risks, such as political and economic instability and changes in
diplomatic and trade relationships, in connection with its international
operations. Two of the Company's independent foundries, UMC and TSMC, which
produce a significant portion of the Company's products, and the Company's joint
venture foundry, USC, are located in Taiwan. The People's Republic of China and
Taiwan have recently experienced strained relations, and the worsening of
relations or the development of hostilities between the two parties could have a
material adverse effect on the Company. Although the Company has not to date
experienced any material adverse effect on its operations as a result of such
regulatory, geopolitical, economic and other factors, there can be no assurance
that such factors will not adversely impact the Company's operations in the
future or require the Company to modify its current business practices. In
addition, the laws of certain foreign countries may not protect the Company's
intellectual property rights to the same extent as do the laws of the United
States.
Page 21 of 23
22
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
In October 1995, Brooktree Corporation ("Brooktree") filed a complaint
against the Company in the United States District Court for the Southern
District of California, alleging that most of the Company's current products
infringe a Brooktree patent. Such lawsuit resulted in substantial expense to the
Company to defend the action and diverted the efforts of the Company's technical
and management personnel. In August 1996, the Company and Brooktree entered into
a settlement and license agreement pursuant to which all claims and
counterclaims between the parties were dismissed. S3 made no admission of
infringement or any other wrongdoing. The settlement requires S3 to pay to
Brooktree a license fee and royalties over a five-year period, and each company
has agreed not to sue the other with respect to video and graphics products over
such five-year period.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
4.1 Indenture, dated as of September 12, 1996, between the Company and
State Street Bank and Trust Company of California, N.A., as
Trustee.
4.2 Registration Rights Agreement, dated as of September 12, 1996,
among the Company and Lehman Brothers Inc., PaineWebber
Incorporated, and Cowen and Company, as Initial Purchasers.
27 Financial Data Schedule (filed only with the electronic submission
of Form 10-Q in accordance with the Edgar requirements).
(b) Reports on Form 8-K
On September 18, 1996, the Company filed a report on Form 8-K with
respect to the press release issued regarding the convertible subordinated
note offering.
Page 22 of 23
23
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.
S3 INCORPORATED
(Registrant)
/S/GEORGE A. HERVEY
---------------------------------
GEORGE A. HERVEY
Vice President, Finance
and Chief Financial Officer
(Principal Financial and Accounting Officer)
November 13 , 1996