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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
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(MARK ONE)

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997

[ ] 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 OF INCORPORATION (I.R.S. EMPLOYER IDENTIFICATION NO.)
OR ORGANIZATION)

2801 MISSION COLLEGE BOULEVARD, 95052-8058
SANTA CLARA, CALIFORNIA (ZIP CODE)
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (408) 588-8000

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE

SECURITIES REGISTERED PURSUANT TO SECTION 12(g)OF THE ACT:
COMMON STOCK, $.0001 PAR VALUE
SERIES A PARTICIPATING PREFERRED STOCK PURCHASE RIGHTS

Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference to Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]

The aggregate market value of voting stock held by non-affiliates of the
Registrant was approximately $296,616,282 as of March 2, 1998, based upon the
closing price on the Nasdaq National Market reported for such date. This
calculation does not reflect a determination that certain persons are affiliates
of the Registrant for any other purpose.

50,592,080 shares of the Registrant's Common stock, $.0001 par value, were
outstanding at March 2, 1998.

DOCUMENTS INCORPORATED BY REFERENCE

Items 10 (as to directors), 11 and 12 of Part III incorporate by reference
information from the Registrant's Proxy Statement to be filed with the
Securities and Exchange Commission in connection with the solicitation of
proxies for the Registrant's 1998 Annual Meeting of Stockholders.
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2

PART I

ITEM 1. BUSINESS.

When used in this Report, the words "expects", "anticipates", "estimates"
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, trends in the personal computer
("PC") market, the percentage of export sales and sales to strategic customers,
and the adoption or retention of industry standards, and the availability and
cost of products from the Company's suppliers, are subject to risks and
uncertainties, including those set forth under "Factors That May Affect Results"
and elsewhere in this report, 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
statements 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.

GENERAL

S3(R) Incorporated ("S3" or the "Company") is a leading supplier of
multimedia acceleration hardware and its associated software 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 multimedia user interface and
applications. By complementing the computing power of the general purpose CPU,
the Company's integrated software and silicon-based accelerator solutions
significantly improve the multimedia performance of PCs while reducing overall
system cost and complexity. S3 has been a pioneer in graphics acceleration since
1991, when it was the first company to ship in volume a single chip graphics
accelerator with a local bus interface. S3 has since delivered new generations
of high performance accelerator solutions with 32-bit and 64-bit multimedia
products such as integrated 2D and 3D graphics and video accelerators, motion
picture experts group ("MPEG") decoders enabling more advanced graphics and
integrated full-motion video acceleration. As the demand for greater multimedia
capabilities in PCs increases, particularly the demand for 2D/3D technology, the
Company is focused on delivering accelerator solutions for use in business
desktop, home and mobile computing systems. S3's families of accelerator
products and software are currently used by many of the world's leading original
equipment PC manufacturers ("OEMs") and add-in card and motherboard
manufacturers.

S3 was incorporated on January 9, 1989 in the State of Delaware. The
Company operates in one principal industry segment.

MARKETS AND RECENT DEVELOPMENTS

Throughout the development of the graphical user interface ("GUI")
accelerator market, S3 has been a leader in the evolution of accelerator
technology. In 1991, S3 developed the first single chip graphics accelerator to
be shipped in volume that integrated all of the specialized functions required
to accelerate GUI environments created by Windows, OS/2 and other advanced PC
operating systems.

In 1993, S3 introduced the Vision(TM) family, the industry's first
Peripheral Component Interconnect ("PCI") 64 bit graphics controllers supporting
the new Intel system bus that would quickly proliferate with the introduction of
the Pentium Microprocessor. In 1994, S3 introduced the Trio(R) family, the
industry's first 64-bit GUI accelerators with integrated clock and RAMDAC
functionality and brought S3's high performance acceleration technology to the
mainstream. In 1995, S3 broadened the Trio family to include video acceleration
and introduced the industry's first integrated 2D/3D graphics accelerator
family, ViRGE(R).

In 1996, the Company expanded the breadth of its product line to introduce
products for the mobile computing market and introduced second generation 2D/3D
products. In January 1996, S3 entered the mobile computing market with the
introduction of its first notebook PC product, the Aurora 64V+(TM) dual

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display 2D multimedia accelerator. In October 1996, the Company introduced its
second generation 2D/3D products, the ViRGE/DX(TM) and ViRGE/GX(TM)
accelerators.

In 1997, the Company introduced its third generation 2D/3D products for
desktop PCs and its second generation mobile accelerators. In March 1997, the
Company introduced its third generation 2D/3D product, the ViRGE/GX2(TM)
graphics and video accelerator. In April 1997, the Company announced its second
notebook PC product, the ViRGE/MX(TM) 2D/3D mobile accelerator. In October 1997,
the Company announced the ViRGE/MXi(TM) accelerator, the industry's first 3D
graphics accelerator with integrated DRAM for mainstream notebook PCs. In
November 1997, the Company announced its newest member of its Trio family of
accelerators, the Trio 3D(TM) accelerator.

The Company believes that accelerators will continue to evolve as end users
demand applications with enhanced features. Rapid technology advances are
expected by the Company to continue to result in PCs that incorporate more
powerful CPUs (such as Intel's Pentium MMX and Pentium II), increased memory and
storage capacity, enhanced connectivity features that utilize advanced network
operating systems such as Novell Netware, OS/2 and enhanced versions of the
Windows platform. The Company expects the PC, including systems for the business
desktop, mobile, and home markets, to evolve from a personal productivity tool
with a simple graphical user interface to an interactive, real time system with
enhanced features.

To address this market evolution, the Company has continued to develop
products for the business desktop, mobile and home PC markets. The Company is
developing products that build on its acceleration and on-chip power management
technology to bring desktop equivalent multimedia acceleration and real time
communications capabilities to the mobile market. The Company also continues to
invest in 3D acceleration, which it believes will continue to be incorporated
into home PCs to create a platform for games and entertainment and into business
desktop, home and mobile PCs to create a platform for navigation and browsing
for interactive, on-line services.

There can be no assurance that the Company will be able to successfully
complete the development of these products or to commence shipments of these
products in a timely manner, or that product specifications will not change
during the development period. In addition, even if the products are
successfully developed and shipped, there can be no assurance that the products
described above will be successful in the marketplace.

PRODUCTS AND TECHNOLOGY

S3 currently offers graphics and video accelerators for desktop and mobile
computers that are differentiated by a variety of features. All of S3's
accelerator solutions are designed to complement the CPU by executing those
functions most appropriate to a dedicated accelerator while allowing the CPU to
execute the more general purpose computing functions. To reduce product
manufacturing cost and to facilitate the development of future products, S3
optimizes accelerator functions by implementing the most frequently used
functions in silicon, while the least used functions are implemented in software
to be processed by the CPU.

Graphics and Video Accelerator Products

S3's graphics and video accelerator product line includes a broad array of
products to support PC add-in card, motherboard and computer system OEM designs
in both desktop and mobile computers. These products provide S3's customers with
a range of price/performance options, including entry-level single-chip
integrated DRAM and SGRAM-based 2D accelerators for desktop computers, mid-range
DRAM and SGRAM-based 2D accelerators for desktop computers, mid-range DRAM and
SGRAM-based 2D/3D accelerators for desktop computers, and SGRAM-based 2D/3D
accelerators with integrated memory for mobile computers. The Company's product
line breadth and pin-compatible strategy allows its customers to migrate to
higher performance, higher functionality solutions, while staying within a
single accelerator architecture and family of compatible software drivers. The
system OEM thereby has the flexibility of designing its own upgrades or
selecting from a number of leading add-in card manufacturers that offer products
based on the Company's products. Display memory supported by the Company's
accelerators ranges from 1 to 8 megabytes of DRAM/SGRAM. All of the Company's
products support advanced levels of integration, including integrated

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RAMDAC and clock synthesis, video acceleration based on S3's Streams
Processor(TM) technology, and video connectivity via S3's Scenic Highway(TM)
local peripheral bus. The Company's accelerators support the industry standard
vesa local ("VL") and PCI local buses, with newer products supporting the
emerging Advanced Graphics Port ("AGP") bus.

Trio64V+. The Trio64V+(TM) is a 64-bit, DRAM-based 2D graphics and video
accelerator. It is pin compatible with S3's prior generation Trio64(TM)
accelerator and includes integrated RAMDAC and clock synthesis functions.
Additionally, the Trio64V+ includes video acceleration based on S3's Streams
Processor technology and video connectivity via S3's Scenic Highway local
peripheral bus.

Trio64V2. The Trio64V2(TM) is a 64-bit, DRAM and SDRAM-based graphics and
video accelerator. The Trio64V2/DX(TM) is DRAM-based and pin compatible with
S3's Trio64V+ accelerator. The Trio64V2/GX(TM) incorporates a synchronous memory
interface to support SDRAM frame buffers for improved performance, increased
resolutions and pixel depths and higher refresh rates. The Trio64V2 includes an
enhanced RAMDAC, clock synthesis, enhanced video acceleration that includes
vertical video filtering, and video connectivity.

ViRGE. ViRGE is a 64-bit, DRAM-based 2D/3D graphics and video accelerator.
It is pin compatible with the Trio64V+ accelerator and includes the Trio64V+'s
RAMDAC and clock synthesis functions. Additionally, the ViRGE accelerator
includes video acceleration based on S3's Streams Processor technology and video
connectivity via S3's Scenic Highway local peripheral bus.

ViRGE/DX/GX. ViRGE/DX and ViRGE/GX are second generation 64-bit, 2D/3D
graphics and video accelerators, utilizing DRAM and SGRAM, respectively.
ViRGE/DX is pin compatible with the ViRGE 2D/3D accelerator and the Trio64V+ and
Trio64V2 2D accelerators. ViRGE/GX is pin compatible with the Trio64V2 2D
accelerator. Both the ViRGE/DX and ViRGE/GX include the RAMDAC and clock
synthesis functions and enhanced video acceleration based on S3's Streams
Processor technology and video connectivity via S3's Scenic Highway local
peripheral bus. ViRGE/DX and ViRGE/GX accelerators provide significant
performance improvement over the first generation ViRGE accelerators, and
include SmartFilter(TM) technology for higher performance and higher quality
texture mapping and a parallel processing perspective engine for increased
throughput. ViRGE/DX and ViRGE/GX are designed to enable the next level of
gaming applications as well as to deliver the 2D/3D platform required for
emerging business desktop applications. These desktop applications include data
visualization, accelerated visual reality modeling language ("VRML"), 3D
presentations and spreadsheets.

ViRGE/GX2. ViRGE/GX2 is the third generation 64-bit, SGRAM-based 2D/3D
graphics and video accelerator that supports TV-out, DuoView(TM) dual-display
capability, Intel's AGP standard, and is digital versatile disc ("DVD") capable.
ViRGE/GX2 includes advanced 3D and display technology designed to bridge the gap
between mainstream consumer electronics and PC technology. These features
include DuoView technology, which enables users to display different images
simultaneously on separate monitors and is designed to increase the
functionality of applications such as multi-player gaming, Web browsing and
video conferencing. In addition, AGP support is intended to provide increased
multimedia performance, while integrated TV-out enables output from the PC to a
TV. The Company also provides a scaleable solution that combines either hardware
or software MPEG-2 decoders with ViRGE/GX2's integrated DVD features. Also,
ViRGE/GX2 delivers a full set of 3D rendering features including MIP mapping,
tri-linear filtering and perspective correction of textures.

Aurora64V+. The Aurora64V+ is a 64-bit, DRAM-based 2D graphics and video
accelerator for mobile computers. It includes the Trio64V+'s integrated RAMDAC
and clock synthesis functions, a flat panel display interface and, through
DuoView technology, the ability to simultaneously display information on the
flat panel and either a computer monitor or television. DuoView technology also
enables users to view multiple windows during video conferencing applications.
Additionally, the Aurora64V+ includes video acceleration based on S3's Streams
Processor technology and video connectivity via S3's Scenic Highway local
peripheral bus.

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ViRGE/MX/MXi. ViRGE/MX and ViRGE/MXi are the second generation 3D graphics
accelerators for notebook PCs, which combine the same level of 2D/3D video
acceleration found in the Company's desktop accelerators with advanced power
management and flat panel display support. The two products feature DuoView,
integrated TV-out and a full set of 3D rendering, including MIP mapping,
tri-linear filtering and perspective correction textures. The products also
support the AGP standard. ViRGE/MXi is the industry's first 3D graphics
accelerator with integrated DRAM for mainstream notebook PCs. With two megabytes
of S3-designed DRAM (known as S3RAM(TM)), the ViRGE/MXi provides improved power
management and Macrovision copy protection for DVD. Macrovision copy protection,
the official Analog Protection System ("APS") for DVD systems, is required for
all DVD PCs that provide a TV-out connection. The integrated Macrovision
technology enables the users to save the power, expense and board space required
for an external TV encoder solution.

Trio3D. Trio 3D is the third generation of the Trio family of accelerators.
It features a 128-bit pipeline architecture, support for 125 MHz SGRAM memory
and S3's Burst Command Interface(TM) -- a proprietary protocol technology that
works in conjunction with either the PCI or AGP bus to increase the command and
data efficiency of the Trio3D architecture. Trio3D also supports 3D rendering
and is the first accelerator to fully implement the industry standard Video
Interface Port ("VIP") bus which provides a dedicated interface from the
graphics accelerator to digital video devices and streamlines the movement of
this data versus current PCI bus solutions. The Trio 3D allows for a low-cost,
easy-to-implement interface to third party multimedia peripherals such as video
cameras, TV-tuners and DVD/MPEG-2 decoders. It also provides support for AGP
standard and is designed to be pin-compatible with existing Trio and ViRGE-based
designs. In addition, Trio 3D's software compatibility with previous generations
of S3 products is intended to enable faster time-to-market for manufacturers.

Software

The Company believes that a complete solution for its customers must
include not only high performance acceleration features implemented in silicon,
but also a broad line of software, including BIOS, drivers and utilities, that
are designed to optimize the performance of its accelerators. The software is
shipped as an integral part of the Company's accelerator products. The Company
maintains a flexible driver architecture, allowing its drivers to be easily
upgraded for the enhanced features supported in next generation accelerator
products. S3 uses a combination of in-house software developers and independent
contractors to develop its software drivers. Strategic software, including BIOS
and drivers for the Windows family of operating systems, is developed by the
Company's in-house software development team. The Company believes that software
expertise is vital to determining the optimal trade-off between silicon and
software for next generation accelerator performance and functionality
enhancements. The Company has also developed extensive capabilities for testing
its accelerators, software drivers and BIOS across a range of applications and
OEM system configurations.

The Company's software includes the following drivers:

OPERATING SYSTEM DRIVERS
------------------------

IBM OS/2 Microsoft Windows NT 3.51
Microsoft Windows(R)(1)3.1 Microsoft Windows NT 4.0
Microsoft Windows 95 Microsoft Windows NT 5.0
Microsoft Windows 98

In 1996, the Company expanded its end-user utility support. Designed to be
included with drivers by the Company's OEMs, these utilities are intended to
provide increased end-user ease-of-use support and extended control of S3
multimedia accelerator functions. The Company released the refresh utility for
Windows 95 and Windows 3.1, allowing the user to change refresh rates, and the
color utility for Windows 95, Windows 98 and Windows NT 4.0, giving the user
control of hue, saturation, contrast, and brightness for video playback.
- ---------------
(1) Windows is a registered trademark of Microsoft Corporation.

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In 1997, the Company released several end-user utilities with the drivers.
The switch utility for the Windows family of operating systems provides multiple
display device switching, DuoView/Simultaneous display control, display
resolution and refresh rate control, video color adjustment and TV output
controls. The info utility for Windows 95 and Windows 98 gives the user S3
graphics adapter information, graphics mode information, system information and
a list of the installed S3 utilities with version numbers. The gamma utility,
for Windows 95, and Windows 98 and Windows NT, allows the user to interactively
modify the display gamma settings for the current color depth.

In September 1996, Packard Bell NEC released the Company's
internally-developed TV-Tuner(TM) application, which displays live TV on the
computer using Packard Bell NEC's hardware. The application allows channel
selection, volume control, record/playback features similar to a video cassette
recorder, closed caption display, and it supports international video inputs
such as NTSC, PAL and SECAM.

The Company also developed OEM-specific display control utilities for its
customers who use the mobile graphics accelerators. These utilities enable
end-user utilization of the DuoView and mobile computing functions of the
Aurora64V+ and ViRGE MX/MXi accelerators.

Throughout 1996, the Company released several updates of its Galileo(R)
utility, which was first introduced in 1995 and provides ease-of-use support for
resolution and color depth configuration changes and monitor centering.

3D Software(2)

S3's software strategy for its traditional 2D graphics accelerators was
achieved primarily through the development of software drivers to interface the
acceleration hardware with industry-standard application programmer interfaces
("API"), including those for Windows and OS/2. Direct support for specific
applications was limited primarily to leading DOS-based CAD programs such as
AutoCAD and Microstation, due to the APIs' role in de-coupling application
programs from the actual graphics hardware.

In the emerging 3D acceleration market of 1996, however, an absence of
industry-standard 3D graphics APIs caused S3 to actively promote its own,
proprietary DOS-based 3D API. This proprietary software has enabled the porting
of specific 3D games and other 3D applications to the ViRGE hardware platforms.
Specific titles that have been ported to the ViRGE architecture include Terminal
Velocity, FX Fighter, MechWarrior 2, Screamer, Cyberspeed, Destruction Derby,
Havoc, Descent II, VR Soccer, Mega Race 2, Web3D, 3D Maestro and Truespace.

In 1997, the Company continued to develop its proprietary API by providing
software developers with advanced tools and code samples to enhance and
streamline their development cycle for optimal performance of the key features.

S3 is also actively developing software drivers for what have emerged as
the standard APIs for 3D acceleration. Microsoft's Direct3D has emerged as the
standard API for the mainstream PC platform and Silicon Graphic's OpenGL emerged
as the standard API for high-performance 3D graphics. S3 intends to support its
proprietary API, OpenGL, Direct3D, and third-party APIs based on market
acceptance of such APIs and S3's needs to support and promote new features of
future accelerators. S3 has developed an OpenGL driver for the ViRGE family of
2D/3D accelerators to support CAD/engineering, modeling/ rendering and other
high-end 3D applications traditionally supported on workstation platforms. In
August 1997, the Company and Silicon Graphics, Inc. announced a long term
licensing agreement whereby S3 will distribute OpenGL. The Company will provide
its OEM customers with source and object code for OpenGL, a proven, highly
versatile 2D and 3D graphics API that enables PC, workstation and supercomputing
hardware vendors to provide high-performance graphics solutions.

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(2) The software titles set forth below may be trademarks or registered
trademarks of their respective owners.

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Future Accelerators and Software

The Company has in development several graphics and video accelerators and
related software products for currently scheduled introduction throughout 1998.
S3 believes that its extensive software, systems and silicon expertise, use of
advanced design tools, centralized engineering group with strong design
expertise, and close working relationships with strategic customers and software
developers should position the Company to continue to rapidly and
cost-effectively define, develop and market advanced accelerators and related
software for the PC market. The Company analyzes and uses industry tools such as
3D Winbench 98 and other independent benchmarking software in its efforts to
provide the highest level of accelerator and feature compliance. In future
products, the Company plans to be fully compliant with the graphics initiative
from Intel for AGP as defined by the PC98 and PC99 system design guides, which
are a reference for designing PCs and peripherals for the Microsoft Windows
family of operating systems and are primarily driven by Microsoft, Intel and
other industry leaders.

Recognizing the rapid conversion of consumer electronic products from
analog to digital technology, the convergence of consumer and computing systems
into new and evolving information access devices and the personal computer's
inherent position as the most advanced and well-positioned digital platform, the
Company intends to leverage its PC system architecture and multimedia
acceleration expertise to develop new products for both computer and consumer
applications that exploit these trends.

S3's accelerator products are designed to improve the graphics performance
of PCs using Intel and other x86-based microprocessors, 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 and may have a material adverse effect on the Company's
operating results. The market for the Company's accelerator products 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 product life cycle of 12 to 18 months.

RISK FACTORS

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, order cancellations or
rescheduling and the other factors discussed below. These factors could
adversely affect demand for the Company's products. In addition, the pricing
environment for graphics accelerators has recently experienced increasing
pricing pressures and is expected to continue to experience pricing pressures,
due in part 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 1996, experienced
significant decreases in average selling prices in 1997. The graphics
accelerator market is transitioning from 2D acceleration to 3D acceleration, and
the Company has introduced its ViRGE family of 2D/3D accelerators in response to
this transition. As a result of the entry of competitors into the 3D
acceleration market, the Company has experienced and anticipates that it may
continue to experience increased pricing pressures on average selling prices for
the ViRGE family of 2D/3D accelerators. In addition, the Company does not
currently offer products addressing the high performance 3D acceleration market,
which adversely affects the Company's

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gross margin and profitability. If the Company is unable to introduce and
successfully market higher performance products, if the Company's products do
not achieve market acceptance, or if pricing pressures increase above normal
anticipated levels, the Company's operating results could be adversely affected.
Furthermore, 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 such 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. 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 generally 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.

Due to the foregoing factors, it is likely that in some future quarter or
quarters the Company's operating results may be below the expectations of public
market analysts and investors. In such event, the price of the Company's common
stock would likely be materially and adversely affected.

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 18 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 add-in card and motherboard 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 does not currently offer products addressing the high
performance 3D acceleration market. 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. 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, the
Company has recently introduced accelerators designed to work with synchronous
graphics RAM ("SGRAM") and/or synchronous DRAM ("SDRAM") which the Company
believes offer

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better performance for its price than the more expensive video RAM ("VRAM").
However, there can be no assurance that other memory technologies, such as
Rambus DRAM, will not achieve a greater degree of market acceptance than SGRAMs
or SDRAMs.

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 could be adversely affected. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations."

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 long-term supply arrangements with two of its foundries, a "take
or pay" contract with Taiwan Semiconductor Manufacturing Company ("TSMC") and a
joint venture foundry, United Semiconductor Corporation ("USC"). In 1995, the
Company expanded and formalized its relationship with TSMC to provide additional
capacity over the 1996 to 2000 timeframe. The foundry agreement with TSMC
requires the Company to make certain annual advance payments to purchase certain
committed capacity amounts to be applied against the following year's capacity
or forfeit advance payments against such amounts. In addition, the Company,
together with United Microelectronics Corporation ("UMC") and Alliance
Semiconductor Corporation, owns USC. The Company currently owns 15.75% of USC
and maintains the right to purchase up to 31.25% of USC's output. 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. To the extent USC experiences operating losses, the Company will
recognize its proportionate share of such losses and may be required to
contribute additional capital. The Company believes that a number of
manufacturers are expanding or planning to expand their fabrication capacity
over the next several years, which could lead to over-capacity in the market and
resulting decreases in costs of finished wafers. If the wafers produced by USC
cannot be produced at competitive prices, USC could sustain operating losses.
There can be no assurance that such operating losses will not have a material
adverse effect on the Company's results of operations.

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 or an
injunction arising from alleged violations of third party intellectual property
rights, the Company may not have a sufficient amount of time to replace the
supply of products manufactured by that foundry. There can be no assurance that
the Company will obtain sufficient advanced process technology foundry capacity
to meet customer demand in the future. 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.

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. The Company currently expects these three foundries to
supply the substantial portion of the Company's products in 1998. 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.

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The Company is using multiple sources 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 adequate availability of certain packaging technologies, 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. See
"Business -- Sales, Marketing and Distribution" and "-- Manufacturing and Design
Methodology."

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 may consider in the future various 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 such 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 has entered into the USC joint venture. The
need to commit substantial capital may require the Company to seek additional
equity or debt financing. Although the Company currently believes that the need
for such additional capital is minimal for the next two years, if such capital
is needed, 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. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Liquidity and Capital Resources" and
"Business -- Manufacturing and Design Methodology."

Dependence on Accelerator Product Line

S3's products are designed to improve the graphics and multimedia
performance of Pentium-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 processing and general
purpose computing capabilities will be integrated into future versions of Intel
Corporation ("Intel") and other Pentium-based microprocessors and that standard
multimedia accelerators in the future will likely integrate memory, system
logic, audio, communications or other additional functions. In particular, Intel
has announced plans to develop chips that integrate graphics and processor
functions to serve the lower cost PC market. A substantial portion of the
Company's 1997 sales were derived from products addressing the lower cost PC
market, and the Company anticipates that a substantial portion of its 1998 sales
will also be derived from products addressing this market. The Company has not
previously offered either single function or integrated accelerator products

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that provide these functions, which have traditionally been provided by separate
single function chips or chipsets. The 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 Pentium-based microprocessors and integrate additional functionality,
there can be no assurance that the Company will be able to develop such new or
enhanced products in a timely manner or correctly anticipate the additional
functionality that will be required to compete effectively in this market. The
Company's initial product containing a number of these functions, Plato/PX, has
been discontinued. In addition, in 1997 the Company wrote off approximately
$17.2 million of intangible assets including certain licenses, patents and other
technology as a result of management's decision to focus on the core graphics
business. In the first quarter of 1998, the Company discontinued its audio and
communications products line. 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. For example, in 1996, there
was an absence of an industry standard 3D graphics API. As a result, the Company
developed and promoted its proprietary API. Microsoft has since introduced its
Direct3D API and Silicon Graphics has introduced OpenGL, which have emerged as
the standard APIs for 3D acceleration. While the Company's 3D accelerators
currently support the Company's proprietary API, Microsoft's Direct 3D API and
OpenGL, there can be no assurance that another API will emerge as an industry
standard that the Company's accelerators will not support. Also, due to the
widespread industry acceptance of Intel's microprocessor architecture and
interface architecture, including its AGP bus, Intel exercises significant
influence over the PC industry generally, and the inability of the Company to
develop successfully products that are compatible with the AGP technology, Intel
microprocessors or other aspects of the PC microprocessor architecture, whether
the need for compatibility results from significant modifications by Intel to
its existing technology, architecture or standards, would have a material
adverse effect on the Company's business, financial condition and results of
operations. Any delay in the public release of information relating to any such
modifications could also have a material adverse effect on the Company's
business, financial condition and results of operations. 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.

Substantial Competition

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a collaboration with 3Dlabs, Inc., Ltd. to develop a graphics processor
targeting the high end workstation market. To the extent that Intel's
initiatives in the graphics sector are successful, the Company's business,
financial condition and results of operations could be materially and adversely
affected. There can be no assurance that the Company's product offerings to
address the demand for the next generation of 2D/3D accelerators will be
competitive, and if such product offerings are not competitive, the Company's
results of operations in 1998 and future periods could be materially and
adversely affected. The Company's current products do not address the high
performance segment of the market, which has resulted in substantial pricing and
margin pressures on the Company's products and adversely affected the Company's
recent results of operations. The entry of additional competitors into the 2D/3D
accelerator market has resulted in and is expected to continue to result in
pricing pressures on average selling prices of the Company's products. To the
extent the Company expands its product line to add products with additional
functionality, it will encounter substantial competition from established
semiconductor companies and may experience competition from companies designing
chips based on different technologies. Furthermore, 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 companies that supply
only accelerator chips. In addition, certain of the Company's potential
competitors that supply add-in cards and/or motherboards, such as Intel, may
seek to use their card/board business to leverage the startup of their graphics
accelerator business. 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.

Customer Concentration

The Company expects a significant portion of its future sales to remain
concentrated within a limited number of strategic customers. This concentration
is also reflected in the Company's accounts receivable where greater than 50% of
the balance is represented by four customers at December 31, 1997.

Three customers, Synnex Technology, Inc. ("Synnex"), CNW International
Limited, and Compaq Computer Corporation, accounted for 20%, 13% and 12%,
respectively, of net sales in 1997. Two customers, Diamond Multimedia Systems,
Inc. and Synnex Technology, Inc., accounted for 16% and 15%, respectively, of
net sales in 1996. Two customers, Diamond Multimedia Systems, Inc. and Intel
Corporation, accounted for 17% and 12%, respectively, of net sales in 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 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 Company's distributors are permitted to return to the Company the
products purchased by them, and the Company provides its distributors with price
protection in the event that the Company reduces the prices of its products.
Synnex, the Company's largest customer in 1997, is the Company's largest Asian
distributor, and a substantial percentage of the Company's 1997 net sales were
made through distributors.

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

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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. Any problems encountered in the implementation of such a
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. Competition for such personnel is
intense, and there can be no assurance that the Company can retain and recruit
necessary personnel to operate its business and support its future growth. In
August 1997, Walter D. Amaral joined the Company as Senior Vice President and
Chief Financial Officer. In December 1997, Terry N. Holdt returned to the
Company as its Chief Executive Officer and President and Chairman of the Board.
The Company's co-founder, Diosdado Banatao, resigned as Chairman of the Board
but continues to serve as a member of the Board of Directors. There can be no
assurance as to the effects of this management transition on the Company's
business and operating results. 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. See
"Business -- Employees" and "Executive Officers of the Registrant."

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 a number of 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 resulted in, and could in the future result in,
substantial 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 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.

In October 1995, Brooktree filed a complaint against the Company in the
United States District Court for the Southern District of California, alleging
that certain of the Company's products infringed a Brooktree patent. Such a
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

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parties were dismissed and the Company agreed to pay to Brooktree a license fee
and royalties related to certain product revenues over a five-year period.

Since November 1997, a number of complaints have been filed in federal and
state courts seeking an unspecified amount of damages on behalf of an alleged
class of persons who purchased shares of the Company's common stock at various
times between April 17, 1996 and November 3, 1997. The complaints name as
defendants the Company, certain of its officers and former officers and certain
directors of the Company, asserting that they violated federal and state
securities laws by misrepresenting and failing to disclose certain information
about the Company's business. In addition, certain shareholders have filed
derivative actions seeking recovery on behalf of the Company alleging, among
other things, breach of fiduciary duties by such individual defendants. The
Company has not yet formally responded to these complaints. While management
intends to defend the actions against the Company vigorously, there can be no
assurance that an adverse result or settlement with regards to such lawsuits
would not have a material adverse effect on the Company's financial condition or
results of operations.

The Company has received from the United States Securities and Exchange
Commission a request for information relating to the Company's restatement
announcement in November 1997. The Company has responded and intends to continue
to respond to such requests.

International Operations

Export sales accounted for 70%, 58%, and 44% of the Company's net sales in
1997, 1996, and 1995, respectively, and 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, 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. While to date the Company
has not experienced an adverse impact associated with the economic downturn in
Asia, there can be no assurance that the recent volatility in the Asian economy
will not adversely affect the Company's business, financial condition and
results of operations. 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, and the
Company's joint venture foundry, USC, are located in Taiwan. The Company
currently expects these three foundries to supply the substantial portion of the
Company's products in 1998. The People's Republic of China and Taiwan at times
experienced strained relations in 1995 and 1996, 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 to date not 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.

Leverage

In connection with the sale of $103,500,000 aggregate principal amount of
Convertible Subordinated Notes in September 1996, the Company's ratio of its
long-term debt to its total capitalization increased from approximately 9.5% at
June 30, 1996 to approximately 31.2% at December 31, 1996. At December 31, 1997,
this ratio decreased to 28.6%. As a result of this additional indebtedness, the
Company's principal and interest obligations have increased substantially over
1996 levels. The degree to which the Company is leveraged could

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adversely affect the Company's ability to obtain additional financing for
working capital or other purposes and could make it more vulnerable to economic
downturns and competitive pressures. The Company's increased leverage could also
adversely affect its liquidity, as a substantial portion of available cash from
operations may have to be applied to meet debt service requirements and, in the
event of a cash shortfall, the Company could be forced to reduce other
expenditures to be able to meet such requirements. See "Selected Consolidated
Financial Data," and "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Liquidity and Capital Resources."

Volatility of Stock Price

The market price of the shares of the Company's common stock, like that of
the common stock of many other semiconductor companies, has been and is likely
to be highly volatile, and the market has from time to time experienced
significant price and volume fluctuations that are unrelated to the operating
performance of particular companies. The market price of the Company's common
stock could be subject to significant fluctuations in response to
quarter-to-quarter variations in the Company's anticipated or actual operating
results, announcements of new products, technological innovations or setbacks by
the Company or its competitors, conditions in the semiconductor and PC
industries, the commencement of, developments in or outcome of litigation,
changes in or the failure by the Company to meet earnings estimates by
securities analysts, market conditions for high technology stocks in general,
and other events or factors.

Litigation

Since November 1997, a number of complaints have been filed in federal and
state courts seeking an unspecified amount of damages on behalf of an alleged
class of persons who purchased shares of the Company's common stock at various
times between April 17, 1996 and November 3, 1997. The complaints name as
defendants the Company, certain of its officers and former officers and certain
directors of the Company, asserting that they violated federal and state
securities laws by misrepresenting and failing to disclose certain information
about the Company's business. In addition, certain shareholders have filed
derivative actions seeking recovery on behalf of the Company, alleging, among
other things, breach of fiduciary duties by such individual defendants. The
Company has not yet formally responded to these complaints. While management
intends to defend the actions against the Company vigorously, there can be no
assurance that an adverse result or settlement with regards to these lawsuits
would not have a material adverse effect on the Company's financial condition or
results of operations.

SALES, MARKETING AND DISTRIBUTION

S3 markets and distributes its products through a direct sales organization
supported by field applications engineers, as well as through a network of
independent manufacturers' representatives and regional distributors. In North
America, the Company uses a combination of independent manufacturers'
representatives and a direct sales force operating from the Company's sales
offices in California, Florida, Georgia, Oregon and Texas. In Asia, the Company
operates from sales and distribution offices in Hong Kong, Japan, Singapore and
Taiwan, and through manufacturers' representatives and local distributors
located in the People's Republic of China, Hong Kong, Japan, Korea and Taiwan.
In Europe, the Company uses organizations that are both manufacturers'
representatives and distributors in France and Germany. The loss of one or more
representatives could have an adverse effect on the Company's operating results.
The Company has a global shipment program pursuant to which certain finished
products are shipped directly to customers from the Company's independent
assembly and testing houses. This program is intended to provide more timely
delivery of such products to those customers by eliminating the intermediate
step of shipping finished products to the Company's Santa Clara, California
facility for repackaging and reshipment.

The Company sells multimedia accelerators to leading systems manufacturers
such as Acer Incorporated, AST Research Incorporated, Compaq Computer
Corporation, Dell Computer Corporation, Gateway 2000, Inc., Hewlett-Packard
Company, IBM, Packard Bell NEC, and Toshiba Corporation and to leading add-in
board and motherboard manufacturers such as Diamond Multimedia Systems, Inc.,
DataExpert Corporation, ELSA GmbH, Intel Corporation, Micronics Computers, Inc.,
Number Nine Visual Technology Corporation,

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STB Systems, Inc. and Vtech Holdings Limited. Sales to these customers are
typically made pursuant to specific purchase orders, which are cancelable
without significant penalties. In 1997, three customers, Synnex Technology Inc.,
CNW International Limited, and Compaq Computer Corporation, accounted for 20%,
13% and 12%, respectively, of net sales. In 1996, two customers, Diamond
Multimedia Systems, Inc., and Synnex Technology, Inc., accounted for 16% and
15%, respectively, of net sales. Two customers accounted for 17% and 12% of net
sales in 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 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 event could have a material
adverse effect on the Company's operating results. See "Factors That May Affect
Results -- Customer Concentration."

Export sales accounted for 70%, 58%, and 44%, of net sales in 1997, 1996,
and 1995 respectively. Approximately 28% of export sales in 1997 were to
affiliates of United States customers. Due to its export sales, the Company is
subject to the risks of conducting business internationally, including those set
forth above under "Factors That May Affect Results -- International Operations."

CUSTOMER SUPPORT AND SERVICE

The Company believes that customer service and technical support are
important competitive factors in the accelerator market. The Company provides
technical support for customers in major markets in North America, Europe and
Asia. Distributors and manufacturers' representatives supplement the Company's
efforts by providing additional customer service and technical support for the
Company's products. The Company also provides several other types of technical
support, including software distribution through the World Wide Web, product
demonstration software, evaluation boards and application notes.

The Company works closely with its customers in tracking the progress of
its product designs, providing applications design support and upgrading the
customers' software to provide the latest enhancements under the Company's
software maintenance program. The Company believes that close contact with its
customers not only improves their level of satisfaction, but also provides
important insights into defining the system requirements for next generation
accelerators and related software products.

MANUFACTURING AND DESIGN METHODOLOGY

The Company currently relies on several independent foundries to
manufacture all of its products. The Company's strategy is to utilize a number
of qualified foundries that it believes provide cost, technology or capacity
advantages for specific products. This strategy allows the Company to avoid the
significant capital investment to construct an in-house wafer fabrication
facility. As a result, the Company is able to focus its resources on product
design and development, quality assurance, marketing, and customer support. The
Company's accelerators are currently manufactured using a three and four level
metal CMOS processes with line geometries as small as 0.35 micron. The Company
will utilize a five level metal CMOS process with 0.25 micron line geometries
for certain of its products scheduled for 1998 production. In order to provide
increased functionality to meet the needs of the multimedia market without
substantially increasing die size, the Company's products will have to be
manufactured using increasingly smaller line geometries. The Company designs its
products using proprietary circuit modules that are scalable in size to enable
more rapid adoption of smaller line geometry manufacturing processes and a
common design rule approach to operate within the process parameters of multiple
foundries. Multiple sources for certain products increase the Company's ability
to supply its customers with those products and reduce the Company's dependence
on any single foundry. However, the Company has not developed alternate sources
of supply for certain products, and its newly introduced products are typically
produced initially by a single foundry until alternate sources can be qualified.
The Company currently has long-term manufacturing capacity arrangements with two
suppliers in four wafer fabrication lines described below. The Company conducts
business with all but one of its current foundry suppliers by delivering written
purchase orders specifying the particular product ordered, quantity, price,
delivery date and shipping terms and, therefore, the foundries are generally not
obligated to supply

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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.

Historically, certain subcontract suppliers have also provided packaging
and testing for the Company's products and other activities necessary to deliver
finished products. The Company pays those suppliers for assembled or fully
tested products meeting predetermined specifications. In the assembly process,
the silicon wafers are separated into individual die after wafer level testing
that are then assembled into packages and tested in accordance with the
Company's test procedures. Following assembly, the packaged devices are further
tested and inspected pursuant to the Company's quality assurance program before
shipment to customers. Due to increasing complexity and high pin counts required
by the Company's products, the Company is increasing its use of Ball Grid Array
("BGA") packaging. While there are currently multiple sources for BGA packages,
the rapid growth in industry demand for BGA packages may limit availability in
the future. To ensure the integrity of its foundries' quality assurance
procedures, the Company develops detailed test procedures and specifications for
each product and requires the foundry to use those procedures and specifications
before shipping finished products or wafers. Product returns to date have not
been significant.

There can be no assurance that the Company will obtain sufficient sources
of supply of product to meet customer demand in the future. Obtaining sufficient
foundry capacity is particularly difficult during periods of high growth, and
may become substantially more difficult if the Company's product requirements
increase significantly. In addition, because the Company must order products and
build inventory substantially in advance of product shipments, 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. 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. See "Factors That May Affect Results -- Dependence
on Foundries and Other Third Parties" and "-- Transactions to Obtain
Manufacturing Capacity; Future Capital Needs."

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.

The Company uses an automated design environment based on advanced
workstations, dedicated product simulators, system simulation with hardware and
software modeling, and the use of a high level design description language in
order to more rapidly define, develop and deliver new and enhanced products. The
Company considers its computer-aided engineering ("CAE") and computer-aided
design ("CAD") capabilities to be important to its future success in all areas
of new product development and intends to continue to enhance its CAE/CAD
systems. Although the Company extensively tests its software and hardware
products prior to their introduction, it is possible that design errors may be
discovered after initial product sampling,

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18

resulting in delays in volume production or recall of products sold. The
occurrence of any such errors could have a material adverse effect on the
Company's product introduction schedule and operating results.

RESEARCH AND DEVELOPMENT

The Company believes that continued timely development and introduction of
new products are essential to maintaining its competitive position. The Company
currently conducts most of its product development effort in-house and, at
December 31, 1997, had a staff of 379 research and development personnel, of
whom approximately 24% are involved in software development. The Company also
employs outside consultants to assist with software testing. The Company is
focusing its current development efforts primarily on the development of
enhanced versions of its existing family of graphics and multimedia accelerators
and adding new functionality to its products for business desktop, mobile and
home PC markets. In addition, the Company intends to continue to devote
significant resources to the development of a broad range of high-performance
software drivers to support its products. During 1997, 1996, and 1995, the
Company spent approximately $95.8 million, $63.4 million, and $42.1 million,
respectively, on research and development activities. In the fourth quarter of
1997, the Company wrote-off approximately $17.2 million of intangible assets,
including certain licenses, patents and other technology, as a result of
management's decision to focus attention on the core graphics business. As a
result of this decision, no future cash flows were expected related to these
assets.

COMPETITION

The markets in which the Company competes are extremely competitive and the
Company expects that competition will increase. The principal factors of
competition in the Company's markets include 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, and
customer support. Price competition in the industry is intense and may increase,
which may have a material adverse effect on the Company's operating results.
There can be no assurance that the Company will be able to compete successfully
as to price or any of these other factors.

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., 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
smaller 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 developed,
are developing or have announced plans to develop 3D graphics chips. These
include Intel, which recently introduced the Intel740 3D graphics processor that
is currently expected to become available in the first half of 1998, and Texas
Instruments Incorporated, which has announced a development and marketing
agreement with 3Dlabs Inc., Ltd. In addition, Intel has acquired Chips and
Technologies, Inc., a leading provider of accelerators for the mobile PC market,
and has announced a collaboration with 3Dlabs, Inc., Ltd. to develop a graphics
processor targeting the high end workstation market. To the extent that Intel's
initiatives in the graphics sector are successful, the Company's business,
financial condition and results of operations could be materially and adversely
affected. There can be no assurance that the Company's product offerings to
address the demand for the next generation of 2D/3D accelerators will be
competitive, and if such product offerings are not competitive, the Company's
results of operations in 1998 and future periods could be materially and
adversely affected. The Company's current products do not address the high
performance segment of the market, which has resulted in substantial pricing and
margin pressures on the Company's products and adversely affected the Company's
recent results of operations. The entry of additional competitors into the 2D/3D
accelerator market has resulted in and is expected to continue to result in
pricing pressures on average selling prices of the Company's products. To the
extent the Company expands its product line to add products with additional
functionality, it will encounter substantial competition from established
semiconductor companies and may experience competition from

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companies designing chips based on different technologies. Furthermore, 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
companies that supply only accelerator chips. In addition, certain of the
Company's potential competitors that supply add-in cards and/or motherboards,
such as Intel, may seek to use their card/board business to leverage the startup
of their graphics accelerator business. 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.

LICENSES, PATENTS AND TRADEMARKS

The Company has filed several United States patent applications for its
technology and to date has been issued six United States patents. The Company
has also built its patent portfolio substantially through acquisitions. In 1997,
the Company acquired certain microprocessor patents from Exponential Technology
Inc. In January 1998, the Company entered into a patent purchase and
cross-licensing agreement with Cirrus Logic, Inc. pursuant to which the Company
purchased 10 graphics patents and 25 graphics patent applications and
cross-licensed other graphics-related technology. The Company attempts to
protect its trade secrets and other proprietary information through agreements
with its customers, suppliers, employees and consultants, and through other
security measures. Although the Company intends to protect its rights
vigorously, there can be no assurance that these measures will be successful or
that any issued patents will provide the Company with adequate protection with
respect to the covered products, technology or processes.

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, such as the Brooktree litigation, by or against
the Company could result in significant expense to the Company and divert the
efforts of the Company's technical and management personnel, whether or not such
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 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. See
"Factors That May Affect Results -- Importance of Intellectual Property;
Litigation Involving Intellectual Property," "Legal Proceedings" and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."

The Company has applied to the United States Patent and Trademark Office
for registration of a number of trademarks and also holds common law rights in a
number of trademarks. A U.S. trademark registration

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20

has been issued to the Company for the marks Galileo, S3, S3 (stylized), S3 Trio
32, S3 Trio64, S3d (stylized), Scenic, Trio, True Acceleration, S3 Vision 968
and ViRGE.

The S3 corporate logo, the Aurora family of marks, Cooperative Accelerator
Architecture, Burst Command Interface, DuoView, InfiniPatch, InfiniRate,
Innovations In Acceleration, No Compromise Acceleration, No Compromise
Integration, QuickRamp, RIO!, S3FM, S3RAM, S3S, Scenic Highway, Sight. Sound.
Speed., Silicon Film, SmartFilter, Streams Processor, the Trio family of marks,
TV-Tuner, and the ViRGE family of marks are trademarks of the Company. The
Company has also applied for trademark registration of some of its trademarks in
certain foreign jurisdictions. There can be no assurance that the Company will
obtain the registrations for which it has applied. Other trademarks referenced
in this document are owned by their respective companies.

If the Company's use of a registered or unregistered trademark were found
to violate a third party's common law or statutory trademark rights, the
Company's business could be adversely affected. In addition, the laws of certain
countries in which the Company's products are or may be developed, manufactured
or sold, including Hong Kong, Japan and Taiwan, may not protect the Company's
products and intellectual property rights to the same extent as the laws of the
United States.

BACKLOG

Sales of the Company's products are made pursuant to standard purchase
orders that are cancelable without significant penalties. In addition, purchase
orders are subject to price renegotiations and to changes in quantities of
products and delivery schedules in order to reflect changes in customers'
requirements and manufacturing availability. The Company's business, and to a
large and growing extent that of the entire semiconductor industry, is
characterized by short lead time orders and quick delivery schedules. In
addition, the Company's actual shipments depend on the manufacturing capacity of
the Company's suppliers and the availability of products from such suppliers. As
a result of the foregoing factors, the Company does not believe that backlog at
any given time is a meaningful indicator of future sales.

EMPLOYEES

At December 31, 1997, the Company employed 654 individuals, of whom 86 were
employed in operations, 379 in research and development, 117 in sales, marketing
and technical support, and 72 in administration and other support functions.
Approximately 75% of these employees hold engineering degrees. Competition for
personnel in the semiconductor, software and the PC industry in general is
intense. The Company believes that its future success will depend, in part, on
its ability to continue to attract, train, motivate, retain and manage highly
skilled technical, marketing and management personnel. None of the Company's
employees is represented by a labor union or is subject to a collective
bargaining agreement. The Company believes that its relations with its employees
are good.

YEAR 2000 COMPLIANCE

The inability of computers, software and other equipment utilizing
microprocessors to recognize and properly process data fields containing a 2
digit year is commonly referred to as the Year 2000 Compliance issue. As the
year 2000 approaches, such systems may be unable to accurately process certain
date-based information.

The Company believes it has identified all significant applications that
will require modification to ensure Year 2000 Compliance. Internal and external
resources are being used to make the required modifications and test Year 2000
Compliance. The modification process of all significant applications is
substantially complete. The Company plans on completing the testing process of
all significant applications by December 31, 1998.

In addition, the Company has communicated with others with whom it does
significant business to determine their Year 2000 Compliance readiness and the
extent to which the Company is vulnerable to any third party Year 2000 issues.
However, there can be no guarantee that the systems of other companies on which
the Company's systems rely will be timely converted, or that a failure to
convert by another company, or

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a conversion that is incompatible with the Company's systems, would not have a
material adverse effect on the Company.

The total cost to the Company of these Year 2000 Compliance activities has
not been and is not anticipated to be material to its financial position or
results of operations in any given year. These costs and the date on which the
Company plans to complete the Year 2000 modification and testing processes are
based on management's best estimates, which were derived utilizing numerous
assumptions of future events including the continued availability of certain
resources, third party modification plans and other factors. However, there can
be no guarantee that these estimates will be achieved and actual results could
differ from those plans.

ITEM 2. PROPERTIES.

In 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. In January 1997, the Company
relocated its principal administrative, sales, marketing, research and
development facility consisting of approximately 300,000 square feet of space in
two buildings located in Santa Clara, California, the initial phase of the
development. This space is leased for an initial 12-year term. The Company has
an option to build an additional two buildings comprising approximately 300,000
square feet. This option expires in January 1999. The Company has vacated its
previous Santa Clara facilities prior to the expiration of their lease terms in
order to occupy the new facilities. The previous facilities consisted of
approximately 159,000 square feet in four buildings in Santa Clara, California.
The Company has sublet two of the buildings and terminated the leases on the
remaining two buildings at no material cost. The Company also leases office
space in Georgia, Texas, Hong Kong, Japan and Taipei, Taiwan, and a warehouse in
Singapore in order to provide sales, distribution and technical support to
customers in the United States and Asia. Additional research and development
offices are also leased in Bangalore, India. The facilities leased are currently
sufficient for the Company's operations.

In connection with the Company's investment in the real estate partnership,
in February 1997, the Company (together with the developer) has obtained
permanent nonrecourse financing for the construction of the Santa Clara
facilities. The Company is not a guarantor on the permanent financing.

ITEM 3. LEGAL PROCEEDINGS.

Since November 1997, a number of complaints have been filed in federal and
state courts seeking an unspecified amount of damages on behalf of an alleged
class of persons who purchased shares of the Company's common stock at various
times between April 17, 1996 and November 3, 1997. The complaints name as
defendants the Company, certain of its officers and former officers and certain
directors of the Company, asserting that they violated federal and state
securities laws by misrepresenting and failing to disclose certain information
about the Company's business. In addition, certain shareholders have filed
derivative actions seeking recovery on behalf of the Company, alleging, among
other things, breach of fiduciary duties by such individual defendants. The
Company has not yet formally responded to these complaints. While management
intends to defend the actions against the Company vigorously, there can be no
assurance that an adverse result or settlement with regards to these lawsuits
would not have a material adverse effect on the Company's financial condition or
results of operations.

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 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.

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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

Not applicable.

EXECUTIVE OFFICERS OF THE REGISTRANT

The executive officers of the Company and their ages as of March 27, 1998
are as follows:

NAME AGE
---- ---

President and Chief Executive Officer, Chairman of the
Terry N. Holdt.............. 54 Board
Walter D. Amaral............ 46 Sr. Vice President Finance, Chief Financial Officer
Daniel A. Karr.............. 38 Vice President of Sales
Paul G. Franklin............ 54 Sr. Vice President of Operations
Ronald T. Yara.............. 51 Sr. Vice President of Strategic Marketing and Secretary

Mr. Terry N. Holdt, age 54, has served as Chairman of the Board, Chief
Executive Officer and President of the Company since December 1997, and as a
director since January 1992. Mr. Holdt served as Vice Chairman of the Board from
August 1996 to December 1997, and from January 1992 to August 1996, served as
President and Chief Executive Officer of the Company. Mr. Holdt was Chairman of
the Board of Paradigm Technology, Inc., a semiconductor company, from June 1991
to January 1992 and was its President and Chief Executive Officer from June 1988
to May 1991. From September 1986 to June 1988, Mr. Holdt held various executive
positions at Linear Corporation, a manufacturer of electronic telemetry systems,
where he was most recently President. From 1981 to 1985, he held various
executive positions at Western Digital Corporation, a manufacturer of computer
peripherals, where he was most recently Executive Vice President and Chief
Operating Officer. Mr. Holdt holds a B.S.E.E. and an M.S.E.E. from the
University of Illinois. Mr. Holdt is also a member of the Board of Directors of
SenDEC Corporation and Maxoptix Corporation.

Mr. Amaral, Senior Vice President and Chief Financial Officer, joined the
Company in August 1997. From April 1995 to August 1997, Mr. Amaral served as
Senior Vice President, Finance and Chief Financial Officer of NetManage
Incorporated, a supplier of networking software. From April 1992 to April 1995,
Mr. Amaral was Senior Vice President and Chief Financial Officer of Maxtor
Corporation, a disk drive manufacturer. From 1977 to 1992, Mr. Amaral held
numerous positions at Intel Corporation, where he was most recently Corporate
Controller. Mr. Amaral holds a B.S. in Business with a concentration in
Accounting from San Jose State University.

Mr. Karr, Vice President of Sales, became an employee of the Company in
April 1996. From January 1988 to April 1996, Mr. Karr held various positions at
Cirrus Logic, Inc., a manufacturer of integrated circuits, where he was most
recently Sales Director. From May 1985 to January 1988, Mr. Karr held marketing
and technical support positions at Adaptec, Inc., a supplier of bandwidth
management solutions, where he was most recently Product Manager. Mr. Karr
earned a B.A. in Physics and Mathematics from Linfield College.

Mr. Franklin, Senior Vice President of Operations, became an employee of
the Company in September 1992. From March 1991 to September 1992 he was a
consultant to the Company. Mr. Franklin was a consultant for a number of
semiconductor companies from January 1990 through March 1991. From March 1986 to
December 1989, Mr. Franklin was Vice President of Operations of Actel
Corporation, a supplier of field programmable gate arrays. Prior to 1986 Mr.
Franklin held various management positions at Monolithic Memories Inc., a
supplier of semiconductor memories and programmable logic.

Mr. Ronald T. Yara, age 51, co-founded the Company and has served as a
director of the Company since July 1995. Mr. Yara is currently Senior Vice
President, Strategic Marketing and Secretary of the Company. From September 1996
to April 1997, Mr. Yara also served as Senior Vice President of Corporate
Marketing. From the inception of the Company in 1989 until December 1993, he
served as Vice President, Marketing. From December 1984 to December 1989, Mr.
Yara held various positions at Chips & Technologies, Inc., a semiconductor
company he co-founded, most recently as Vice President of Business Development.
From February 1975 to 1984, Mr. Yara served in various positions at Intel
Corporation, most recently as Product Marketing Manager of Communication
Products. He earned a B.S.E.E. from Purdue University and an M.S.E.E. from the
University of Santa Clara.

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PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

The Company's common stock is traded on the Nasdaq National Market under
the symbol "SIII". See "Item 8. -- Selected Quarterly Consolidated Data" on page
50 for the range of high and low closing sales prices for the common stock on
the Nasdaq National Market, as reported by Nasdaq.

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA.

YEARS ENDED DECEMBER 31,
--------------------------------------------------------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS AND RATIOS)
--------------------------------------------------------
1997 1996 1995 1994 1993
-------- -------- -------- -------- --------

STATEMENT OF INCOME DATA
Net sales........................... $436,359 $439,243 $316,309 $140,309 $112,969
Gross margin(1)..................... 166,136 172,876 126,542 42,334 47,309
Research and development expenses... 95,792 63,382 42,080 17,913 11,539
Selling, marketing and
administrative expenses........... 55,879 48,800 33,510 18,310 12,500
Income from operations.............. 14,465 60,694 50,952 6,111 23,270
Income before cumulative effect of
accounting change................. 8,878 41,588 35,374 5,502 15,120
Net income(2)....................... $ 8,878 $ 41,588 $ 35,374 $ 5,502 $ 18,620
Per share amounts(5)
Income before cumulative effect of
accounting change.................
Basic............................. $ 0.18 $ 0.88 $ 0.83 $ 0.15 $ 0.46
Diluted(3)........................ $ 0.17 $ 0.81 $ 0.75 $ 0.14 $ 0.40
Net income
Basic............................. $ 0.18 $ 0.88 $ 0.83 $ 0.15 $ 0.57
Diluted(3)........................ $ 0.17 $ 0.81 $ 0.75 $ 0.14 $ 0.50
Shares used in computing per share
amount
Basic............................. 49,519 47,460 42,691 36,032 32,594
Diluted(3)........................ 51,740 52,451 47,013 39,621 37,472
Ratio of earnings to fixed
charges(4)........................ 7.26x 32.92x -- 165.98x 137.34x
BALANCE SHEET DATA
Cash and equivalents................ $ 90,484 $ 94,616 $ 69,289 $ 25,772 $ 22,538
Short-term investments.............. 27,186 62,768 24,630 8,800 21,997
Working capital..................... 209,993 225,550 144,620 59,727 55,057
Total assets........................ 492,854 485,172 321,643 89,460 81,660
Long-term obligations............... 27,070 20,852 24,761 813 384
Convertible subordinated notes...... 103,500 103,500 -- -- --
Stockholders' equity................ $270,840 $260,321 $205,864 $ 68,878 $ 60,985

- ---------------
(1) Gross margin was adversely impacted in 1994 by a pre-tax $9.9 million charge
for adjusting the valuation of the Company's non-integrated 32-bit
inventory.

(2) Includes the cumulative effect of adopting SFAS 109 in 1993 which increased
net income by $3.5 million ($0.11 per share for basic and $0.10 per share
for diluted).

(3) Diluted earnings per share includes the effect of incremental shares
issuable upon the conversion of the convertible subordinated notes, the
dilutive effect of outstanding options and an adjustment to net income for
the interest expense (net of income taxes) related to the notes unless the
impact of such conversion is anti-dilutive.

(4) For purposes of calculating the ratio of earnings to fixed charges, (i)
earnings consist of consolidated income before income taxes plus fixed
charges and (ii) fixed charges consist of interest expense incurred and the
portion of rental expense under operating leases deemed by the Company to be
representative of the interest factor. The Company had no fixed charges in
1995.

(5) The earnings per share amounts prior to 1997 have been restated as required
to comply with Statement of Financial Accounting Standards No. 128, Earnings
Per Share. For further discussion of earnings per share and the impact of
Statement No. 128, see the Notes to Consolidated Financial Statements
beginning on page 36.

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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.

When used in this discussion, the words "expects," "anticipates,"
"estimates" 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, trends in the PC market, the percentage of
export sales and sales to strategic customers and the availability and cost of
products from the Company's suppliers, are subject to risks and uncertainties,
including those set forth below and in Item 1 of this Report under the caption
"Business -- 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 statements 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 statement is based.

RESULTS OF OPERATIONS

The following table sets forth for the years indicated certain financial
data as a percentage of net sales:

YEARS ENDED DECEMBER 31,
--------------------------
1997 1996 1995
------ ------ ------

Net sales................................................... 100.0% 100.0% 100.0%
Cost of sales............................................... 61.9 60.6 60.0
----- ----- -----
Gross margin................................................ 38.1 39.4 40.0
Operating expenses:
Research and development.................................. 22.0 14.4 13.3
Selling, marketing and administrative..................... 12.8 11.1 10.6
----- ----- -----
Total operating expenses.......................... 34.8 25.5 23.9
----- ----- -----
Income from operations...................................... 3.3 13.9 16.1
Other income (expense), net................................. (0.5) 0.5 1.4
----- ----- -----
Income before income taxes.................................. 2.8 14.4 17.5
Provision for income taxes.................................. .8 4.9 6.3
----- ----- -----
Net income.................................................. 2.0% 9.5% 11.2%
===== ===== =====

The Company's operating results may fluctuate from those in prior periods
or may be adversely affected in periods in which the Company is undergoing a
product line transition in which production and sales of new products are
ramping up and in which existing products are under extreme price pressures due
to competitive factors. If new products are not brought to market in a timely
manner or do not address market needs or performance requirements, then the
Company's operating results will be adversely affected. As a result of the
foregoing, the Company's operating results and stock price may be subject to
significant volatility, particularly on a quarterly basis. 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.

NET SALES

The Company's net sales to date have been generated from the sale of its
graphics and multimedia accelerators. The Company's products are used in, and
its business is dependent on, the personal computer

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25

industry with sales primarily in the U.S., Asia, and Europe. Net sales were
$436.4 million in 1997, a 1% decrease below the $439.2 million in 1996. Net
sales for 1997 consisted primarily of the Company's ViRGE and Trio families of
integrated accelerators. The fluctuation in sales from 1996 to 1997 was a result
of declining unit average selling prices due to aggressive pricing from certain
of the Company's competitors as well as the sale of older generation products,
offset by the increase in unit shipments. 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.

Net sales were $439.2 million in 1996, a 39% increase above the $316.3
million in 1995. Net sales increased in 1996 primarily as a result of the
addition of the ViRGE product line and strong demand for the Company's 64-bit
Trio products that resulted in increased unit shipments. The increased sales of
the ViRGE and Trio family of accelerators was partially offset by a decrease in
the 64-bit Vision family of accelerators, which has decreased significantly as
the Company transitioned to sales of its ViRGE family of 2D/3D accelerators.

The pricing environment for graphics accelerators has recently experienced
and is expected to continue to experience increasing pricing pressures due in
part to aggressive pricing from certain of the Company's competitors as well as
the sale of older generation products. In particular, the Company's Trio family
of integrated 2D accelerators experienced significant decreases in average
selling prices in 1997. The graphics accelerator market is transitioning from 2D
acceleration to 3D acceleration, and the Company has introduced its ViRGE family
of 2D/3D accelerators in response to this transition. As a result of the entry
of competitors into the 3D acceleration market, the Company has experienced and
anticipates that it may continue to experience increased pricing pressures on
average selling prices for the ViRGE family of 2D/3D accelerators. If the
Company is unable to introduce and successfully market higher performance
products, if the Company's products do not achieve market acceptance, or if the
pricing pressures increase above normal anticipated levels, the Company's
operating results could be adversely affected.

Export sales accounted for 70%, 58%, and 44% of net sales in 1997, 1996,
and 1995 respectively. Approximately 28% of export sales in 1997 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 sales transactions are denominated in U.S. dollars.

Three customers accounted for 20%, 13% and 12% of net sales in 1997. Two
customers accounted for 16% and 15% of net sales in 1996. Two customers
accounted for 17% and 12% of net sales in 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
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
Company's largest customer in 1997 was the Company's largest Asian distributor,
and a substantial percentage of the Company's 1997 net sales were made through
distributors.

The occurrence of any supply problems for the Company's products may
adversely affect the rate of growth in net sales. Net sales may also be
adversely affected by delays in the production ramp of customers' new programs
and systems which incorporate the Company's products. In addition, the Company
generally 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.

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26

GROSS MARGIN

Gross margin percentage was 38%, 39% and 40% in 1997, 1996 and 1995,
respectively. The gross margin in 1997 was impacted by decreases in overall
average selling prices of the 64-bit Trio family and ViRGE family of
accelerators, which resulted in part from the increased proportion of the
Company's export sales to Asian customers and the substantial price competition
experienced in the Asian market. In addition, the Company does not currently
offer products addressing the high performance 3D acceleration market, which
adversely affects the Company's gross margin. These factors were offset in part
by the profitability of the USC joint venture, and the decrease in unit average
costs resulting from the Company's foundries' conversion to 8-inch .35 micron
technology. The Company's proportionate share of USC's net income was $31.0
million in 1997.

The gross margin in 1996 was impacted by decreases in overall average
selling prices of the 64-bit Trio family and ViRGE family of accelerators,
offset by the decrease in the unit average costs resulting from the Company's
foundries' conversion to 8-inch wafers and 0.45 micron technology and changes in
the pricing strategies from independent foundries for finished goods inventory
due to the alleviation of supply constraints in 1996 and shift in product mix
from the Vision products to the 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, the profitability of
the USC joint venture (the Company recognizes its proportionate share of USC
profits and losses), the extent to which the Company forfeits or utilizes it
production capacity rights with TSMC, the extent to which the Company will incur
additional licensing fees and shifts in sales mix between add-in card and
motherboard manufacturers and systems OEMs.

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 its products are 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. The Company's
customers' ability to reschedule or cancel orders without significant penalty
could adversely affect the Company's operating results, as the Company may be
unable to adjust its purchases from its independent foundries to match such
customers' changes and cancellations. To the extent the Company produces excess
or insufficient inventories of particular products, the Company's operating
results could be adversely affected.

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. Research and development expenses were $95.8 million in
1997, $63.4 million in 1996 and $42.1 million in 1995. In the fourth quarter of
1997, the Company wrote-off approximately $17.2 million of intangible assets,
including certain licenses, patents and other technology, as a result of
management's decision to focus attention on the core graphics business. As a
result of this decision, no future cash flows were expected related to these
assets. In addition, research and development spending increases reflect
additions to the Company's engineering staff and initial product verification
and nonrecurring engineering expenses related to the introduction of new
products, including product development for the desktop, mobile and home PC
markets.

Products in the Company's market typically have a life cycle of 12 to 18
months. 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 motherboard and add-in card
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 the market in a timely manner successful new products, that products or
technologies developed by others will not render the Company's products
noncompetitive, or that the Company's products will be selected for design into
its customers' products. In addition, it is possible that the Company's products
may be found defective after the Company has already shipped significant volume
production. There can be no assurance that the

26
27

Company would be able to successfully correct such problems or that such
corrections would be acceptable to customers. The occurrence of any such events
would have a material adverse effect on the Company's operating results.

SELLING, MARKETING AND ADMINISTRATIVE EXPENSES

Selling, marketing and administrative expenses were $55.9 million in 1997,
$48.8 million in 1996 and $33.5 million in 1995. Selling and marketing costs
have increased from year to year as a result of additional personnel, increased
commissions and increased marketing costs associated with the introduction of
new products. Administrative costs have increased due to the hiring of
additional personnel necessary to support the increased level of operations.

OTHER INCOME (EXPENSE), NET

Other income (expense), net, decreased in 1997 to $2.1 million of expense
in 1997 from $2.2 million of income in 1996. The decrease is attributable to the
interest expense incurred on $103.5 million aggregate principal amount of
convertible subordinated notes, which were issued by the Company in September
1996, as well as lower average amounts of cash and short-term investments, which
resulted in a decrease in interest income. Other income, net, decreased in 1996
to $2.2 million from $4.5 million in 1995. The decrease is attributable to the
interest expense incurred on $103.5 million aggregate principal amount of
convertible subordinated notes, which were issued by the Company in September
1996.

INCOME TAXES

The Company's effective income tax rate was 28% in 1997, 34% in 1996 and
36% in 1995. The 1997 tax rate was lower due to an increased income tax benefit
from research and development credits and as a result of lower pre-tax profits.
The 1996 tax rate was lower due to an increase in tax credits as a result of the
increase in research and development expenses in absolute dollars.

LIQUIDITY AND CAPITAL RESOURCES

Cash and equivalents and short-term investments decreased in 1997 by $39.7
million to $117.7 million from $157.4 million at the end of 1996. The Company
used $21.1 million for operating activities and used $4.2 million for investing
activities in 1997. In addition, the Company generated $21.1 million of cash
from financing activities.

Cash used for operating activities was $21.1 million in 1997, as compared
to cash provided by operating activities of $34.2 million in 1996. The decrease
in 1997 was due to lower net income, an increase in inventories, prepaid
expenses and other, and a decrease in accounts payable, partially offset by a
decrease in accounts receivable. The increase in inventory was due to the
Company's effort to reduce the amount of inventory in the channel resulting in
increased inventory on hand at December 31, 1997. The decrease in accounts
receivable was a result of lower sales in the fourth quarter of 1997 as compared
to the fourth quarter of 1996.

Cash provided by operating activities was $34.2 million in 1996, an
increase of $14.2 million from $20.0 million in 1995. The increase was due to
higher net income, lower accounts receivable, and income taxes payable,
partially offset by an increase in inventory and prepaid expenses and other and
a decrease in accounts payable. The decrease in accounts receivable is a result
of greater linearity in sales in the fourth quarter of 1996 compared to the
fourth quarter of 1995, in which a substantial proportion of shipments occurred
in the third month of that quarter as compared to the first two months of that
quarter. The increase in inventory is primarily due to higher levels of finished
goods to support increased levels of business. Cash provided by operating
activities for 1995 was $20.0 million primarily due to an increase in net income
and to working capital management in 1995 as compared to 1994. The Company
experienced an increase in inventory and accounts receivable due to a
substantial increase in net sales. These increases were partially offset by
increases in accounts payable and accrued liabilities. Continued expansion of
the Company's business is likely to require higher levels of accounts receivable
and inventory.

27
28

Investing activities for the years ended December 31, 1997, 1996, and 1995
reflected property and equipment purchases, purchases, sales and maturities of
short-term investments, and a 1997 technology investment. Continued expansion of
the Company's business may require higher levels of capital equipment purchases,
foundry investments and other payments to secure manufacturing capacity.

Financing activities provided cash of $21.1 million, $111.6 million, and
$96.0 million for 1997, 1996, and 1995, respectively. The increase in 1997 was
primarily the result of sales of common stock pursuant to employee stock option
and stock purchase plans and borrowings on notes payable. The increase in 1996
primarily reflects the offering of $103.5 million aggregate principal amount of
convertible subordinated notes completed in September 1996. Net proceeds from
the sale of the notes were approximately $100.1 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 5,385,015 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. The 1995 amount primarily reflects the net
proceeds of the follow-on common stock offering completed in May 1995.

In 1995, the Company entered into two long-term manufacturing capacity
arrangements. The Company entered into an agreement with UMC and Alliance
Semiconductor Corporation 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, Republic of China. The
Company invested $53.0 million in 1996 and $36.4 million in 1995 for its 23.75%
equity interest. In January 1998, the Company reduced its equity interest to
15.75% through the sale of a portion of its USC shares, and received
approximately $68.0 million in cash. Under the terms of the agreement, if at any
time a "Liquidity Event" occurs, S3 will be entitled to receive, in addition to
the initial payment of 2.4 billion New Taiwan dollars, a contingent payment of
up to 19 New Taiwan dollars per share, or up to an additional 1.5 billion New
Taiwan dollars (approximately U.S. $46.0 million at exchange rates prevailing on
December 31, 1997). A "Liquidity Event" is defined as any event by which UMC, or
its successor, will have the opportunity to receive value from transfer of its
ownership of shares of stock in USC in an arms-length transaction other than by
way of transfer to employees for incentives, whether or not UMC or its
successor, in fact, participates in such opportunity. A Liquidity Event will
include, for example, completion of a public offering of USC securities on a
recognized securities exchange; a sale of USC stock owned by UMC (or by a UMC
successor) in an arms-length transaction; or a sale of all or substantially all
of the assets of USC. The facility commenced production utilizing advanced
submicron semiconductor manufacturing processes in late 1996. The Company has
the right to purchase up to 31.25% of the output from the foundry. In addition,
the Company expanded and formalized its relationship with 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, which total $14.4 million as of December 31, 1997,
over the term of the agreement. The Company paid $9.6 million in 1997 and $7.2
million in 1996. See Notes 1, 8, 10 and 16 of Notes to Consolidated Financial
Statements.

Working capital at December 31, 1997 and December 31, 1996 was $210.0
million and $225.6 million, respectively. At December 31, 1997 the Company's
principal sources of liquidity included cash and equivalents of $90.5 million
and $27.2 million in short-term investments. In addition, the Company has a
$75.0 million unsecured revolving line of credit that expires September 26,
1999. The Company had $10.0 million outstanding under the line of credit as of
December 31, 1997. The Company was not in compliance with one financial covenant
at December 31, 1997. Accordingly, the bank is not required to fund requested
borrowing. Subsequent to year-end, the lender waived non-compliance with the
violated debt covenant for the period ended December 31, 1997. The Company
believes it will not be in compliance with this covenant for the current quarter
but does not expect current non-compliance to materially affect the Company's
liquidity or financial condition. In addition, the Company has available two
separate secured equipment lines of credit totaling $10.0 million. The Company
had $5.6 million and $6.5 million outstanding under these secured equipment
lines of credit at December 31, 1997 and 1996, respectively. The Company

28
29

must maintain certain financial covenants in connection with these lines of
credit. See Note 8 of Notes to Consolidated Financial Statements. The Company
believes that its available funds will satisfy the Company's projected working
capital and capital expenditure requirements for at least the next 12 months,
other than expenditures for future potential manufacturing agreements.

In January 1998, the Company agreed to a patent purchase and
cross-licensing deal with Cirrus Logic, Inc. to enable a patent portfolio
exchange between the two companies. Through this patent purchase, S3 purchased
10 graphics patents and 25 graphics patent applications from Cirrus Logic for a
price of $40 million. With respect to Cirrus Logic's remaining patents not
covered in the purchase, and S3's patents, S3 and Cirrus Logic have entered into
an accompanying cross-licensing agreement. Under the terms of the
cross-licensing agreement, S3 and Cirrus Logic have a perpetual license to each
other's graphics patents and additional licenses with respect to the other
party's patents for agreed upon periods of time. The closing of both the patent
purchase and cross-licensing agreement occurred in March 1998.

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, advances or
issuances of equity securities to wafer manufacturing companies in exchange for
guaranteed production, or the formation of joint ventures to own and operate or
construct wafer fabrication facilities. Manufacturing arrangements such as these
may require substantial capital investments, which may require the Company to
seek additional equity or debt financing. There can be no assurance that such
additional financing, if required, will be available when needed or, if
available, will be on satisfactory terms. In addition, the Company may, from
time to time, as business conditions warrant, invest in or acquire businesses,
technology or products that complement the business of the Company.

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, there is a risk that the Company
will forecast incorrectly and produce excess or insufficient inventories of
particular products because the Company's products are volatile and subject to
rapid technological and price changes. 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 produces excess or
insufficient inventories of particular products, the Company's operating results
could be adversely affected.

In October 1995, Brooktree filed a complaint against the Company in the
United States District Court for the Southern District of California, alleging
that certain of the Company's current products infringed 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 related to certain product revenues over a five-year period.

29
30

fiduciary duties by such individual defendants. The Company has not yet formally
responded to these complaints. While management intends to defend the actions
against the Company vigorously, there can be no assurance that an adverse result
or settlement with regards to these lawsuits would not have a material adverse
effect on the Company's financial condition or results of operations.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

Disclosures under this item are not required for the current year.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS OF S3 INCORPORATED

PAGE(S)
-------

Independent Auditors' Report................................ 31
Consolidated Statements of Income for the years ended
December 31, 1997, 1996, and 1995......................... 32
Consolidated Balance Sheets as of December 31, 1997 and
1996...................................................... 33
Consolidated Statements of Stockholders' Equity for the
years ended December 31, 1997, 1996, and 1995............. 34
Consolidated Statements of Cash Flows for the years ended
December 31, 1997, 1996, and 1995......................... 35
Notes to Consolidated Financial Statements.................. 36
Selected Quarterly Consolidated Financial Data
(Unaudited)............................................... 50

INDEX TO FINANCIAL STATEMENTS OF UNITED SEMICONDUCTOR CORPORATION

Report of Price Waterhouse LLP.............................. 57
United Semiconductor Corporation
Balance Sheet as of December 31, 1997 and 1996............ 58
United Semiconductor Corporation Statement of Income for the
Years Ended December 31, 1997 and 1996.................... 59
United Semiconductor Corporation Statement of Changes in
Stockholders' Equity for the Years Ended December 31, 1997
and 1996.................................................. 60
United Semiconductor Corporation Statement of Cash Flows for
the Years Ended December 31, 1997 and 1996................ 61
United Semiconductor Corporation Notes to Financial
Statements December 31, 1997 and 1996..................... 62

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31

INDEPENDENT AUDITORS' REPORT

Board of Directors and Stockholders
S3 Incorporated:

We have audited the accompanying consolidated balance sheets of S3
Incorporated and subsidiaries as of December 31, 1997 and 1996, and the related
consolidated statements of income, stockholders' equity and cash flows for each
of the three years in the period ended December 31, 1997. Our audits also
included the financial statement schedule at Item 14(a)(2). These financial
statements and financial statement schedule are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements and financial statement schedule based on our audits. We
did not audit the financial statements of United Semiconductor Corporation
("USC"), the Company's investment in which is accounted for by use of the equity
method. The Company's equity of $104,465,000 in USC's net assets at December 31,
1997, and of $30,962,000 in that company's net income for the year then ended
are included in the accompanying financial statements. The financial statements
of USC were audited by other auditors whose report has been furnished to us, and
our opinion, insofar as it relates to the amounts included for such company, is
based solely on the report of such other auditors.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits and the report of other auditors provide a reasonable
basis for our opinion.

In our opinion, based on our audits and the report of the other auditors,
such consolidated financial statements present fairly, in all material respects,
the financial position of S3 Incorporated and subsidiaries at December 31, 1997
and 1996, and the results of their operations and their cash flows for each of
the three years in the period ended December 31, 1997 in conformity with
generally accepted accounting principles. Also, in our opinion, the financial
statement schedule, when considered in relation to the basic consolidated
financial statements taken as a whole, presents fairly in all material respects
the information set forth therein.

DELOITTE & TOUCHE LLP

San Jose, California
January 23, 1998

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32

S3 INCORPORATED

CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

YEAR ENDED DECEMBER 31,
--------------------------------
1997 1996 1995
-------- -------- --------

Net sales.................................................. $436,359 $439,243 $316,309
Cost of sales.............................................. 270,223 266,367 189,767
-------- -------- --------
Gross margin............................................... 166,136 172,876 126,542
Operating expenses:
Research and development................................. 95,792 63,382 42,080
Selling, marketing and administrative.................... 55,879 48,800 33,510
-------- -------- --------
Total operating expenses......................... 151,671 112,182 75,590
-------- -------- --------
Income from operations..................................... 14,465 60,694 50,952
Interest income.......................................... 5,295 4,328 4,481
Interest expense......................................... (6,477) (1,971) --
Other income (expense)................................... (952) (128) 8
-------- -------- --------
Other income (expense), net................................ (2,134) 2,229 4,489
-------- -------- --------
Income before income taxes................................. 12,331 62,923 55,441
Provision for income taxes................................. 3,453 21,335 20,067
-------- -------- --------
Net income................................................. $ 8,878 $ 41,588 $ 35,374
======== ======== ========
Per share amounts:
Basic.................................................... $ 0.18 $ 0.88 $ 0.83
Diluted.................................................. $ 0.17 $ 0.81 $ 0.75
Shares used in computing per share amounts:
Basic.................................................... 49,519 47,460 42,691
Diluted.................................................. 51,740 52,451 47,013

See accompanying notes to consolidated financial statements.

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33

S3 INCORPORATED

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARES AND PER SHARE DATA)

ASSETS

DECEMBER 31,
--------------------
1997 1996
-------- --------

Current assets:
Cash and equivalents...................................... $ 90,484 $ 94,616
Short-term investments.................................... 27,186 62,768
Accounts receivable (net of allowances of $5,664 in 1997
and
$2,648 in 1996)........................................ 60,713 76,120
Inventories............................................... 71,882 53,466
Prepaid expenses and other................................ 51,172 39,079
-------- --------
Total current assets.............................. 301,437 326,049
Property and equipment -- net............................... 46,628 34,047
Production capacity rights.................................. 4,800 14,400
Investment in joint venture................................. 104,465 93,430
Other assets................................................ 35,524 17,246
-------- --------
Total............................................. $492,854 $485,172
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable.......................................... $ 42,819 $ 51,160
Notes payable............................................. 26,717 17,802
Accrued liabilities....................................... 10,987 12,063
Deferred revenue.......................................... 10,921 12,113
Income taxes payable...................................... -- 7,361
-------- --------
Total current liabilities......................... 91,444 100,499
Notes payable............................................... 4,800 14,400
Other liabilities........................................... 22,270 6,452
Convertible subordinated notes.............................. 103,500 103,500
Commitments and contingencies (Notes 10 and 14)
Stockholders' equity:
Preferred stock, $.0001 par value; 5,000,000 shares
authorized;
none outstanding....................................... -- --
Common stock, $.0001 par value; 70,000,000 shares
authorized; 50,549,279, and 48,331,794, shares
outstanding in 1997 and 1996........................... 187,276 169,411
Unrealized gain (loss) on investments..................... 3,666 (54)
Accumulated translation adjustment........................ (19,944) --
Retained earnings......................................... 99,842 90,964
-------- --------
Total stockholders' equity........................ 270,840 260,321
-------- --------
Total............................................. $492,854 $485,172
======== ========

See accompanying notes to consolidated financial statements.

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34

S3 INCORPORATED

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(IN THOUSANDS, EXCEPT SHARES)

UNREALIZED
COMMON STOCK GAIN (LOSS) ON
--------------------- SHORT-TERM TRANSLATION RETAINED
SHARES AMOUNT INVESTMENTS ADJUSTMENT EARNINGS TOTAL
---------- -------- -------------- ----------- --------- --------

BALANCE AT JANUARY 1, 1995.......... 36,456,674 $ 54,905 $ (29) $ -- $14,002 $ 68,878
Issuance of common stock, net of
issuance costs of $599......... 7,850,000 89,833 -- -- -- 89,833
Exercise of stock options......... 2,330,911 2,969 -- -- -- 2,969
Employee stock purchase plan...... 159,742 1,222 -- -- -- 1,222
Tax benefit of stock option
transactions................... -- 7,508 -- -- -- 7,508
Stock option compensation......... -- 37 -- -- -- 37
Unrealized gain on investments.... -- -- 43 -- -- 43
Net income........................ -- -- -- -- 35,374 35,374
---------- -------- ------ -------- ------- --------
BALANCE AT DECEMBER 31, 1995........ 46,797,327 156,474 14 -- 49,376 205,864
Exercise of stock options......... 1,204,235 4,550 -- -- -- 4,550
Employee stock purchase plan...... 231,161 2,467 -- -- -- 2,467
Tax benefit of stock option
transactions................... -- 4,725 -- -- -- 4,725
Stock compensation plan........... 99,071 1,195 -- -- -- 1,195
Unrealized loss on investments.... -- -- (68) -- -- (68)
Net income........................ -- -- -- -- 41,588 41,588
---------- -------- ------ -------- ------- --------
BALANCE AT DECEMBER 31, 1996........ 48,331,794 169,411 (54) -- 90,964 260,321
Exercise of stock options......... 1,703,768 8,796 -- -- -- 8,796
Employee stock purchase plan...... 414,646 3,180 -- -- -- 3,180
Tax benefit of stock option
transactions................... -- 3,825 -- -- -- 3,825
Stock compensation plan........... 99,071 2,064 -- -- -- 2,064
Unrealized gain on investments.... -- -- 3,720 -- -- 3,720
Accumulated translation
adjustment..................... -- -- -- (19,944) -- (19,944)
Net income........................ -- -- -- -- 8,878 8,878
---------- -------- ------ -------- ------- --------
BALANCE AT DECEMBER 31, 1997........ 50,549,279 $187,276 $3,666 $(19,944) $99,842 $270,840
========== ======== ====== ======== ======= ========

See accompanying notes to consolidated financial statements.

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35

S3 INCORPORATED

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

YEAR ENDED DECEMBER 31,
--------------------------------
1997 1996 1995
-------- --------- -------

OPERATING ACTIVITIES
Net income............................................... $ 8,878 $ 41,588 $35,374
Adjustments to reconcile net income to net cash provided
by (used for) operating activities:
Deferred income taxes................................. 5,432 (10,469) (3,334)
Depreciation and amortization......................... 18,491 10,713 6,789
Production capacity rights............................ (2,400) (7,200) --
Deferred rent......................................... (96) (138) 6
Stock compensation.................................... 2,064 1,195 37
Equity in income from joint venture................... (30,962) (3,999) --
Changes in assets and liabilities:
Accounts receivable................................. 15,407 8,090 (50,458)
Inventories......................................... (18,416) (10,173) (35,089)
Prepaid expenses and other.......................... (8,271) (6,975) (2,830)
Accounts payable.................................... (8,341) (10,921) 45,832
Accrued liabilities................................. 1,884 4,573 10,748
Deferred revenue.................................... (1,192) 12,079 21
Income taxes payable................................ (3,536) 5,810 12,891
-------- --------- -------
Net cash provided by (used for) operating activities..... (21,058) 34,173 19,987
-------- --------- -------
INVESTING ACTIVITIES
Property and equipment purchases, net.................... (28,085) (23,403) (17,601)
Purchases of short-term investments...................... (16,404) (74,798) (34,837)
Sales/maturities of short-term investments............... 55,705 36,592 19,050
Investment in real estate partnership.................... -- (2,100) --
Technology investment.................................... (5,000) -- --
Investment in joint venture.............................. -- (53,006) (36,425)
Other assets............................................. (10,412) (3,778) (2,681)
-------- --------- -------
Net cash used for investing activities................... (4,196) (120,493) (72,494)
-------- --------- -------
FINANCING ACTIVITIES
Sale of common stock, net................................ 11,976 7,017 94,024
Sale of convertible subordinated notes................... -- 103,500 --
Debt issuance costs...................................... -- (3,370) --
Net borrowings (repayments) of notes payable............. 10,000 (2,000) 2,000
Net borrowings (repayments) on equipment financing....... (854) 6,500 --
-------- --------- -------
Net cash provided by financing activities................ 21,122 111,647 96,024
-------- --------- -------
Net increase (decrease) in cash and equivalents.......... (4,132) 25,327 43,517
CASH AND EQUIVALENTS AT BEGINNING OF PERIOD................ 94,616 69,289 25,772
-------- --------- -------
CASH AND EQUIVALENTS AT END OF PERIOD...................... $ 90,484 $ 94,616 $69,289
======== ========= =======
SUPPLEMENTAL CASH FLOW INFORMATION
Interest paid............................................ $ 6,665 $ 231 --
Income taxes paid net of refunds......................... $ 10,119 $ 20,483 $ 9,105
SUPPLEMENTAL NONCASH INVESTING AND FINANCING ACTIVITIES
Notes payable for production capacity rights............. -- -- $31,200

See accompanying notes to consolidated financial statements.

35
36

S3 INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995

1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES

Organization

S3 Incorporated ("S3" or the "Company") was incorporated on January 9, 1989
and is a leading supplier of high performance multimedia accelerator solutions.
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
(see Note 13). Its products are manufactured, assembled and tested by
independent wafer foundries and contract manufacturers.

Basis of Presentation

The consolidated financial statements include the accounts of S3
Incorporated and its wholly-owned subsidiaries. All significant inter-company
balances and transactions have been eliminated. Investments in entities in which
the Company does not have control, but has the ability to exercise significant
influence over operating and financial policies are accounted for by the equity
method.

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Significant estimates include allowances for doubtful accounts
and customer returns, deferred tax assets, the useful lives of fixed assets and
intangible assets, inventory reserves and other reserves. Actual results could
differ from those estimates, and such differences may be material to the
financial statements.

Cash Equivalents

The Company considers all highly liquid debt investments purchased with a
remaining maturity of three months or less to be cash equivalents.

Short-Term Investments

Short-term investments represent debt securities which are stated at fair
value. The differences between amortized cost (cost adjusted for amortization of
premiums and accretion of discounts which are recognized as adjustments to
interest income) and fair value representing unrealized holding gains or losses
are recorded as a separate component of stockholders' equity until realized.
While the Company's intent is to hold debt securities to maturity, they are
classified as available-for-sale because the sale of such securities may be
required prior to maturity. Any gains and losses on the sale of debt securities
are determined on a specific identification basis.

Inventories

Inventories consist of work in process and finished goods and are stated at
the lower of cost (first-in, first-out) or market. The Company's products
typically experience short product life cycles and the Company estimates the
market value of its inventory based on anticipated selling prices adjusted for
completion and selling costs. Should the Company experience a substantial
unanticipated decline in the selling price of its products and/or demand
thereof, a material valuation adjustment and corresponding charge to operations
could result.

Required payments under a wafer supply agreement to secure future capacity
are capitalized and amortized to inventory costs as the related product is
received.

36
37
S3 INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995

Property and Equipment

Property and equipment are stated at cost. Depreciation is provided using
the straight-line method over estimated useful lives of three to five years.
Leasehold improvements are amortized using the straight-line method over the
shorter of the lease term or the assets' useful lives.

Long-Lived Assets

Effective January 1, 1996, the Company adopted Statement of Financial
Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." SFAS 121
requires recognition of impairment of long-lived assets in the event the net
book value of such assets exceeds the future undiscounted cash flows
attributable to such assets. The Company annually evaluates the recoverability
of its long-lived assets based on the estimated future undiscounted cash flows.
In the quarter ended December 31, 1997, the Company wrote off approximately
$17.2 million of intangible assets including certain licenses, patents and other
technology as a result of management's decision to focus attention on the core
graphics business. As a result of this decision, no future cash flows were
expected related to these assets.

Wafer Fabrication Joint Venture

Preproduction costs incurred by the wafer fabrication joint venture (see
Note 4 and Note 10) during construction and equipping of the facility were
capitalized by the Company and are being amortized over 5 years.

Foreign Currency Translation

The assets and liabilities of the Company's subsidiaries and joint venture
are translated into U.S. dollars at current exchange rates and revenues and
expenses are translated at average monthly exchange rates. The resulting
translation adjustments are recorded in a separate component of stockholders'
equity. Total translation adjustments were $19.9 million as of December 31,
1997.

Revenue Recognition

Revenue from product sales made directly to customers is generally
recognized upon shipment. Accruals for estimated sales returns and allowances
are recorded at the time of sale. Certain of the Company's sales are made to
distributors under agreements allowing price protection and rights of return on
unsold products by the distributors. The Company defers recognition of revenue
on such sales until the product is sold by the distributors.

Concentration of Credit Risk

Financial instruments which potentially subject the Company to
concentrations of credit risk consist primarily of cash equivalents, short-term
investments, trade accounts receivable and foreign exchange contracts. The
Company invests only in high credit quality short-term debt instruments and
limits the amount of credit exposure to any one entity. A majority of the
Company's trade receivables is derived from sales to manufacturers in the
computer industry. The Company performs ongoing credit evaluations of its
customers' financial condition and limits the amount of credit extended when
deemed necessary but generally requires no collateral. The Company maintains
reserves for potential credit losses, and all such losses to date have been
within management's expectations.

37
38
S3 INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995

Fair Value of Financial Instruments

Financial instruments include cash equivalents and short-term investments
(see Note 2). Cash equivalents and short-term investments are stated at fair
market values based on quoted market prices. The fair value of the Company's
convertible subordinated notes approximated its carrying cost as of December 31,
1997. The Company maintains certain long-term investments, classified as
available-for-sale securities and included in other assets. The estimated fair
value of these investments was $8.6 million at December 31, 1997 based on quoted
market prices. See also Note 2, Short-term Investments. The difference between
the fair value and costs of these investments is recorded in the equity account
under unrealized gain on investments.

Research and Development Expenses

Research and development is expensed as incurred. To the extent research
and development costs include the development of computer software, the Company
believes that software development is an integral part of the semiconductor
design and expenses all such costs as incurred.

Income Taxes

The Company accounts for income taxes using the asset and liability
approach pursuant to SFAS No. 109, "Accounting for Income Taxes."

Stock-Based Compensation

The Company accounts for stock-based awards to employees using the
intrinsic value method in accordance with APB No. 25, "Accounting for Stock
Issued to Employees." The Company adopted the disclosure requirements of SFAS
No. 123, "Accounting for Stock-Based Compensation" (SFAS 123), which require the
disclosure of pro forma net income and earnings per share as if the Company
adopted the fair value-based method in measuring compensation expense as of the
beginning of fiscal 1995.

Earnings Per Share

In February 1997 the Financial Accounting Standards Board issued Statement
No. 128, "Earnings Per Share" (SFAS No. 128) which establishes standards for
computing and presenting earnings per share (EPS). SFAS No. 128 replaces the
presentation of primary and fully diluted EPS with a presentation of basic and
diluted EPS. Basic EPS is computed by dividing income available to common
shareholders by the weighted-average number of common shares outstanding for the
period. Diluted EPS reflects the potential dilution that would occur from any
instrument or options which could result in additional common shares being
issued. SFAS No. 128 was adopted for the Company's fiscal year 1997. All
prior-period EPS data presented has been restated to conform with SFAS No. 128.

New Accounting Pronouncements

In June 1997, the Financial Accounting Standards Board adopted Statements
of Financial Accounting Standards No. 130 "Reporting Comprehensive Income",
which requires that an enterprise report, by major components and as a single
total, the change in its net assets during the period from nonowner sources; and
No. 131 "Disclosures about Segments of an Enterprise and Related Information",
which establishes annual and interim reporting standards for an enterprise's
business segments and related disclosures about its products, services,
geographic areas, and major customers. Adoption of these statements will not
impact the Company's consolidated financial position, results of operations or
cash flows. Both statements are effective for fiscal years beginning after
December 15, 1997, with earlier application permitted.

38
39
S3 INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995

Reclassifications

Certain prior year amounts have been reclassified to conform to the current
year presentation. Such reclassifications had no effect on net income or
stockholders' equity.

2. SHORT-TERM INVESTMENTS

The fair value and the amortized cost of available-for-sale securities at
December 31, 1997 and 1996 are presented in the tables which follow. Fair values
are based on quoted market prices obtained from an independent broker.
Available-for-sale securities are classified as current assets as all debt
maturities are within one year. Gross proceeds from sales of marketable
securities were $55,705,000 and $36,592,000 during 1997 and 1996, respectively.
Gross gains and losses realized on such sales or maturities were not material
for each of the two years. For the purpose of determining gross realized gains
and losses, the cost of securities sold is based upon specific identification.
For each category of investment securities the table presents gross unrealized
holding gains and losses.

UNREALIZED UNREALIZED
AMORTIZED MARKET HOLDING HOLDING
COST VALUE GAINS LOSSES
--------- ------- ---------- ----------
(IN THOUSANDS)

DECEMBER 31, 1997:
Corporate Debt Securities.............................. $21,931 $21,954 $ 42 $(19)
Mortgage-Backed Securities............................. 3,197 3,197 -- --
Debt securities of states of the United States and
political subdivisions of the states................. 2,038 2,035 -- (3)
------- ------- ------ ----
Total short-term investments................. 27,166 27,186 42 (22)
------- ------- ------ ----
Corporate Equity Securities............................ 5,000 8,646 3,646 --
------- ------- ------ ----
Total short-term and long-term investments... $32,166 $35,832 $3,688 $(22)
======= ======= ====== ====

UNREALIZED UNREALIZED
AMORTIZED MARKET HOLDING HOLDING
COST VALUE GAINS LOSSES
--------- ------- ---------- ----------
(IN THOUSANDS)

DECEMBER 31, 1996:
Corporate Debt Securities.............................. $41,634 $41,582 $ 3 $ 55
U.S. Government Securities............................. 2,698 2,697 -- 1
Mortgage-Backed Securities............................. 14,269 14,272 4 1
Debt securities of states of the United States and
political subdivisions of the states................. 4,221 4,217 -- 4
------- ------- ------ ----
Total........................................ $62,822 $62,768 $ 7 $ 61
======= ======= ====== ====

3. INVENTORIES

Inventories consist of:

DECEMBER 31,
------------------
1997 1996
------- -------
(IN THOUSANDS)

Work in process.................................. $28,392 $22,556
Finished goods................................... 43,490 30,910
------- -------
Total.................................. $71,882 $53,466
======= =======

39
40
S3 INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995

4. INVESTMENTS

Investment in USC

The Company has a 23.75% equity investment in the stock of United
Semiconductor Corporation ("USC"), a joint venture foundry which owns and
operates a semiconductor manufacturing facility in Taiwan. See also Note 16,
Subsequent Events. Operations in 1995 consisted primarily of construction and
other capitalizable preproduction activities, and, therefore, the 1995 results
of operations for the entity were immaterial. Summarized financial information
below uses the respective year-end exchange rate for the financial position and
an average exchange rate for the respective year for results of operations.
Summarized financial information of USC at December 31, 1997 and 1996 is as
follows (in thousands):

YEAR ENDED DECEMBER 31,
-----------------------------
1997 1996
------------- ------------

RESULTS OF OPERATIONS
Sales.......................................... U.S. $328,966 U.S. $60,656
Net income..................................... 136,969 577

DECEMBER 31,
------------------------------
1997 1996
------------- -------------

FINANCIAL POSITION
Current Assets................................ U.S. $349,419 U.S. $224,829
Non-current Assets............................ 370,394 387,775
Current Liabilities........................... 127,873 89,322
Non-current Liabilities....................... 159,644 157,482
Stockholders' Equity.......................... 432,296 365,800

Interest in Partnership

In 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. The Company's investment of $2.1 million represents 50%
interest in Mission Real Estate L.P. (the partnership), in which the Company is
a limited partner. Permanent nonrecourse financing has been obtained. The
Company is not a guarantor on the permanent financing.

5. PROPERTY AND EQUIPMENT

Property and equipment consist of:

DECEMBER 31,
--------------------
1997 1996
-------- --------
(IN THOUSANDS)

Machinery and equipment................................ $ 71,340 $ 52,019
Furniture and fixtures................................. 5,460 2,690
Leasehold improvements................................. 3,688 478
-------- --------
Total............................................. 80,488 55,187
Accumulated depreciation and amortization.............. (33,860) (21,140)
-------- --------
Property and equipment, net............................ $ 46,628 $ 34,047
======== ========

40
41
S3 INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995

6. ACCRUED LIABILITIES

Accrued liabilities consist of:

DECEMBER 31,
-----------------
1997 1996
------- -------
(IN THOUSANDS)

Accrued compensation and benefits.......................... $ 8,888 $10,462
Other...................................................... 2,099 1,601
------- -------
$10,987 $12,063
======= =======

7. CONVERTIBLE SUBORDINATED NOTES

In September 1996, the Company completed a private placement of $103.5
million aggregate principal amount of convertible subordinated notes. 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 5,385,015 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 approximately
$3.4 million are included in other assets and are amortized on a straight-line
basis over the term of the notes.

8. LINE OF CREDIT AND NOTES PAYABLE

The Company has a $75.0 million unsecured revolving line of credit that
expires September 26, 1999. The Company had $10.0 million outstanding under the
line of credit at December 31, 1997. Borrowings bear interest at the bank's
prime rate (8.5% at December 31, 1997). The most restrictive covenants under the
agreement require the Company, among other things, to maintain a minimum
tangible net worth of $270 million, a minimum quick ratio of 1.5 to 1.0, maximum
debt to tangible net worth of 0.9 to 1.0 and profitability computed on the most
recent four quarters. The Company was not in compliance with one financial
covenant at December 31, 1997. Accordingly, the bank is not required to fund
requested borrowings. Subsequent to year-end, the lender waived non-compliance
with the violated debt covenant for the period ended December 31, 1997.
Management does not expect current non-compliance to materially affect the
Company's liquidity or financial condition.

In addition, the Company has two separate secured equipment lines of credit
totaling $10.0 million. The Company had $5.6 million outstanding under these
secured equipment lines of credit at December 31, 1997. Borrowings bear interest
at the prime rate (8.5% at December 31, 1997) and the Company is required to
comply with the same financial covenants as its unsecured line of credit.

In connection with a wafer supply agreement, the Company issued notes
payable to a supplier (see Note 10). The notes bear interest at 10.0% per annum
commencing on the individual notes' maturity dates if such notes are not paid.
Future payments of these notes are as follows (in thousands):

1998....................................................... $ 9,600
1999....................................................... 4,800
-------
$14,400
=======

41
42
S3 INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995

9. STOCKHOLDERS' EQUITY

The number of shares of preferred stock authorized to be issued is
5,000,000 with a par of $0.0001 per share. The preferred stock may be issued
from time to time in one or more series. The Board of Directors is authorized to
provide rights, preferences, privileges and restrictions of the shares of such
series. As of December 31, 1997, no shares of preferred stock had been issued.

Stockholder Rights Plan

On May 14, 1997, the Board adopted a Stockholder Rights Plan. To implement
the plan, S3's Board declared a dividend of one preferred stock purchase right
(a "Right") for each outstanding share of S3 common stock held of record on June
1, 1997. Each Right represents a contingent right to purchase, under certain
circumstances, a fractional share of a newly created series of S3 preferred
stock. The Rights would become exercisable and trade independently from S3
common stock upon the public announcement of the acquisition by a person or
group of 15 percent or more of S3's common stock, or ten days after commencement
of a tender or exchange offer for S3 common stock that would result in the
acquisition of 15 percent or more of S3's common stock. In the event one of the
limited conditions is triggered, each Right entitles the registered holder to
purchase one one-thousandth of a share of Preferred Stock at an exercise price
of $85 per right. The Rights may be redeemed at $0.01 per Right pursuant to the
plan by the Board of Directors. The Rights expire May 14, 2007.

Employee Stock Purchase Plan

Under the Company's 1993 Employee Stock Purchase Plan (the "Purchase Plan")
1,400,000 shares of common stock are reserved for issuance pursuant thereto. The
Purchase Plan permits eligible employees to purchase shares at a price equal to
85% of the lower of the fair market value at the beginning or end of the
offering period. At December 31, 1997, 1,011,823 shares have been issued under
the Purchase Plan and 388,177 shares have been reserved for further issuance.

Stock Plan

Under the Company's stock option plan (the "Option Plan") at December 31,
1997, 20,110,840 shares of common stock have been authorized for the grant of
incentive or nonstatutory stock options and the direct award or sale of shares
to employees, directors and consultants. Incentive stock options must be granted
at not less than fair market value at the date of grant. The exercise price of
nonstatutory options and the share price for shares sold generally may be no
less than 85% of fair market value at the date of the grant or sale. At December
31, 1997, 10,981,264 shares of common stock are reserved for issuance under the
Option Plan and 929,424 shares were available for future grant.

42
43
S3 INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995

A summary of stock option activity is as follows:

NUMBER OF WEIGHTED AVERAGE
SHARES PRICE PER SHARE
---------- ----------------

BALANCE, JANUARY 1, 1995........................ 6,808,754 $ 2.75
Options granted................................. 2,970,550 15.47
Options exercised............................... (2,330,911) 1.27
Options cancelled............................... (463,454) 6.61
----------
BALANCE, DECEMBER 31, 1995...................... 6,984,939 8.37
Options granted................................. 6,538,362 12.09
Options exercised............................... (1,204,235) 3.83
Options cancelled............................... (3,398,967) 15.28
----------
BALANCE, DECEMBER 31, 1996...................... 8,920,099 9.06
Options granted................................. 11,950,388 7.77
Options exercised............................... (1,703,768) 5.16
Options cancelled............................... (9,114,879) 11.17
----------
BALANCE, DECEMBER 31, 1997...................... 10,051,840 $ 6.28
==========

Options to purchase 2,284,502, 2,267,969 and 2,030,259 shares were
exercisable at December 31, 1997, 1996 and 1995 with a weighted average exercise
price of $7.16, $4.29 and $3.51 respectively.

Options generally vest over a period of four years and generally become
exercisable beginning either six months or one year from the date of employment
or grant. Options generally expire ten years from the date of grant. The Company
repriced options on 6,520,033 shares to $5.125, the fair market value on
December 18, 1997. The repriced options are treated as cancelled and regranted,
however, they retained their original vesting terms and expiration dates. All
replacement options are subject to a one-year blackout on exercise (with the
exception of those options held by employees whose employment was terminated on
January 20, 1998 as part of the restructuring program announced by the Company).
With regard to other employees whose employment was not terminated as part of
the restructuring, if their employment is terminated prior to the end of the
blackout period, any repriced options will be forfeited.

Stock Compensation Arrangement

Pursuant to an incentive compensation plan for certain employees, the
Company issued 99,071 shares of common stock on June 30, 1997 and on June 30,
1996. The Company accrued the related compensation cost ratably over the
periods.

Stock-Based Compensation

Under APB 25, the Company generally recognizes no compensation expense with
respect to stock-based awards to employees. Pro forma information regarding net
income (loss) and net income (loss) per share is required by SFAS 123 for awards
granted after December 31, 1994, as if the Company had accounted for its
stock-based awards to employees under the fair value method of SFAS 123. The
fair value method of the Company's stock-based awards to employees was estimated
using the Black-Scholes option pricing model. The Black-Scholes option valuation
model was developed for use in estimating fair value of traded options that have
no vesting restrictions and are fully transferable. The Black-Scholes model
requires the input of highly subjective assumptions including the expected stock
price volatility. Because the Company's stock-based awards to employees have
characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in management's

43
44
S3 INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995

opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its stock-based awards to employees.

The following table summarizes significant ranges of outstanding and
exercisable options at December 31, 1997:

OPTIONS OUTSTANDING
------------------------------------ OPTIONS EXERCISABLE
WEIGHTED ----------------------
AVERAGE WEIGHTED WEIGHTED
REMAINING AVERAGE AVERAGE
RANGE OF NUMBER CONTRACTUAL EXERCISE NUMBER EXERCISE
EXERCISE PRICES OUTSTANDING LIFE (YRS) PRICE EXERCISABLE PRICE
- --------------- ----------- ----------- -------- ----------- --------

$ 0.12 - $ 4.03 1,019,752 5.75 $ 3.04 914,743 $ 2.95
4.13 - 5.13 6,643,951 8.96 5.11 177,081 4.79
5.16 - 10.00 674,508 7.79 7.37 363,089 7.30
10.06 - 10.06 765,792 8.03 10.06 451,972 10.06
10.13 - 23.00 947,837 7.83 14.14 377,617 14.87
---------- ---------
$ 0.12 - $23.00 10,051,840 8.38 $ 6.28 2,284,502 $ 7.16
========== =========

The fair value of the Company's stock-based awards to employees was
estimated assuming no expected dividends and the following weighted-average
assumptions:

STOCK EMPLOYEE STOCK
OPTION PLAN PURCHASE PLAN
-------------------------------- --------------------------------
1997 1996 1995 1997 1996 1995
---- ---- ---- ---- ---- ----

Expected life from vest
date................... 0.5 yrs. 0.5 yrs. 0.5 yrs. 0.0 yrs. 0.0 yrs. 0.0 yrs.
Volatility............... 69% 60% 60% 65% 60% 60%
Risk-free interest
rate................... 5.9% 6.1% 5.6% 5.5% 6.1% 5.6%

The weighted-average estimated fair value of stock options granted during
1997, 1996 and 1995 was $3.53, $4.97 and $6.65 per share, respectively. The
weighted-average estimated fair value of shares granted under the Purchase Plan
during 1997, 1996 and 1995 was $5.17, $6.97 and $4.97 per share, respectively.

For pro forma purposes, the estimated fair value of the Company's
stock-based awards to employees is generally amortized over the vesting period
of four years (for options) and the offering period (for stock purchases under
the Purchase Plan). The Company's pro forma information is as follows:

YEAR ENDED DECEMBER 31,
--------------------------------
1997 1996 1995
-------- -------- --------
(IN THOUSANDS, EXCEPT PER SHARE
AMOUNTS)

Pro forma net income (loss)........................... $(7,575) $28,504 $30,333
Pro forma earnings (loss) per share:
Basic............................................... $ (0.15) $ 0.60 $ 0.71
Diluted............................................. $ (0.15) $ 0.56 $ 0.66

Because SFAS 123 is applicable only to awards granted subsequent to
December 31, 1994, its pro forma effect will not be fully reflected until
approximately 1999.

10. LEASES AND COMMITMENTS

Operating Leases

The Company leases administrative facilities under operating leases that
expire in 2008. During 1995, the Company entered into a limited partnership
arrangement with a developer to obtain a ground lease and

44
45
S3 INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995

develop and operate the Company's Santa Clara, California facilities. In January
1997, prior to the expiration of the lease terms of the previous facilities, the
Company relocated its principal administrative facilities to the new Santa Clara
facilities at which time the Company's minimum operating lease payment of
$369,000 commenced for the initial 12 year term. The Company has sublet a
portion of its previous facilities for the remaining lease terms and has
negotiated a lease termination on the other two facilities at no material cost.

Future minimum annual payments under operating leases are as follows:

OPERATING LEASES
----------------
(IN THOUSANDS)

1998.................................................. $ 8,114
1999.................................................. 7,729
2000.................................................. 6,213
2001.................................................. 5,124
2002.................................................. 4,426
Thereafter............................................ 26,554
-------
Total minimum lease payments................ $58,160
=======

The total of minimal rentals to be received in the future under
non-cancelable subleases is $4,457,000 as of December 31, 1997.

Rent expense for 1997, 1996, and 1995, was $5,622,000, $3,483,000, and
$2,002,000, respectively.

Wafer Supply Agreements and Commitments

During 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 Corporation 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, Republic of China. The Company invested $36.4 million in 1995, and $53.0
in 1996 for its equity interest of 23.75%. See Subsequent Events, Note 16,
regarding the sale of approximately one-third of S3's interest in USC, which
reduced S3's equity interest to 15.75%. The facility commenced production
utilizing advanced submicron semiconductor manufacturing processes in 1996. The
Company has the right to purchase up to 31.25% of the output from the foundry.

In addition, in 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 (see Note 8). The Company paid
$9.6 million, $7.2 million and $1.2 million in 1997, 1996 and 1995,
respectively. At December 31, 1997, the remaining advance payments (and
corresponding promissory notes) totaled $14.4 million ($9.6 million in prepaid
expenses and $4.8 million in production capacity rights).

In the ordinary course of business, the Company places purchase 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.

45
46
S3 INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995

11. INCOME TAXES

The provision for income taxes consists of:

YEARS ENDED DECEMBER 31,
------------------------------
1997 1996 1995
------- -------- -------
(IN THOUSANDS)

CURRENT TAX EXPENSE:
Federal............................................ $(6,102) $ 27,838 $20,796
State.............................................. 4,123 3,966 2,605
------- -------- -------
(1,979) 31,804 23,401
------- -------- -------
DEFERRED TAX EXPENSE:
Federal............................................ 7,552 (9,322) (2,897)
State.............................................. (2,120) (1,147) (437)
------- -------- -------
5,432 (10,469) (3,334)
------- -------- -------
Total...................................... $ 3,453 $ 21,335 $20,067
======= ======== =======

The tax benefits resulting from disqualifying dispositions of shares
acquired under the Company's incentive stock option plan and from the exercise
of non-qualified stock options reduced taxes currently payable as shown by
$3,825,000 in 1997, which is reflected as additional paid-in capital.

The difference between the provision for taxes on income and the amount
computed by applying the federal statutory income tax rate to income before
taxes is explained below:

YEARS ENDED DECEMBER 31,
-----------------------------
1997 1996 1995
------- ------- -------
(IN THOUSANDS)

Tax computed at 35%................................... 4,316 $22,023 $19,404
State income taxes, net of federal effect............. 1,302 2,987 2,725
Tax credits........................................... (2,200) (3,396) (1,690)
Other................................................. 35 (279) (372)
------- ------- -------
Provision for income taxes............................ $ 3,453 $21,335 $20,067
======= ======= =======
Effective tax rate.................................... 28% 34% 36%
======= ======= =======

46
47
S3 INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995

Significant components of the Company's deferred income tax asset are as
follows:

DECEMBER 31,
------------
1997 1996
-------- -------
(IN THOUSANDS)

Deferred tax assets:
Reserves not currently deductible......................... $ 5,138 $ 6,955
Deferred revenue.......................................... 4,214 4,828
Compensation expense not currently deductible............. 3,762 3,823
Depreciation/Amortization................................. 4,021 --
Credits................................................... 5,307 --
Other..................................................... -- 266
-------- -------
Total deferred tax assets......................... 22,442 15,872
-------- -------
Deferred tax liabilities:
Earnings from foreign joint venture....................... (13,573) (1,594)
Other..................................................... (23) --
-------- -------
Total deferred tax liabilities.................... (13,596) (1,594)
-------- -------
Net deferred tax asset............................ $ 8,846 $14,278
======== =======

The Company has research and development tax credit carry-forwards for
federal and state of approximately $6.5 million, expiring in 2012.

12. EMPLOYEE BENEFIT PLANS

The Company implemented a non-qualified cash profit sharing plan in 1994
under which all employees are eligible to receive, on an annual basis, an equal
cash bonus based on pretax profits. The cash bonus under this plan was $0,
$1,987,000, and $1,175,000 in 1997, 1996, and 1995, respectively.

The Company has a 401(k) tax-deferred savings plan whereby all employees
meeting certain age and service requirements may contribute up to 20% of their
eligible compensation (up to a maximum allowed under IRS rules). Contributions
may be made by the Company at the discretion of the Board of Directors. No
contributions by the Company have been made to the plan since its inception.

13. EXPORT SALES AND SIGNIFICANT CUSTOMERS

The Company's primary operations are located in the United States. The
Company sells its products into the personal computer market primarily in the
U.S., Asia and Europe. Export sales accounted for 70%, 58% and 44% of net sales
in 1997, 1996, and 1995, respectively. Approximately 28%, 37% and 35% of export
sales in 1997, 1996, and 1995, respectively, were to affiliates of United States
customers. In 1997, 14% and 53% of export sales were shipped to Hong Kong and
Taiwan, respectively. In 1996, 16% and 45% of export sales were shipped to Hong
Kong and Taiwan, respectively. Three customers accounted for 20%, 13% and 12%,
respectively, of net sales in 1997. Two customers accounted for 16% and 15%
respectively, of net sales in 1996. Two customers accounted for 17% and 12%
respectively, of net sales in 1995.

14. CONTINGENCIES

47
48
S3 INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995

all such pending matters will not have a material adverse effect on the
Company's financial position or results of operations.

Since November 1997, a number of complaints have been filed in federal and
state courts seeking an unspecified amount of damages on behalf of an alleged
class of persons who purchased shares of the Company's common stock at various
times between April 17, 1996 and November 3, 1997. The complaints name as
defendants the Company, certain of its officers and former officers and certain
directors of the Company, asserting that they violated federal and state
securities laws by misrepresenting and failing to disclose certain information
about the Company's business. In addition, certain shareholders have filed
derivative actions seeking recovery on behalf of the Company, alleging, among
other things, breach of fiduciary duties by such individual defendants. The
Company has not yet formally responded to these complaints. While management
intends to defend the actions against the Company vigorously, there can be no
assurance that an adverse result or settlement with regards to these lawsuits
would not have a material adverse effect on the Company's financial condition or
results of operations.

15. EARNINGS PER SHARE

The following table sets forth the computation of basic and diluted
earnings per share:

YEARS ENDED DECEMBER 31,
----------------------------------------
1997 1996 1995
---------- ---------- ----------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

NUMERATOR
Net Income
Basic.......................................... $ 8,878 $41,588 $35,374
Interest expense on subordinated debt.......... -- 1,071 --
------- ------- -------
Diluted........................................ $ 8,878 $42,659 $35,374
======= ======= =======
DENOMINATOR
Denominator for basic earnings per share.......... $49,519 $47,460 $42,691
Common stock equivalents.......................... 2,221 3,469 4,322
Subordinated debt................................. 0 1,522 0
------- ------- -------
Denominator for diluted earnings per share........ $51,740 $52,451 $47,013
======= ======= =======
Basic earnings per share............................ $ 0.18 $ 0.88 $ 0.83
Diluted earnings per share.......................... $ 0.17 $ 0.81 $ 0.75

16. SUBSEQUENT EVENTS

On December 31, 1997, the Company entered into an agreement with UMC to
sell to UMC 80 million shares of stock of USC for a purchase price of 2.4
billion New Taiwan dollars. The Company received the purchase price
(approximately $68 million in cash) in January 1998 upon closing.

Under the terms of the agreement, if at any time a "Liquidity Event"
occurs, S3 will be entitled to receive, in addition to the initial payment of
2.4 billion New Taiwan dollars, a contingent payment of up to 19 New Taiwan
dollars per share, or up to an additional 1.5 billion New Taiwan dollars
(approximately U.S. $46.0 million at exchange rates prevailing on December 31,
1997). A "Liquidity Event" is defined as any event by which UMC, or its
successor, will have the opportunity to receive value from transfer of its
ownership

48
49
S3 INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995

of shares of stock in USC in an arms-length transaction other than by way of
transfer to employees for incentives, whether or not UMC or its successor, in
fact, participates in such opportunity. A Liquidity Event will include, for
example, completion of a public offering of USC securities on a recognized
securities exchange; a sale of USC stock owned by UMC (or by a UMC successor) in
an arms-length transaction; or a sale of all or substantially all of the assets
of USC.

USC is a foundry joint venture between S3, UMC and Alliance Semiconductor
Corporation that was formed in 1995. S3 paid 2.4 billion New Taiwan dollars for
its initial 23.75% equity interest in USC. As a result of the January 1998 sale
to UMC, S3's percentage ownership in USC decreased to 15.75%. The Company has
the right to purchase up to 31.25% of the output from the foundry.

In January 1998, the Company agreed to a patent purchase and
cross-licensing agreement with Cirrus Logic, Inc. to enable a patent portfolio
exchange between the two companies. Through this patent purchase, S3 purchased
10 graphics patents and 25 graphics patent applications from Cirrus Logic for a
price of $40 million. With respect to Cirrus Logic's remaining patents not
covered in the purchase, and S3's patents, S3 and Cirrus Logic have entered into
a cross-licensing agreement. Under the terms of the cross-licensing agreement,
S3 and Cirrus Logic have a perpetual license to each other's graphics patents
and additional licenses with respect to the other party's patents for agreed
upon periods of time.

49
50

SELECTED QUARTERLY CONSOLIDATED DATA (UNAUDITED)(1)

FOURTH THIRD SECOND FIRST
QUARTER QUARTER QUARTER QUARTER
-------- -------- ------- --------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

YEAR ENDED DECEMBER 31, 1997
Net sales........................................... $101,911 $119,604 $84,589 $130,255
Gross margin........................................ 38,727 40,813 31,961 54,635
Income (loss) from operations....................... (13,021) 6,993 (2,570) 23,063
Net income (loss)................................... $ (8,122) $ 4,384 $(1,766) $ 14,382
Earnings per share:(4)
Basic............................................. $ (0.16) $ 0.09 $ (0.04) $ 0.30
Diluted(3)........................................ $ (0.16) $ 0.08 $ (0.04) $ 0.27
Shares used in computing earnings per share:(4)
Basic............................................. 50,440 49,764 49,201 48,672
Diluted(3)........................................ 50,440 52,380 49,201 57,503
Stock prices:(2)
High................................................ $ 13.19 $ 17.44 $ 13.13 $ 18.88
Low................................................. $ 4.81 $ 10.56 $ 9.19 $ 12.44
YEAR ENDED DECEMBER 31, 1996
Net sales........................................... $127,916 $110,085 $99,122 $102,120
Gross margin........................................ 52,940 42,006 37,637 40,293
Income from operations.............................. 21,792 13,251 10,993 14,658
Net income.......................................... $ 14,569 $ 8,928 $ 7,712 $ 10,379
Earnings per share:(4)
Basic............................................. $ 0.30 $ 0.19 $ 0.16 $ 0.22
Diluted(3)........................................ $ 0.27 $ 0.17 $ 0.15 $ 0.21
Shares used in computing earnings per share:(4)
Basic............................................. 48,134 47,598 47,191 46,917
Diluted(3)........................................ 57,840 51,803 50,114 50,047
Stock prices:(2)
High................................................ $ 23.38 $ 20.00 $ 15.75 $ 17.63
Low................................................. $ 16.25 $ 10.06 $ 10.88 $ 11.88

- ---------------
(1) The preceding table presents selected unaudited consolidated financial
results for each of the eight quarters in the two-year period ended December
31, 1997. In the Company's opinion, this unaudited information has been
prepared on the same basis as the audited information and includes all
adjustments (consisting of only normal recurring adjustments) necessary for
a fair statement of the financial information for the period presented.

(2) The Company's common stock trades on the Nasdaq National Market under the
symbol SIII. The table indicates the range of the high and low closing
prices, as reported by Nasdaq.

(4) The 1997 and 1996 earnings per share amounts have been restated to comply
with Statement of Financial Accounting Standards No. 128, Earnings Per
Share. For further discussion of earnings per share and the impact of
Statement No. 128, see the Notes to Consolidated Financial Statements
beginning on page 36.

At December 31, 1997, there were approximately 614 stockholders of record
of the Company's common stock and approximately 40,000 beneficial stockholders.
The Company has never declared or paid cash

50
51

dividends on its capital stock and does not anticipate paying any cash dividends
in the foreseeable future. The Company currently intends to retain future
earnings for the development of its business.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.

Not applicable.

PART III

Certain information required by Part III is incorporated by reference from
the Company's definitive Proxy Statement to be filed with the Securities and
Exchange Commission in connection with the solicitation of proxies for the
Company's 1998 Annual Meeting of Stockholders (the "Proxy Statement").

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

The information required by this section is incorporated by reference from
the information in the section entitled "Election of Directors -- Nominees" in
the Proxy Statement. The required information concerning executive officers of
the Company is contained in the section entitled "Executive Officers of the
Registrant" in Part I of this Form 10-K.

Item 405 of Regulation S-K calls for disclosure of any known late filing or
failure by an insider to file a report required by Section 16 of the Exchange
Act. This disclosure is contained in the section entitled "Section 16(a)
Beneficial Ownership Reporting Compliance" in the Proxy Statement and is
incorporated herein by reference.

ITEM 11. EXECUTIVE COMPENSATION.

The information required by this section is incorporated by reference from
the information in the sections entitled "Election of Directors -- Directors'
Compensation" and "Executive Compensation" in the Proxy Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

The information required by this section is incorporated by reference from
the information in the section entitled "Security Ownership of Certain
Beneficial Owners and Management" in the Proxy Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

Not applicable.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.

(a) The following documents are filed as a part of this Form 10-K:

(1) Financial Statements:

Reference is made to the Index to Consolidated Financial Statements
of S3 Incorporated and the Index to Financial Statements of United
Semiconductor Corporation under Item 8 in Part II of this Form 10-K.

51
52

(2) Financial Statement Schedules:

The following financial statement schedule of S3 Incorporated for the
years ended December 31, 1997, 1996 and 1995 is filed as part of this
Report and should be read in conjunction with the Consolidated Financial
Statements of S3 Incorporated.

REFERENCE
PAGE
---------

Independent Auditors' Report on Financial Statement
Schedule................................................. 31
Schedule II -- Valuation and Qualifying Accounts........... 55

All other schedules are omitted because they are not applicable or the
required information is shown in the financial statements or notes thereto.

(3) Exhibits:

The exhibits listed below are required by Item 601 of Regulation S-K.
Each management contract or compensatory plan or arrangement required to be
filed as an exhibit to this Form 10-K has been identified.

EXHIBIT
NUMBER NOTES DESCRIPTION OF DOCUMENT
---------- ----- -----------------------

3(i).1 (1) Restated Certificate of Incorporation.
3(i).2 (6) Certificate of Amendment of Restated Certificate of
Incorporation.
3(i).3 (10) Certificate of Designation of Series A Participating
Preferred Stock.
3(ii) (10) Amended and Restated Bylaws.
4.1 (1) Specimen common stock certificate.
4.2 (8) Indenture, dated as of September 12, 1996 between Registrant
and State Street Bank and Trust Company of California, N.A.,
as Trustee, including the form of Note.
4.3 (9) Registration Rights Agreement, dated September 12, 1996,
among Registrant, Lehman Brothers Inc., PaineWebber
Incorporated and Cowen & Company.
4.4 (10) Rights Agreement dated as of May 14, 1997 between S3
Incorporated and The First National Bank of Boston, Rights
Agent.
10.1* 1989 Stock Plan of S3 Incorporated, as amended (the "1989
Plan").
10.2* (1) Form of Incentive Stock Option Agreement under the 1989
Plan.
10.3* (1) Form of Nonstatutory Stock Option Agreement under the 1989
Plan.
10.4* (1) Form of common stock Purchase Agreement under the 1989 Plan.
10.5* (2) S3 Incorporated 1993 Employee Stock Purchase Plan.
10.6 (1) Form of Indemnification Agreement between the Registrant and
its directors.
10.7 (3) Office Lease dated May 13, 1993, between the Registrant and
San Tomas No. 2 Limited Partnership.
10.8 (3) First Amendment of Office Lease dated September 9, 1993,
between the Registrant and San Tomas No. 2 Limited
Partnership.
10.9 (4) Office Lease dated March 30, 1994, between the Registrant
and San Tomas No. 1 Limited Partnership.
10.10 (4) Second Amendment of Office Lease dated March 30, 1994,
between the Registrant and San Tomas No. 2 Limited
Partnership.
10.11 (5) Foundry Venture Agreement among Registrant, Alliance
Semiconductor Corporation and United Microelectronics
Corporation dated as of July 8, 1995.

52
53

EXHIBIT
NUMBER NOTES DESCRIPTION OF DOCUMENT
---------- ----- -----------------------

10.12 (7) Lease between Mission Real Estate, L.P. and Registrant dated
November 29, 1995.
10.13 (11) Revolving Credit Agreement dated as of September 26, 1997 by
and among S3 Incorporated, the Lenders named therein,
Comerica Bank -- California as Administrative Agent, and
Fleet Bank and Documentation Agent.
10.14* Employment Agreement between Registrant and Terry N. Holdt
dated December 18, 1997.
10.15* Employment Agreement between Registrant and Gary J. Johnson
dated December 18, 1997.
21.1 Subsidiaries of Registrant.
23.1 Consent of Deloitte and Touche LLP (San Jose, California).
23.2 Consent of Price Waterhouse LLP (Hsinchu, Taiwan).
24.1 Power of Attorney (see page 71 of this Form 10-K).
27.1 Financial Data Schedules for 1997, 1996 and 1995.
27.2 Financial Data Schedules for the first three quarters of
1997.
27.3 Financial Data Schedules for the first three quarters of
1996.

- ---------------
* Indicates management contract or compensatory plan or arrangement.

(1) Incorporated by reference from the Registrant's Registration Statement on
Form S-1 (File No. 33-57114).

(2) Incorporated by reference to Exhibit 10.15 to the Registrant's Registration
Statement on Form S-8 (File No. 33-65186).

(3) Incorporated by reference to the exhibit of the same number to the
Registrant's Annual Report on Form 10-K for the year ended December 31,
1993.

(4) Incorporated by reference to the exhibit of the same number to the
Registrant's Annual Report on Form 10-K for the year ended December 31,
1994.

(5) Incorporated by reference to the exhibit of the same number to the
Registrant's Current Report on Form 8-K filed July 25, 1995.

(6) Incorporated by reference to the exhibit of the same number to the
Registrant's Annual Report on Form 10-K for the year ended December 31,
1995.

(7) Incorporated by reference to Exhibit 10.14 to the Registrant's Annual
Report on form 10-K for the year ended December 31, 1995.

(8) Incorporated by reference to Exhibit 4.1 to Registrant's Quarterly Report
on Form 10-Q for the quarter ended September 30, 1996.

(9) Incorporated by reference to Exhibit 4.2 to Registrant's Quarterly Report
on Form 10-Q for the quarter ended September 30, 1996.

(10) Incorporated by reference to the exhibit of the same number to Registrant's
Quarterly Report on Form 10-Q for the quarter ended June 30, 1997.

(11) Incorporated by reference to Exhibit 10.1 to the Registrant's Quarterly
Report on Form 10-Q for the quarter ended September 30, 1997.

(b) Reports on Form 8-K:

A Current Report on Form 8-K, dated November 3, 1997, was filed by the
Registrant on November 4, 1997. This report announced that the Registrant issued
a press release, which was attached to such report, concerning the discovery of
errors in the timing of its recognition of sales to international distributors
and the

53
54

anticipated restatement of the Company's financial statements to reflect
adjustments to revenue that would decrease revenue and net income from
previously reported amounts.

A Current Report on Form 8-K, dated November 6, 1997, was filed by the
Registrant on November 7, 1997. This report announced that the Registrant issued
a press release, which was attached to such report, concerning a lawsuit filed
against the Company.

A Current Report on Form 8-K, dated December 19, 1997, was filed by the
Registrant on December 22, 1997. This report announced that the Registrant
appointed Terry Holdt as its Chief Executive Officer, President and Chairman of
the Board, that Gary Johnson was named Vice Chairman of the Board and that
Diosdado Banatao resigned as Chairman of the Board, but would continue to serve
as a member of the Board of Directors.

54
55

SCHEDULE II

VALUATION AND QUALIFYING ACCOUNTS
YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
(IN THOUSANDS)

REVERSALS
BALANCE AT CHARGED TO TO COSTS BALANCE AT
BEGINNING COSTS AND AND END OF
DESCRIPTION OF PERIOD EXPENSES EXPENSES DEDUCTIONS(1) PERIOD
----------- ---------- ---------- --------- -------------- ----------

Allowance for doubtful accounts:
1997.................................... $1,438 $1,200 $ -- $(1,131) $1,507
1996.................................... 645 1,522 -- (729) 1,438
1995.................................... 375 1,014 -- (744) 645
Sales returns and allowances:
1997.................................... $1,210 $4,680 $ -- $(1,733) $4,157
1996.................................... 969 241 -- -- 1,210
1995.................................... 455 514 -- -- 969

- ---------------
(1) Deductions from these reserves are for the purpose for which these reserves
were created.

55
56

UNITED SEMICONDUCTOR CORPORATION

FINANCIAL STATEMENTS

DECEMBER 31, 1997 AND 1996

56
57

January 22, 1998
(98)R.L36P6034

To the Board of Directors of United Semiconductor Corporation

We have examined the accompanying balance sheets of United Semiconductor
Corporation as of December 31, 1997 and 1996, and the related statements of
income, of changes in stockholders' equity and of cash flows for the years then
ended. Our examinations were made in accordance with the "Rules Governing the
Certification of Financial Statements by Certified Public Accountants" and
generally accepted auditing standards and accordingly included such tests of the
accounting records and such other auditing procedures as we considered necessary
in the circumstances.

In our opinion, the accompanying financial statements examined by us
present fairly the financial position of United Semiconductor Corporation as of
December 31, 1997 and 1996, and the results of its operations and its cash flows
for the years then ended, in conformity with generally accepted accounting
principles consistently applied.

Price Waterhouse LLP
Hsinchu, Taiwan R.O.C.

57
58

UNITED SEMICONDUCTOR CORPORATION

BALANCE SHEET
DECEMBER 31, 1997 AND 1996
(EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)

ASSETS

1997 1996
----------- -----------

CURRENT ASSETS
Cash and cash equivalents (Note 4(1))..................... $ 5,469,227 $ 4,542,328
Marketable securities (Note 4(2))......................... 3,190,746 202,820
Notes receivable -- related parties (Note 5).............. 781 196,616
Accounts receivable (Notes 4(3) and 5)
-- third parties........................................ 937,320 286,639
-- related parties...................................... 939,664 368,065
Other receivable.......................................... 88,905 64,888
Inventories (Note 4(4))................................... 511,486 485,686
Prepaid expenses.......................................... 17,669 11,996
Other current assets...................................... 230,381 21,952
----------- -----------
11,386,179 6,180,990
----------- -----------
PROPERTY, PLANT AND EQUIPMENT (NOTES 4(5) AND 6)
Cost
Machinery and equipment................................... 10,169,495 8,611,439
Transportation equipment.................................. 3,206 2,563
Furniture and fixtures.................................... 130,771 87,661
Leasehold improvements.................................... 10,966 8,076
Other equipment........................................... 14,270 7,995
----------- -----------
10,328,708 8,717,734
Accumulated depreciation.................................. (1,944,961) (354,607)
Construction in progress and prepayments.................. 2,460,306 662,007
----------- -----------
10,844,053 9,025,134
----------- -----------
INTANGIBLE ASSET
Other intangible asset.................................... 1,037,500 1,337,500
----------- -----------
OTHER ASSETS
Deposit-out............................................... 30,979 30,064
Deferred expense.......................................... 54,027 48,216
Deferred income tax assets (Note 4 (11)).................. 103,102 219,786
----------- -----------
188,108 298,066
----------- -----------
TOTAL ASSETS....................................... $23,455,840 $16,841,690
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Short-term loans (Note 4(6)).............................. $ 1,911,632 $ 161,520
Notes payable (Note 5).................................... 125,209 151,043
Accounts payable (Note 5)................................. 534,856 295,274
Accrued expenses (Note 5)................................. 578,013 294,442
Other payables............................................ 352,925 1,551,722
Current portion of long-term loans (Note 4(7))............ 656,744 --
Other current liabilities................................. 7,515 1,604
----------- -----------
4,166,894 2,455,605
----------- -----------
LONG-TERM LIABILITIES
Long-term loans (Note 4(7))............................... 5,190,525 4,329,498
----------- -----------
OTHER LIABILITIES
Accrued pension liabilities (Notes 3 and 4(8))............ 11,619 --
----------- -----------
Total Liabilities.................................. 9,369,038 6,785,103
----------- -----------
STOCKHOLDERS' EQUITY
Common stock (Note 4(9)).................................. 10,000,000 10,000,000
Capital reserve generated from the gain on disposal of
fixed assets............................................ 40 --
Retained earnings (Note 4(10))............................ 4,086,762 56,587
----------- -----------
Total stockholders' equity......................... 14,086,802 10,056,587
----------- -----------
COMMITMENTS AND CONTINGENT LIABILITIES (NOTE 7)
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY......... $23,455,840 $16,841,690
=========== ===========

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

58
59

UNITED SEMICONDUCTOR CORPORATION

STATEMENT OF INCOME
FOR THE YEARS ENDED DECEMBER 31, 1997 AND 1996
(EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS
EXCEPT EARNINGS PER SHARE DATA)

1997 1996
----------- -----------

Operating Revenues
Sales revenue (Note 5).................................... $10,003,022 $ 1,663,010
Sales returns............................................. (21,216) (197)
Sales allowance........................................... (302,184) (40,653)
----------- -----------
Net sales................................................. 9,679,622 1,622,160
Other operating revenues.................................. 81,542 45,277
----------- -----------
Net operating revenues.................................... 9,761,164 1,667,437
----------- -----------
Operating Cost
Cost of goods sold (Note 5)............................... (5,278,405) (1,182,274)
Other operating cost...................................... (38,604) (32,095)
----------- -----------
(5,317,009) (1,214,369)
----------- -----------
Gross Profit................................................ 4,444,155 453,068
----------- -----------
Operating Expenses
Selling expenses.......................................... (88,841) (8,666)
Administrative expenses................................... (250,482) (574,100)
Research and development expenses......................... (443,866) (221,406)
----------- -----------
(783,189) (804,172)
----------- -----------
Operating Income (Loss)..................................... 3,660,966 (351,104)
----------- -----------
Non-operating Income
Interest income........................................... 264,153 232,942
Dividends revenue......................................... 21,420 --
Gain on disposal of investment............................ 16,956 4,474
Foreign exchange gain..................................... 397,616 70,170
Other income.............................................. 6,853 531
----------- -----------
706,998 308,117
----------- -----------
Non-operating Expenses
Interest expense.......................................... (354,973) (118,223)
Provision for loss on obsolescence of inventories......... (50,561) (50,000)
Financial expense......................................... (391) (23,778)
Other loss................................................ (15,881) (206)
----------- -----------
(421,806) (192,207)
----------- -----------
Income(loss) before income tax.............................. 3,946,158 (235,194)
Income tax benefit (Note 4(11))............................. 84,057 250,619
----------- -----------
Net income.................................................. $ 4,030,215 $ 15,425
=========== ===========
Earnings per share
Net income................................................ $ 4.03 $ 0.02
=========== ===========

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

59
60

UNITED SEMICONDUCTOR CORPORATION

STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1997 AND 1996
(EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)

RETAINED TOTAL STOCKHOLDERS'
COMMON STOCK CAPITAL RESERVE EARNINGS EQUITY
------------ --------------- ---------- -------------------

1996:
Balance at January 1, 1996........... $ 5,000,000 $-- $ 41,162 $ 5,041,162
Issued common stock.................. 5,000,000 -- -- 5,000,000
Net income for 1996.................. -- -- 15,425 15,425
----------- --- ---------- -----------
Balance at December 31, 1996......... 10,000,000 -- 56,587 10,056,587

1997:
Net income for 1997.................. -- -- 4,030,215 4,030,215
Transfer of the gain on disposal of
fixed assets to capital reserve.... -- 40 (40) --
----------- --- ---------- -----------
Balance at December 31, 1997......... $10,000,000 $40 $4,086,762 $14,086,802
=========== === ========== ===========

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

60
61

UNITED SEMICONDUCTOR CORPORATION

STATEMENT OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1997 AND 1996
(EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)

1997 1996
----------- -----------

OPERATING ACTIVITIES:
Net income................................................ $ 4,030,215 $ 15,425
Adjustments to reconcile net income to net cash provided
by (used in) operating activities
Provision for loss on obsolescence of inventories......... 38,403 50,000
Depreciation.............................................. 1,591,371 354,607
Amortization.............................................. 320,071 166,740
Bad debt expense.......................................... 24,138 5,908
Fixed assets transferred to deferred assets and
expenses................................................ 26,516 --
Gain on disposal of fixed assets.......................... (40) --
Changes in asset and liability accounts:
Decrease (increase) in notes receivable................... 195,835 (196,616)
Increase in accounts receivable........................... (1,246,418) (660,612)
Increase in other receivables............................. (24,017) (22,324)
Increase in inventories................................... (64,203) (535,686)
Decrease (increase) in prepaid expenses................... (5,673) 13,458
Increase in other current assets.......................... (208,429) (19,000)
Decrease (increase) in deferred income tax assets......... 116,684 (219,786)
(Decrease) increase in notes payable...................... (25,834) 125,148
Increase in accounts payable.............................. 239,582 295,274
Increase in accrued expenses.............................. 283,571 290,804
Increase in other current liabilities..................... 5,911 1,604
Decrease in deferred income tax liabilities............... -- (13,243)
Increase in accrued pension liabilities................... 11,619 --
----------- -----------
Net cash provided by (used in) operating activities....... 5,309,302 (348,299)
----------- -----------
INVESTING ACTIVITIES:
Acquisition of fixed assets............................... (4,644,743) (7,380,918)
Proceeds from disposal of fixed assets.................... 9,180 --
Increase in marketable securities......................... (2,987,926) (202,820)
Increase in deferred expense.............................. (25,882) (49,621)
Increase in deposits-out.................................. (915) (64)
----------- -----------
Net cash used in investing activities..................... (7,650,286) (7,633,423)
----------- -----------
FINANCING ACTIVITIES:
Issuance of common stock.................................. -- 4,250,000
Increase in short-term loans.............................. 1,750,112 84,488
Proceeds from long-term loans............................. 1,517,771 4,329,498
----------- -----------
Net cash provided by financing activities................. 3,267,883 8,663,986
----------- -----------
Net increase in cash and cash equivalents................. 926,899 682,264
Cash and cash equivalents at the beginning of year........ 4,542,328 3,860,064
----------- -----------
Cash and cash equivalents at the end of year.............. $ 5,469,227 $ 4,542,328
=========== ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid for interest (excluding interest capitalized)... $ 345,781 $ 107,333
=========== ===========
Cash paid for income tax.................................. $ 51,501 $ 1,409
=========== ===========
INVESTING ACTIVITIES PARTIALLY PAID BY CASH
Acquisition of fixed assets................................. $ 3,445,946 $ 8,891,391
Add: payable at the beginning of year..................... 1,551,722 41,249
Less: payable at the end of year.......................... (352,925) (1,551,722)
----------- -----------
Cash paid................................................. $ 4,644,743 $ 7,380,918
=========== ===========
FINANCING ACTIVITIES PARTIALLY PROVIDED BY CASH
Issuance of common stock.................................. $ -- $ 5,000,000
Less: common stock issued for the technology know-how..... -- (750,000)
----------- -----------
Cash received............................................. $ -- $ 4,250,000
=========== ===========

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

61
62

UNITED SEMICONDUCTOR CORPORATION

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1997 AND 1996
(EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)

1. HISTORY AND ORGANIZATION

United Semiconductor Corporation was incorporated as a company limited by
shares on October 6, 1995 and commenced its operations in June, 1996. As of
December 31, 1997, the paid-in capital is $10,000,000. The Company's major
business activities are as follows:

a. Semiconductor and semiconductor device foundry.

b. Providing the mask tooling, package, burn-in, and testing services
for the above-mentioned products.

c. Research and development for the technology of wafer fabrication.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Translation of foreign currency transactions

The accounts of the Company are maintained in New Taiwan dollars.
Transactions denominated in foreign currencies are translated into New Taiwan
dollars at the rates of exchange prevailing on the transaction dates.
Receivables, other monetary assets and liabilities denominated in foreign
currencies are translated into New Taiwan dollars at the rates of exchange
prevailing at the balance sheet date. Exchange gains or losses are included in
the current year's results.

Cash equivalents

Cash equivalents are short-term, highly liquid investments which are:

A. Convertible to known amounts of cash at any time; and

B. So near their maturity that they present insignificant risk of
changes in value because of changes in interest rates.

Marketable securities

Marketable securities are recorded at cost when acquired. The carrying
amount of the marketable securities portfolio is stated at the lower of its
aggregate cost or market value at the balance sheet date. The market value for
listed equity securities or close-ended funds are determined by the average
closing prices occurred during the last month of the fiscal year. The market
value for open-ended funds are determined by their equity per unit at balance
sheet date.

Inventories

Inventories, except raw materials stated at actual, are stated at standard
cost which is adjusted to actual cost based on weighted average method at month
end. Inventories are valued at the lower of cost or market value at the year
end. An allowance for loss on obsolescence and decline in market value is
provided when necessary.

Fixed assets

A. Fixed assets are stated at cost. Interest incurred on loans used to
finance the construction of property and plant is capitalized and depreciated
accordingly.

62
63
UNITED SEMICONDUCTOR CORPORATION

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1997 AND 1996
(EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)

B. Depreciation is provided on the straight-line method using the assets'
economic service lives. When the economic service lives are completed, fixed
assets which are still in use are depreciated based on the residual value. The
service lives of the fixed assets are five to ten years.

C. Maintenance and repairs are charged to expenses as incurred. Significant
renewals and improvements are treated as capital expenditures and are
depreciated accordingly.

Intangible asset

The intangible asset represents the technology know-how provided by a major
shareholder as a part of paid-in capital. The asset is amortized over five years
by straight-line method.

Deferred charges

Deferred charges are stated at cost and amortized on a straight-line basis
over the following years: software-3 years; organization cost-5 years.

Retirement plan

The Company has a retirement plan covering all its regular employees. This
plan is separately funded. Starting from 1996, the net pension cost is computed
based on an actuarial valuation in accordance with the provision of FASB No. 18
of the R.O.C., which requires consideration of cost components such as service
cost, interest cost, expected return on plan assets and amortization of net
obligation at transition.

Income tax

Income tax is provided based on accounting income after adjusting for
permanent differences. The provision for income tax includes deferred tax
resulting from items reported in different periods for tax and financial
reporting purposes. A valuation allowance is provided for deferred tax asset to
the extent that it is more likely than not that the tax benefits will not be
realized. Deferred tax assets or liabilities are further classified into current
or non-current items and are presented in the financial statements as net
balance. Over or under provision of prior year income tax liabilities are
included in the current year income tax expense.

Revenue and expenses

Revenue is recognized when the products are delivered or services are
completed. Expenses are recognized as incurred.

3. EFFECT OF CHANGE IN ACCOUNTING PRINCIPLES

Prior to 1996, the Company contributed an amount equal to 2% of total wages
on a monthly basis as pension expense. In 1996, the Company adopted R.O.C. FASB
No. 18 and began recognizing net pension cost based on actuarial valuation. The
effect of the change in accounting principle was immaterial because the Company
was only set up in 1995.

63
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UNITED SEMICONDUCTOR CORPORATION

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1997 AND 1996
(EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)

4. CONTENTS OF SIGNIFICANT ACCOUNTS

(1) CASH AND CASH EQUIVALENTS

DECEMBER 31
------------------------
1997 1996
---------- ----------

Cash:
Cash on hand........................................ $ 1,817 $ 1,056
Demand accounts..................................... 58,655 2,600
Checking accounts................................... 16,607 11,871
Time deposits....................................... 5,342,348 4,526,801
---------- ----------
5,419,427 4,542,328
Cash equivalents:
Bonds with repurchase agreement..................... 49,800 --
---------- ----------
$5,469,227 $4,542,328
========== ==========

(2) MARKETABLE SECURITIES

DECEMBER 31
------------------------
1997 1996
---------- ----------

Mutual funds........................................ $ 251,393 $ 150,250
Listed equity securities stocks..................... 2,939,353 52,570
---------- ----------
$3,190,746 $ 202,820
========== ==========

(3) ACCOUNTS RECEIVABLE -- NET

DECEMBER 31
------------------------
1997 1996
---------- ----------

Accounts receivable -- third parties................ $ 959,159 $ 292,547
Less: Allowance for doubtful accounts............... (21,839) (5,908)
---------- ----------
$ 937,320 $ 286,639
========== ==========

(4) INVENTORIES

DECEMBER 31
------------------------
1997 1996
---------- ----------

Raw materials, supplies and spare parts............. $ 226,426 $ 257,608
Work in process..................................... 315,274 247,877
Finished goods...................................... 58,189 30,201
---------- ----------
599,889 535,686
Less:Allowance for loss on obsolescence............. (88,403) (50,000)
---------- ----------
$ 511,486 $ 485,686
========== ==========

64
65
UNITED SEMICONDUCTOR CORPORATION

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1997 AND 1996
(EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)

(5) PROPERTY, PLANT AND EQUIPMENT

DECEMBER 31, 1997
------------------------------------------
ACCUMULATED
COST DEPRECIATION BOOK VALUE
----------- ------------ -----------

Machinery and equipment............. $10,169,495 $(1,915,540) $ 8,253,955
Transportation equipment............ 3,206 (587) 2,619
Furniture and fixtures.............. 130,771 (24,341) 106,430
Leasehold improvements.............. 10,966 (2,315) 8,651
Other equipment..................... 14,270 (2,178) 12,092
Construction in progress and
prepayments....................... 2,460,306 -- 2,460,306
----------- ----------- -----------
$12,789,014 $(1,944,961) $10,844,053
=========== =========== ===========

DECEMBER 31, 1996
------------------------------------------
ACCUMULATED
COST DEPRECIATION BOOK VALUE
----------- ------------ -----------

Machinery and equipment............. $ 8,611,439 $ (346,433) $ 8,265,006
Transportation equipment............ 2,563 (142) 2,421
Furniture and fixtures.............. 87,661 (6,482) 81,179
Leasehold improvements.............. 8,076 (960) 7,116
Other equipment..................... 7,995 (590) 7,405
Construction in progress and
prepayments....................... 662,007 -- 662,007
----------- ----------- -----------
$ 9,379,741 $ (354,607) $ 9,025,134
=========== =========== ===========

A. Please refer to note 6 for assets pledged as collateral.

B. Interest expense amounting to $24,321 and $40,881 were capitalized in
1997 and 1996, respectively.

(6) SHORT-TERM LOANS

DECEMBER, 31
------------------------------
1997 1996
------------- -------------

Unsecured loans.............................. $ 1,911,632 $ 161,520
============= =============
Annual interest rates........................ 1.25% - 7.66% 1.34% - 6.81%
============= =============

(7) LONG-TERM LOANS

A. Long-term loans are summarized as follows:

DECEMBER 31
------------------------------
1997 1996
------------- -------------

Long-term loans.............................. $ 5,847,269 $ 4,329,498
Less: Current portion........................ (656,744) --
------------- -------------
$ 5,190,525 $ 4,329,498
============= =============

B. Interest rates for long-term loans were floating rates. The range of
interest rates were 1.31% - 7.20% and 1.31% - 6.44% in 1997 and 1996,
respectively.

C. Please refer to note 6 for assets pledged as collateral.

65
66
UNITED SEMICONDUCTOR CORPORATION

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1997 AND 1996
(EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)

(8) RETIREMENT PLAN

A. All of the regular employees of the Company are covered by the pension
plan. Under the plan, the Company contributes an amount equal to 2% of total
wages on a monthly basis to the pension fund deposited in the Central Trust of
China. Pension benefits are generally based on service years (two points per
year for service years under 15 years (including 15 years) and one point per
year for service years over 15 years). Each employee is limited up to 45 points.
Retirement benefits are paid from the fund previously provided.

During 1997, the Company has recognized pension cost amounting to $17,793.
The balance of the Company's employees' retirement fund in Central Trust of
China was $9,270 at December 31, 1997.

B. Based on actuarial assumptions for the year of 1997, the discount rate
and expected rate of return on plan asset are both 6.5% and the rate of
compensation increase is 8%. The funded status of pension plan is listed as
follows:

DECEMBER 31, 1997
-----------------

Vested benefit obligation................................... $ --
Non-vested benefit obligation............................... (4,947)
---------
Accumulated benefit obligation.............................. (4,947)
Effect on projected salary increase......................... (25,388)
---------
Projected benefit obligation................................ (30,335)
Market-related value of plan assets......................... 8,638
---------
Projected benefit obligation exceeds plan asset (funding
status)................................................... (21,697)
Unrecognized net obligation at transition................... 281
Unrecognized pension gain or loss........................... 11,360
---------
Accrued pension liability................................... $ (10,056)
=========

(9) COMMON STOCK

The Company increased its capital by issuing 500,000,000 shares of common
stock for cash at the par value of $10 per share which was approved through a
resolution of the Board of Directors in their meeting on June 21, 1996. The
Company has completed the amendment procedures for registration. After the
capitalization, issued and outstanding shares of common stocks is 1,000,000,000
shares.

(10) RETAINED EARNINGS

A. According to the Company's Articles of Incorporation, current year's
earnings, if any, shall be distributed in the following order:

(1) paying all taxes and dues;

(2) covering prior years' operating losses, if any;

(3) setting aside 10% of the remaining amount, after deducting (1) and
(2), as legal reserve;

(4) allocating not over 10% of par value of common stocks as interest
of capital to common stockholders;

(5) allocating 1% of the remaining amount, after deducting (1), (2),
(3) and (4) above from the current year's earnings, as directors' and
supervisors' fees;

(6) allocating not below 10% of the remaining amount, after deducting
(1), (2), (3) and (4) above from the current year's earnings, as employees'
bonus; and

66
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UNITED SEMICONDUCTOR CORPORATION

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1997 AND 1996
(EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)

(7) distributing the remaining amount in accordance with the
resolution of directors' meeting and stockholders' meeting.

(11) INCOME TAX

A. Income tax benefits for 1997 and 1996 are computed as follows:

1997 1996
----------- ----------

Current income tax for short-term negotiable
income.......................................... $ 5,576 $ 1,409
Increase in deferred tax assets................... (684,882) (416,895)
Increase in allowance for valuation on deferred
tax assets...................................... 161,923 --
Increase in deferred tax liabilities.............. 433,326 164,867
----------- ----------
Income tax benefit................................ $ (84,057) $ (250,619)
=========== ==========

B. Deferred income tax assets and liabilities as of December 31, 1997 and
1996 are as follows:

DECEMBER 31
-------------------------
1997 1996
----------- ----------

Deferred income tax assets -- current............. $ 228,270 $ 21,952
----------- ----------
Deferred income tax assets -- non-current......... $ 1,262,960 $ 784,395
Allowance for valuation on deferred income tax
assets -- non-current........................... (548,423) (386,500)
----------- ----------
714,537 397,895
Deferred income tax liabilities-non-current....... (611,435) (178,109)
----------- ----------
$ 103,102 $ 219,786
=========== ==========

C. Components of deferred income tax assets and liabilities as of December
31, 1997 are as follows:

AMOUNT TAX EFFECT
----------- ----------

Temporary taxable differences..................... $(3,057,175) $ (611,435)
Temporary deductible differences.................. 2,097,640 419,528
Investment tax credits............................ -- 1,071,702
Allowance for valuation on deferred income tax
assets -- non-current........................... -- (548,423)
----------- ----------
$ (959,535) $ 331,372
=========== ==========

D. Pursuant to the "Statute For The Establishment and Administration of
Science-Based Industrial Park", the Company has been granted several periods of
tax holidays with respect to income derived from approved investments.

E. The Company's income tax return for 1995 have been assessed and approved
by the Tax Authority.

67
68
UNITED SEMICONDUCTOR CORPORATION

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1997 AND 1996
(EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)

(12) EARNINGS PER SHARE

1997 1996
---------- ----------

Net income(A)..................................... $4,030,215 $ 15,425
========== ==========
Common stock outstanding at the end of year
(Expressed in thousand shares)(B)............... 1,000,000 1,000,000
========== ==========
Weighted average outstanding common stock
(Expressed in thousand shares)(C)............... 1,000,000 747,945
========== ==========
Earnings per share
(Expressed in New Taiwan dollars) (A/B)......... $ 4.03 $ 0.015
========== ==========
Earnings per share based on weighted average
outstanding common stock (Expressed in New
Taiwan dollars) (A/C)........................... $ 4.03 $ 0.02
========== ==========

5. RELATED PARTY TRANSACTION

(1) Names and Relationships of Related Parties

NAME OF THE RELATED PARTIES THE RELATIONSHIP WITH THE COMPANY
--------------------------- ---------------------------------

United Microelectronics Co., Ltd. The major investor of the Company.
United Integrated Circuit Co., Ltd. Common board chairman.
United Silicon Inc. "
AMIC Technology, Inc. The affiliate of UMC
Novatek Microelectronics Corp. Common major investor
Faraday Technology, Inc. "
S3 Inc. The major investor of the Company
S3 International Ltd. 100% investee of S3 Inc.

(2) Significant Related Party Transactions

a. Sales

1997 1996
-------------------------- ------------------------
PERCENTAGE PERCENTAGE
AMOUNT OF NET SALES AMOUNT OF NET SALES
---------- ------------ -------- ------------

United Microelectronics Co.,
Ltd........................ $2,503,897 26% $971,397 60%
United Integrated Circuit
Co., Ltd................... 302,866 3% -- --
Others....................... 425,071 4% -- --
---------- -- -------- --
$3,231,834 33% $971,397 60%
========== == ======== ==

The above sales are dealt with certain discount in the ordinary course
of business similar to those with other companies. The actual collection
period is approximately two months.

68
69
UNITED SEMICONDUCTOR CORPORATION

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1997 AND 1996
(EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)

b. Purchases

1997 1996
---------------------- -----------------------
PERCENTAGE PERCENTAGE
OF NET OF NET
AMOUNT PURCHASES AMOUNT PURCHASES
-------- ----------- --------- -----------

United Microelectronics Co., Ltd..... $ 15,912 2% $ 63,089 12%
======== === ========= ===

The above purchases are dealt with in the ordinary course of business
similar to those with other companies and are payable after three months
from purchase date.

c. Notes receivable

DECEMBER 31, 1997 DECEMBER 31, 1996
---------------------- -----------------------
PERCENTAGE PERCENTAGE
OF NOTES OF NOTES
AMOUNT RECEIVABLE AMOUNT RECEIVABLE
-------- ----------- --------- -----------

United Microelectronics Co., Ltd..... $ 781 100% $ 196,616 100%
======== === ========= ===

d. Accounts receivable

DECEMBER 31, 1997 DECEMBER 31, 1996
---------------------- -----------------------
PERCENTAGE PERCENTAGE
OF ACCOUNTS OF ACCOUNTS
AMOUNT RECEIVABLE AMOUNT RECEIVABLE
-------- ----------- --------- -----------

United Microelectronics Co., Ltd..... $218,633 12% $ 367,625 56%
United Integrated Circuit Co.,
Ltd................................ 317,533 17% 440 --
S3 International Ltd................. 263,252 14% -- --
Others............................... 148,453 8% -- --
-------- --- --------- ---
947,871 51% 368,065 56%
Less: Allowance for doubtful
accounts........................... (8,207) (1)% -- --.....
-------- --- --------- ---
$939,664 50% $ 368,065 56%
======== === ========= ===

e. Notes payable

DECEMBER 31, 1997 DECEMBER 31, 1996
---------------------- -----------------------
PERCENTAGE PERCENTAGE
OF NOTES OF NOTES
AMOUNT PAYABLE AMOUNT PAYABLE
-------- ----------- --------- -----------

United Microelectronics Co., Ltd..... $ 25,992 21% $ 44,046 29%
======== === ========= ===

f. Accounts payable

DECEMBER 31, 1997 DECEMBER 31, 1996
---------------------- -----------------------
PERCENTAGE PERCENTAGE
OF ACCOUNTS OF ACCOUNTS
AMOUNT PAYABLE AMOUNT PAYABLE
-------- ----------- --------- -----------

United Microelectronics Co., Ltd..... $ 9,428 2% $ -- --
United Integrated Circuit Co.,
Ltd................................ 12,057 2% -- --
-------- --- --------- ---
$ 21,485 4% $ -- --
======== === ========= ===

69
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UNITED SEMICONDUCTOR CORPORATION

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1997 AND 1996
(EXPRESSED IN NEW TAIWAN THOUSAND DOLLARS)

g. Accrued expenses

DECEMBER 31, 1997 DECEMBER 31, 1996
---------------------- -----------------------
PERCENTAGE PERCENTAGE
OF ACCRUED OF ACCRUED
AMOUNT EXPENSES AMOUNT EXPENSES
-------- ----------- --------- -----------

United Microelectronics Co., Ltd..... $ 77,387 13% $ 61,106 21%
======== === ========= ===

h. Property transaction

In May 1997, the Company sold one set of machinery and equipment to
United Integrated Circuit Co., Ltd. for $9,180. The gain on the transaction
was $40.

i. Other transaction

The other transaction with United Microelectronics Co., Ltd. in 1997
and 1996 was as follows:

ITEM 1997 1996
---- ---- ----

Rental expense........................................... $199,329 $153,128

6. ASSETS PLEDGED AS COLLATERAL

BOOK VALUE AS OF DECEMBER 31
----------------------------
1997 1996 SUBJECT OF COLLATERAL
---- ---- ---------------------

Machinery and equipment............. $6,272,029 $2,418,834 Long-term loan
========== ========== ==============

7. COMMITMENTS AND CONTINGENCY

a. The Company's unused letters of credit for import machinery were
approximately USD58,541 thousand dollars, JPY4,691,732 thousand dollars, and
GBP15 thousand dollars at December 31, 1997.

b. The Company has signed several contracts for the purchase of equipment
amounting to USD193,202 thousand dollars, JPY16,033,030 thousand dollars, and
DEM103 thousand dollars. As of December 31, 1997, the amount of outstanding
obligations for these contracts are USD61,278 thousand dollars, JPY8,981,532
thousand dollars, and DEM43 thousand dollars.

c. The DOC of the United States of America (U.S.A.) had made a preliminary
investigation on September 24, 1997 on the changes that static random access
memory (SRAM) manufactured in Taiwan were being sold at less than fair market
value, i.e. dumping prices, and the discussion on imposing duties on those SRAM
is on-going. The final determination will depend on the result of further
investigation. Since the Company does not sell or export any significant volume
of SRAM products to the U.S.A., the Company's management is of the opinion that
the outcome of the investigation will not have a material adverse financial or
operational effect to the Company.

8. COMPARATIVE FIGURES RECLASSIFICATION

Certain accounts in the 1996 financial statements have been reclassified to
conform with the presentation adopted for the 1997 financial statements.

70
71

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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, on March 31, 1998.

S3 INCORPORATED
(Registrant)

By: /s/ TERRY N. HOLDT
------------------------------------
Terry N. Holdt
President
Chief Executive Officer
Chairman of the Board
March 31, 1998

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Terry N. Holdt, Walter D. Amaral, and
Ronald T. Yara, and each of them, his or her true and lawful attorneys-in-fact,
each with full power of substitution, for him or her in any and all capacities,
to sign any amendments to this report on Form 10-K and to file the same, with
exhibits thereto and other documents in connection therewith, with the
Securities and Exchange Commission, hereby ratifying and confirming all that
each of said attorneys-in-fact or their substitute or substitutes may do or
cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the date indicated:

/s/ TERRY N. HOLDT /s/ ROBERT P. LEE
- ----------------------------------------------------- -----------------------------------------------------
Terry N. Holdt Robert P. Lee
President, Chief Executive Officer Director
Chairman of the Board March 31, 1998
March 31, 1998 /s/ JOHN C. COLLIGAN
/s/ WALTER D. AMARAL -----------------------------------------------------
- ----------------------------------------------------- John C. Colligan
Walter D. Amaral Director
Senior Vice President & Chief Financial Officer March 31, 1998
(Principal Financial and Accounting Officer) /s/ CARMELO J. SANTORO
March 31, 1998 -----------------------------------------------------
/s/ GARY J. JOHNSON Carmelo J. Santoro
- ----------------------------------------------------- Director
Gary J. Johnson March 31, 1998
Vice Chairman of the Board /s/ DIOSDADO P. BANATAO
March 31, 1998 -----------------------------------------------------
/s/ RONALD T. YARA Diosdado P. Banatao
- ----------------------------------------------------- Director
Ronald T. Yara March 31, 1998
Director
March 31, 1998

71
72

EXHIBIT INDEX

EXHIBIT
NUMBER NOTES DESCRIPTION OF DOCUMENT
---------- ----- -----------------------

24.1 Power of Attorney (see page 71 of this Form 10-K).
27.1 Financial Data Schedules for 1997, 1996 and 1995.
27.2 Financial Data Schedules for the first three quarters of
1997.
27.3 Financial Data Schedules for the first three quarters of
1996.

- ---------------
* Indicates management contract or compensatory plan or arrangement.

(1) Incorporated by reference from the Registrant's Registration Statement on
Form S-1 (File No. 33-57114).

(2) Incorporated by reference to Exhibit 10.15 to the Registrant's Registration
Statement on Form S-8 (File No. 33-65186).

(3) Incorporated by reference to the exhibit of the same number to the
Registrant's Annual Report on Form 10-K for the year ended December 31,
1993.

(4) Incorporated by reference to the exhibit of the same number to the
Registrant's Annual Report on Form 10-K for the year ended December 31,
1994.

(5) Incorporated by reference to the exhibit of the same number to the
Registrant's Current Report on Form 8-K filed July 25, 1995.

(6) Incorporated by reference to the exhibit of the same number to the
Registrant's Annual Report on Form 10-K for the year ended December 31,
1995.

(7) Incorporated by reference to Exhibit 10.14 to the Registrant's Annual
Report on Form 10-K for the year ended December 31, 1995.

(8) Incorporated by reference to Exhibit 4.1 to Registrant's Quarterly Report
on Form 10-Q for the quarter ended September 30, 1996.

(9) Incorporated by reference to Exhibit 4.2 to Registrant's Quarterly Report
on Form 10-Q for the quarter ended September 30, 1996.

(10) Incorporated by reference to the exhibit of the same number to Registrant's
Quarterly Report on Form 10-Q for the quarter ended June 30, 1997.

(11) Incorporated by reference to Exhibit 10.1 to the Registrant's Quarterly
Report on Form 10-Q for the quarter ended September 30, 1997.