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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549

FORM 10-Q

(Mark One)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarter ended September 30, 1999 OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the transition period from __________ to __________

Commission file number 0-21126

S3 INCORPORATED
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

DELAWARE 77-0204341
---------------------------------------- -------------------
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)

2841 Mission College Boulevard
Santa Clara, California 95052-8058
---------------------------------------- -------------------
(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code: (408) 588-8000

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

Yes [X] No [ ]

The number of shares of the Registrant's Common Stock, $.0001 par value,
outstanding at November 1, 1999 was 76,108,507.
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S3 INCORPORATED
FORM 10-Q

INDEX

PAGE
--------------

PART I. CONDENSED CONSOLIDATED FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements:

Condensed Consolidated Balance Sheets
September 30, 1999 and December 31, 1998 3

Condensed Consolidated Statements of Operations
Three months ended and nine months ended
September 30, 1999 and 1998 4

Condensed Consolidated Statements of Cash Flows
Nine months ended September 30, 1999 and 1998 5

Notes to Unaudited Condensed Consolidated Financial Statements 6-13

Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 14-34

Item 3. Quantitative and Qualitative Disclosures About Market Risk 34-35

PART II. OTHER INFORMATION

Item 1. Legal Proceedings 35

Item 2. Changes in Securities 35

Item 3. Defaults Upon Senior Securities Not Applicable

Item 4. Submission of Matters to a Vote of Security Holders 36

Item 5. Other Information Not Applicable

Item 6. Exhibits and Reports on Form 8-K 36-37

Signatures 38

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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements

S3 INCORPORATED
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)

SEPTEMBER 30, DECEMBER 31,
1999 1998
------------- ------------
(Unaudited)

ASSETS
Current assets:
Cash and cash equivalents $ 72,796 $ 31,022
Short-term investments 74,656 88,553
Accounts receivable (net of allowances
of $16,438 in 1999 and $6,525 in 1998) 95,227 23,864
Inventories 73,728 11,383
Prepaid taxes -- 20,203
Prepaid expenses and other 48,030 22,153
--------- ---------
Total current assets 364,437 197,178

Property and equipment, net 39,383 22,392
Investment in joint venture 91,056 88,056
Goodwill and other acquisition related intangibles 223,377 --
Other assets 14,438 18,175
--------- ---------
Total $ 732,691 $ 325,801
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
Accounts payable $ 134,145 $ 16,315
Notes payable 62,738 14,400
Accrued liabilities 43,872 12,314
Deferred revenue 9,996 1,905
--------- ---------
Total current liabilities 250,751 44,934

Other liabilities 18,602 13,837
Convertible subordinated notes 103,500 103,500

Stockholders' equity:
Common stock, $.0001 par value;
175,000,000 and 70,000,000 shares authorized in 1999
and 1998;
75,525,939 and 51,716,171 shares outstanding in 1999
and 1998 413,486 191,647
Accumulated other comprehensive loss (16,409) (14,755)
Accumulated deficit (37,239) (13,362)
--------- ---------
Total stockholders' equity 359,838 163,530
--------- ---------
Total $ 732,691 $ 325,801
========= =========

See accompanying notes to the unaudited condensed
consolidated financial statements.

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S3 INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)

THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------- -------------------------
1999 1998 1999 1998
---------- ---------- ---------- ----------

Net sales $ 70,484 $ 47,286 $ 172,037 $ 183,092

Cost of sales 54,796 55,206 129,545 168,842
---------- ---------- ---------- ----------
Gross margin 15,688 (7,920) 42,492 14,250

Operating expenses:
Research and development 17,075 19,752 52,562 60,119
Selling, marketing and administrative 9,401 10,024 25,732 33,161
Other operating expense 6,700 6,109 6,700 14,109
Amortization of goodwill and intangibles 895 -- 895 --
---------- ---------- ---------- ----------
Total operating expenses 34,071 35,885 85,889 107,389
---------- ---------- ---------- ----------
Loss from operations (18,383) (43,805) (43,397) (93,139)

Gain on sale of shares of joint venture 7,466 -- 14,673 26,561
Other income (expense), net (181) 127 258 (4,057)
---------- ---------- ---------- ----------

Loss before income taxes and equity
in income of joint venture (11,098) (43,678) (28,465) (70,635)
Benefit for income taxes -- -- -- (11,956)
---------- ---------- ---------- ----------
Loss before equity in income of joint venture (11,098) (43,678) (28,465) (58,679)
Equity in income of joint venture (net of tax) -- 8,277 4,588 15,766
---------- ---------- ---------- ----------
Net loss $ (11,098) $ (35,401) $ (23,877) $ (42,913)
========== ========== ========== ==========
Per share amounts:
Basic $ (0.20) $ (0.69) $ (0.45) $ (0.84)
Diluted $ (0.20) $ (0.69) $ (0.45) $ (0.84)

Shares used in computing per share amounts:
Basic 55,419 51,174 53,284 50,920
Diluted 55,419 51,174 53,284 50,920

See accompanying notes to the unaudited condensed
consolidated financial statements.

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S3 INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

NINE MONTHS ENDED
SEPTEMBER 30,
---------------------
1999 1998
-------- --------

Operating activities:
Net loss $(23,877) $(42,913)
Adjustments to reconcile net loss to net
cash provided by (used for) operating activities:
Deferred income taxes 81 8,846
Depreciation 13,315 18,476
Amortization of goodwill and intangibles 895 --
Loss on disposals of property and equipment -- 8,072
Write-off of acquired in-process research & development 6,700 --
Write-off of acquired technologies -- 8,000
Gain on sale of shares of joint venture (14,673) (26,561)
Equity in income of joint venture (4,588) (15,805)
Changes in assets and liabilities:
Accounts receivable (16,177) 35,877
Inventories (7,362) 38,005
Prepaid taxes / Income taxes payable 20,066 (12,665)
Prepaid expenses and other 1,581 1,115
Accounts payable 20,396 (13,490)
Accrued liabilities and other 12,561 (4,161)
Restructuring reserve -- (391)
Deferred revenue (147) (10,849)
-------- --------
Net cash used for operating activities 8,771 (8,444)
-------- --------
Investing activities:
Property and equipment purchases, net (5,491) (3,970)
Sale of shares of joint venture 14,673 68,025
Sale (purchase) of short-term investments, net 22,219 (46,379)
Sale of investment in real estate partnership 7,812 --
Acquisition of Diamond Multimedia, net of cash acquired (22,114) --
Acquisition of OneStep, LLC (10,869) --
Other assets (1,378) 5,212
Purchase of technology -- (40,000)
-------- --------
Net cash provided by (used for) investing activities 4,852 (17,112)
-------- --------
Financing activities:
Sale of common stock, net 36,925 3,020
Sale of warrant 990 --
Repayments of equipment financing -- (3,169)
Repayments of notes payable (9,764) (10,000)
-------- --------
Net cash provided by (used for) financing activities 28,151 (10,149)
-------- --------
Net increase (decrease) in cash and equivalents 41,774 (35,705)
Cash and cash equivalents at beginning of period 31,022 90,484
-------- --------
Cash and cash equivalents at end of period $ 72,796 $ 54,779
======== ========

See accompanying notes to the unaudited condensed
consolidated financial statements.

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S3 INCORPORATED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation

The condensed consolidated financial statements have been prepared by S3
Incorporated, without audit, pursuant to the rules and regulations of the
Securities and Exchange Commission and include the accounts of S3 Incorporated
and its wholly-owned subsidiaries ("S3" or collectively the "Company"). 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. Certain information and footnote
disclosures, normally included in financial statements prepared in accordance
with generally accepted accounting principles, have been condensed or omitted
pursuant to such rules and regulations. In the opinion of the Company, the
financial statements reflect all adjustments, consisting only of normal
recurring adjustments with the exception of the in-process research and
development charge discussed in Note 2, necessary for a fair presentation of the
financial position at September 30, 1999 and December 31, 1998, and the
operating results and cash flows for the nine months ended September 30, 1999
and 1998. These financial statements and notes should be read in conjunction
with the Company's audited financial statements and notes thereto for the year
ended December 31, 1998, included in the Company's Form 10-K filed with the
Securities and Exchange Commission.

On September 24, 1999, the Company completed the acquisition of all of the
outstanding common stock of Diamond Multimedia Systems, Inc. ("Diamond"). The
transaction was accounted for as a purchase and, accordingly, the results of
operations of Diamond and the estimated fair value of assets acquired and
liabilities assumed were included in the Company's condensed consolidated
financial statements as of September 24, 1999, the effective date of the
purchase, through the end of the period. The acquisition of Diamond is discussed
further in Note 2.

The results of operations for the three and nine months ended September 30,
1999 are not necessarily indicative of the results that may be expected for the
future quarters or the year ending December 31, 1999. Certain reclassifications
of 1998 amounts were made in order to conform to the 1999 presentation.

This Quarterly Report on Form 10-Q contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934. In particular, the assumptions set forth in
Note 2 and the Management Discussion and Analysis section of this Quarterly
Report on Form 10-Q regarding revenue growth, gross margin increases, cost
decreases and cost of capital which underlie the Company's calculation of the
in-process research and development expenses contain forward-looking statements
and are qualified by the risks detailed in "Factors That May Affect Our Results"
and other risks detailed in the Company's Annual Report on Form 10-K for the
year ended December 31, 1998 and its Quarterly Reports on Form 10-Q for the
quarters ended March 31, 1999 and June 30, 1999 and other reports filed by S3
with the Securities and Exchange Commission from time to time. Actual results
could differ materially from those projected in these forward-looking statements
as a result of the risks described above as well as other risks set forth in
S3's periodic reports both previously and hereafter filed with the Securities
and Exchange Commission.

2. Merger Agreement

On September 24, 1999 the Company completed its merger with Diamond, pursuant
to the Agreement and Plan of Merger, dated as of June 21, 1999 (the "Merger
Agreement"), as amended, by and among the Company, Diamond and Denmark
Acquisition Sub, Inc., a Delaware corporation ("Denmark"). Following
consummation of the merger, Diamond became a wholly-owned subsidiary of the
Company. The merger is accounted for under the purchase method of accounting.

Pursuant to the Merger Agreement, each share of Diamond common stock was
converted into the right to receive 0.52 shares of the Company's common stock.
No fractional shares of the Company's common stock were issued and in lieu
thereof and former Diamond stockholders otherwise entitled to a fractional share
received a cash payment equal to such fraction of a share multiplied by $9.5625,
the closing price of the Company's common stock on the Nasdaq National Market on
the effective date of the merger. In addition, pursuant to the Merger Agreement,
each option and right to acquire Diamond common stock granted under Diamond's
stock-based incentive plans outstanding immediately prior to the effective time
of the merger was converted into an option to

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purchase Company common stock and the Company assumed each such option or right
in accordance with the terms of the Diamond stock-based incentive plan by which
it is evidenced. Approximately 18.7 million common shares of S3 stock were
issued to Diamond shareholders and approximately 1.3 million options were
assumed.

The purchase price of $216.7 million includes $172.2 million of stock issued
at fair value (fair value being determined as the average price of the S3 stock
for a period three days before and after the announcement of the merger), $11.7
million in Diamond stock option costs (being determined under both the Black-
Sholes formula and in accordance with the Merger Agreement), cash paid to
Diamond of $20.0 million and $12.8 million in estimated expenses of the
transaction. The purchase price was allocated as follows: $(0.9) million to the
estimated fair value of Diamond net tangible assets purchased (as of September
24, 1999), $6.7 million to purchased in-process research and development, $13.9
million to purchased existing technology, $15.1 million to tradenames, $5.9
million to workforce-in-place, $12.5 million to Diamond distribution channel
relationships and $163.5 million to goodwill. Goodwill is recorded as a result
of consideration paid in excess of the fair value of net tangible and intangible
assets acquired. Goodwill and identified acquisition related intangible assets
are amortized on a straight-line basis over the periods indicated below. The
allocation of the purchase price to intangibles was based upon management's
estimates. The purchase price and the related allocation is subject to further
refinement and change over the next year.

Management is in the final process of completing its integration plans
related to Diamond. The integration plans include initiatives to combine the
operations of Diamond and S3 and consolidate duplicative operations. Areas where
management estimates may be revised primarily relate to employee severance and
relocation costs and other exit costs. Adjustments to accrued integration costs
related to Diamond will be recorded as adjustments to the fair value of net
assets in the purchase price allocation. Accrued integration charges included
$3.1 million related to involuntary employee separation and relocation benefits
for employees and $1.5 million in other exit costs primarily relating to the
closing or consolidation of facilities and the termination of certain
contractual relationships. The accruals recorded related to the integration of
Diamond are based upon management's current estimate of integration costs.

The intangible assets and goodwill acquired have estimated useful lives and
estimated first year amortization, as follows:

CALCULATED
ESTIMATED FIRST YEAR
AMOUNT USEFUL LIFE AMORTIZATION
------------ ----------- ------------

Purchased existing technology $ 13,900,000 2-5 years $ 4,128,333
Tradenames 15,100,000 7 years 2,157,143
Workforce-in-place 5,900,000 4 years 1,475,000
Diamond distribution channel relationships 12,500,000 5 years 2,500,000
Goodwill 163,503,000 5 years 32,700,600

The value assigned to purchased in-process research and development ("IPR&D")
was determined by identifying research projects in areas for which technological
feasibility had not been established. The value was determined by estimating the
expected cash flows from the projects once commercially viable, discounting the
net cash flows back to their present value and then applying a percentage of
completion to the calculated value as defined below.

The net cash flows from the identified projects are based on our estimates of
revenues, cost of sales, research and development costs, selling, general and
administrative costs, royalty costs and income taxes from those projects. These
estimates are based on the assumptions mentioned below. The research and
development costs included in the model reflect costs to sustain projects, but
exclude costs to bring in-process projects to technological feasibility.

The estimated revenues are based on management projections of each in-process
project and the business projections were compared and found to be in line with
industry analysts' forecasts of growth in substantially all of the relevant
markets. Estimated total revenues from the IPR&D product areas are expected to
peak in the year 2000 and decline over the following two years as other new
products are expected to become available. These projections are based on our
estimates of market size and growth, expected trends in technology and the
nature and expected timing of new project introductions by our competitors and
us.

Projected gross margins approximate Diamond's recent historical performance
and are in line with comparable industry margins. The estimated selling, general
and administrative costs are consistent with Diamond's historical cost
structure, which is in line with industry averages. Research and development
costs are consistent with Diamond's historical cost structure.

The discount rate used in discounting the net cash flows from IPR&D ranged
from 25% to 35%. Relatively high discount rates were used to reflect the
inherent uncertainties surrounding the successful development of the IPR&D,
market acceptance of the technology, the useful life of such technology and the
uncertainty of technological advances which could potentially impact the
estimates described above.

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The percentage of completion for each project was determined using costs
incurred to date on each project as compared to the remaining research and
development to be completed to bring each project to technological feasibility.
The percentage of completion varied by individual project ranging from 20% to
60%.

If the projects discussed above are not successfully developed, the sales and
profitability of the combined company may be adversely affected in future
periods.

Pro forma results

The following unaudited pro forma summary is provided for illustrative
purposes only and is not necessarily indicative of the consolidated results of
operations for future periods or that actually would have been realized had the
Company and Diamond been a consolidated entity during the periods presented. The
summary combines the results of operations as if Diamond had been acquired as of
the beginning of the periods presented.

The summary includes the impact of certain adjustments such as goodwill
amortization, changes in amortization, intercompany sales transactions, changes
in interest expense related to intercompany loans and changes in deferred tax
assets and liabilities. Additionally, in-process research and development of
$6.7 million discussed above has been excluded from the periods presented due to
its non-recurring nature.

NINE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 1999 SEPTEMBER 30, 1998
------------------ ------------------
(IN THOUSANDS, EXCEPT
PER SHARE AMOUNTS)

Net sales $ 491,232 $ 659,848
Net loss $(131,183) $(114,044)
Net loss per share (basic and diluted) $ (1.84) $ (1.64)

On a combined basis, there were no material transactions between the Company
and Diamond during the periods presented except for sales of product by the
Company to Diamond which have been eliminated.

3. Inventories

Inventories are stated at the lower of cost (determined on a first-in,
first-out basis) or market. Inventories consisted of:

SEPTEMBER 30, DECEMBER 31,
1999 1998
------------- ------------

(IN THOUSANDS)
INVENTORIES CONSIST OF:
Raw materials $24,117 $ --
Work in process 16,068 6,340
Finished goods 33,543 5,043
------- -------
Total $73,728 $11,383
======= =======

4. Investments

Investment in USC

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 United
Semiconductor Corporation ("USC"), a separate Taiwanese company, for the purpose
of building and managing a semiconductor

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manufacturing facility in Taiwan, Republic of China. The Company invested a
total of $89.4 million for its equity interest of 23.75%. On December 31, 1998,
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 $68.0 million in cash) in
January 1998 upon closing. 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 June of 1999, the Company announced that it would receive $42.0 million
for a patent license and release of contingencies on the previous USC stock sale
from UMC. Payments will be received over five fiscal quarters beginning in the
quarter ended June 30, 1999. Under the terms of the agreement, S3 will license
UMC 29 patents covering multimedia products and integrated circuit manufacturing
technology for use in products manufactured by UMC. In addition, the Company
agreed to release UMC from contingencies associated with the sale of 80 million
shares of stock of USC in January 1998. The Company agreed to waive rights to
its USC board seat and determined that it no longer could exercise significant
influence over the financial and operating decisions of USC. Accordingly, in
June 1999 the Company ceased accounting for its investment in USC using the
equity method of accounting.

In June, 1999 UMC announced that it would provide one share of UMC for every
share of USC stock. The expected transaction was a result of UMC's foundry
consolidation plans whereby USC, United Integrated Circuits Corporation
("UICC"), United Silicon Incorporated ("USIC") and UTEK Semiconductor
Corporation ("UTEK"), will be merged into UMC.

As the Company currently owns 252 million shares of USC, this will result in
the transfer of 252 million UMC shares of stock to the Company. The transaction
was approved by UMC shareholders at the end of July 1999. The final share
transfer is expected to occur in January 2000.

Interest in Partnership

In 1995, the Company entered into a limited partnership arrangement (the
"partnership") with a developer to obtain a ground lease and develop and operate
the Company's current Santa Clara facilities. The Company invested $2.1 million
for a 50% limited partnership interest. On June 29, 1999, the Company entered
into an agreement to assign to the general partner the Company's entire interest
in the partnership for $7.8 million. The gain on the assignment of the Company's
partnership interest is being recognized over the term of the facilities lease,
which expires in 2008.

Investment in OneStep, LLC

In July 1999, the Company acquired OneStep, LLC, a software development
company that supplies the Rio Audio Manager to RioPort.com, Inc. for $10.9
million in cash, $10.9 million has been preliminarily allocated to goodwill and
other acquisition related intangibles which will be amortized over five years.
The Rio Audio Manager is designed to allow audio enthusiasts to easily acquire,
create, organize and playback music or spoken audio programming in one simple
application. See Note 10.

5. Notes payable

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. At September 30, 1999, the remaining advance payments
totaled $14.3 million and the corresponding promissory notes totaled $9.6
million. During the second quarter of 1999, the Company and TSMC agreed to
extend the term of the agreement. Accordingly, the Company and TSMC agreed to
extend the capacity term of the agreement two years to 2002. The corresponding
notes payable were extended with the final payment due in 2001.

At September 30, 1999, the Company has a $50.0 million domestic bank facility
permitting borrowings at the prime rate. This bank facility expires January
2001. The covenants covering this debt agreement pertain to minimum levels of
collateral coverage and tangible net worth, quarterly profitability and minimum
levels of liquidity. As of September 30, 1999, the Company was in default with
its loan covenants regarding liquidity. The Company obtained waivers for this
violation as of March 31, 1999 and June 30, 1999 and is seeking to obtain
waivers for this violation as of September 30, 1999. Additionally, the Company
has credit facilities under foreign lines of credit. The Company has a foreign
line of credit of 10 million DeutscheMarks (approximately $5.5 million at

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September 30, 1999). The Company also has a foreign line of credit of 400,000
Great British Pounds (approximately $700K at September 30, 1999). Borrowings
were $53.1 million under these facilities at September 30, 1999.

The Company has various capital lease obligations payable through 2000.

6. Other Operating Expenses

The Company recorded a non-recurring charge of $6.7 million related to the
purchase of Diamond on September 24, 1999. This was determined through valuation
techniques generally used by appraisers in the high-technology industry and was
immediately expensed in the period of acquisition because technological
feasibility had not been established and no alternative use had been
identified. The charge is discussed in more detail in Note 2 to the Unaudited
Condensed Consolidated Financial Statements contained herein.

The Company wrote-off $8.0 million of the acquired technologies in the first
quarter of 1998 that were not realizable based on estimated cash flows from the
sale of products currently sold by the Company. The remaining $32.0 million
intangible asset was being amortized to cost of sales based on the estimated
lives of the currently utilized core technologies, which was generally five
years until the fourth quarter of 1998. During the fourth quarter of 1998,
management reevaluated the carrying value of the intangible assets recorded in
connection with the technology exchange with Cirrus Logic, Inc. and related to
the patents obtained from Brooktree Corporation ("Brooktree"), as well as other
long-lived assets, including property and equipment. This revaluation was
necessitated by management determination based on recent results of operations
and that the future expected sales and cash flows for the Company's operations
would be substantially lower than had been previously expected by management.
Expected undiscounted future cash flows were not sufficient to recover the
carrying value of such assets. Accordingly, an impairment loss of $27.2 million
was recognized for write-downs of a substantial portion of the intangible assets
in the fourth quarter of 1998. The estimated fair value of the intangible assets
was based on management's best estimate of the patent portfolio based on a
comparison to other graphics technology portfolios in the marketplace. Due to
technological changes in the graphics marketplace, the Company concluded it
should accelerate its amortization of its remaining patent portfolio, of
approximately $4.0 million, over the current estimated life of the currently
utilized core technologies, which is two years.

In July 1998, the Company implemented a restructuring plan in order to align
resources with a new business model and to lower the Company's overall cost
structure. In connection with the restructuring, the Company reduced its
headcount and consolidated facilities. Restructuring expense of $6.1 million was
recognized in the third quarter of 1998. As of June 30, 1999, all severance
packages have been paid and there is no remaining balance in the restructuring
reserve.

7. Earnings (Loss) Per Share

Basic earnings (loss) per share (EPS) is computed by dividing income
available to common stockholders by the weighted average number of common shares
outstanding for the period. Weighted average number of common shares outstanding
for the three and nine months ended September 30, 1999 include 18.7 million
shares issued to Diamond shareholders from the date of acquisition, (September
24, 1999) to the end of 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.

When computing earnings (loss) per share, the Company includes only potential
common shares that are dilutive. Exercise of options, and conversion of
convertible debt in the nine months ended September 30, 1999 and in the three
and nine months ended September 30, 1998 are not assumed because the result
would have been anti-dilutive. The warrant exercise during the nine months ended
September 30, 1999 is not assumed because the result would have been
anti-dilutive.

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

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THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- ---------------------
1999 1998 1999 1998
-------- -------- -------- --------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

NUMERATOR
Net loss
Basic $(11,098) $(35,401) $(23,877) $(42,913)
-------- -------- -------- --------
Diluted $(11,098) $(35,401) $(23,877) $(42,913)
======== ======== ======== ========
DENOMINATOR
Denominator for basic loss per share 55,419 51,174 53,284 50,920
Common stock equivalents -- -- -- --
-------- -------- -------- --------
Denominator for diluted loss per share 55,419 51,174 53,284 50,920
======== ======== ======== ========
Basic loss per share $ (0.20) $ (0.69) $ (0.45) $ (0.84)
Diluted loss per share $ (0.20) $ (0.69) $ (0.45) $ (0.84)

8. Comprehensive Income

Under SFAS No. 130, "Reporting Comprehensive Income" ("SFAS 130") unrealized
gains or losses on the Company's available-for-sale securities and foreign
currency translation adjustments are to be included in other comprehensive loss.
Prior year financial statements have been reclassified to conform to the
requirements of SFAS 130.

The following are the components of accumulated other comprehensive loss, net
of tax:

SEPTEMBER 30, DECEMBER 31,
1999 1998
------------- ------------
(IN THOUSANDS)

Unrealized loss on investments $ (2,431) $ (2,329)
Foreign currency translation adjustments (13,978) (12,426)
-------- --------
Accumulated other comprehensive loss $(16,409) $(14,755)
======== ========

The following schedule of other comprehensive income (loss) shows the gross
current-period gain and the reclassification adjustment:

THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------- ----------------------
1999 1998 1999 1998
------ -------- -------- --------
(IN THOUSANDS)

Unrealized gain (loss) on investments:
Unrealized gain (loss) on available-for-sale securities $ 392 $ (2,198) $ (158) $ (4,616)
Less: reclassification adjustment for (gain)
loss realized in net income (11) 7 56 (25)
------ -------- -------- --------
Net unrealized gain (loss) on investments 381 (2,191) (102) (4,641)
Foreign currency translation adjustments 26 189 (1,552) 1,988
------ -------- -------- --------
Other comprehensive income (loss) $ 407 $ (2,002) $ (1,654) $ (2,653)
====== ======== ======== ========

9. Contingencies

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 18, 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 stockholders have filed
derivative actions in the state courts of California and Delaware seeking
recovery on behalf of the Company, alleging, among other things, breach of
fiduciary duties by such individual defendants. The derivative cases in
California state court have been consolidated, and plaintiffs have filed a
consolidated amended complaint. The court has entered a stipulated order in
those derivative cases suspending court proceedings and coordinating discovery
in them with discovery in the class actions in California state courts. On
plaintiffs' motion, the federal court has dismissed the federal class actions
without prejudice. The class actions in California state court have been
consolidated, and plaintiffs have filed a consolidated amended complaint. The
Company has answered that complaint. Discovery is pending. While management
intends to defend the actions against the Company vigorously, there can be no
assurance that an adverse result or

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12
settlement with regards to these 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.

The Company is also defending actions involving Diamond, which was acquired
in September 1999. Diamond has been named as a defendant in several putative
class action lawsuits which were filed in June and July of 1996 and June 1997 in
the California Superior Court for Santa Clara County and the U.S. District Court
for the Northern District of California. Certain executive officers and
directors of Diamond are also named as defendants. The plaintiffs purport to
represent a class of all persons who purchased Diamond's Common Stock between
October 18, 1995 and June 20, 1996 (the "Class Period"). The complaints allege
claims under the federal securities law and California law. The plaintiffs
allege that Diamond and the other defendants made various material
misrepresentations and omissions during the Class Period. The complaints do not
specify the amount of damages sought. No trial date has been set for any of
these actions. While management intends to defend these actions against Diamond
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.

On August 4, 1999, a purported class action complaint was filed against
the Company, Diamond and the members of Diamond's Board of Directors. The
complaint purports to be brought on behalf of all the stockholders of Diamond.
The complaint arises out of the merger of Diamond with S3. The complaint alleges
that Diamond and the members of the Board of Directors breached their fiduciary
duties to the stockholders by failing to obtain reasonable consideration for
Diamond's stockholders in the S3 transaction. The complaint seeks an injunction
against the transaction, rescission of the transaction, compensatory damages,
and other remedies. The defendants have not yet responded to the complaint. No
trial date or other schedule has been established in this matter. While
management intends to defend the actions against Diamond 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.

On April 23, 1999, 3Dfx Interactive, Inc. ("3Dfx") filed a lawsuit against
Diamond for breach of contract based upon unpaid invoices in the amount of
$3,895,225. On June 4, 1999 Diamond filed an answer and cross-complaint alleging
breach of contract, breach of the covenant of good faith and fair dealing,
breach of implied warranty and negligence, and thereafter amended the
cross-complaint to include a claim for accounting. Diamond's cross-claim seeks
offsets totaling $4,868,035 for (1) 3Dfx's breach of an agreement to provide
price advantages and other "most favored customer" terms to Diamond; (2)
defective 3Dfx product and (3) an accounting of 3Dfx's business records to
facilitate the determination of Diamond's damages. These damages offset the
amount claimed by 3Dfx for unpaid invoices and result in a net claim of $941,155
by Diamond. At the time it filed its complaint, 3Dfx sought to attach Diamond
assets worth $3,895,225. On June 16, 1999 the court issued a right to attach
order in the amount of $2,859,035. Diamond thereafter substituted a bond for the
attached property, and all attached assets were released. Diamond intends to
file a motion to set aside the writ of attachment with a hearing in early
January 2000. Discovery has commenced and is ongoing. The parties have also
conducted mediation of their dispute, and may continue to pursue mediation. No
trial date has been set.

Sega initiated a claim for arbitration in Tokyo, Japan against Diamond in
December 1998. The claim arises out of an agreement entered into between Sega
and Diamond in September 1995, in which Sega agreed to provide Diamond with Sega
game software that Diamond would bundle with its 3-D graphics board "The Edge."
Sega claims that Diamond breached the parties' agreement by failing to pay Sega
a contractual minimum guaranteed royalty for the games as set forth in the
agreement. Sega claims as damages unpaid royalties in the amount of three
million, eight hundred thousand and ten dollars and fifty cents ($3,800,010.50),
plus pre-judgment interest of twelve percent (12%), calculated from January 31,
1998. On May 28, 1999, Diamond responded to Sega's claims by filing an answer in
which it denied the material allegations of Sega's claims. On October 21, 1999,
Diamond filed a supplemental brief with the arbitration panel, in which it set
forth the factual basis for its denials of Sega's claims. A hearing was held
before the arbitration panel on October 28, 1999, at which the arbitration panel
granted Sega the opportunity to file a reply to Diamond's supplemental brief by
December 10, 1999. A further hearing on this matter has been scheduled for
December 17, 1999. Diamond contests the material allegations of Sega's claims.
In addition, Diamond has alleged that Sega's failure to provide it with 3-D
optimized game software on a timely basis adversely affected sales of The Edge.
Diamond claims that these lost sales and profits therefrom provide an offset to
Sega's claims in the arbitration. While management intends to defend the action
against Diamond vigorously, there can be no assurance that an adverse result or
settlement with regards to this arbitration would not have a material adverse
effect on the Company's financial condition or results of operation.

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In October 1998, the Company was named as a defendant in a lawsuit filed in
the United States District Court for the Central District of California.
Plaintiffs were the Recording Industry Association of America, Inc. (the
"RIAA"), a trade organization representing recording companies and the Alliance
of Artists and Recording Companies (the "AARC") an organization controlled by
the RIAA which exists to distribute royalties collected by the copyright
office. The complaint alleged that the Company's Rio product, a portable music
player, is subject to regulation under the Audio Home Recording Act (the "AHRA")
and that the device did not comply with the requirements of the AHRA. On August
2, 1999, Diamond and the RIAA entered into a settlement, pursuant to which the
lawsuit filed by the RIAA against Diamond and Diamond's counterclaims are to be
dismissed. Diamond and the RIAA have announced the mutually satisfactory
resolution of outstanding legal issues. The terms of the settlement are
confidential.

The Company is also party to other claims and pending legal proceedings that
generally involve employment and trademark issues. These cases are, in the
opinion of management, ordinary and routine matters incidental to the normal
business conducted by the Company. 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.

10. Subsequent Events

In October 1999, S3 announced that it has created an equity partnership for
the Rio technology, RioPort.com, Inc., which will deliver an integrated platform
for acquiring, managing and experiencing music and spoken audio programming from
the Internet. As a result of the equity partnership, the Company will retain a
minority investment in RioPort.com, Inc. and account for its investment using
the equity method of accounting. In addition, in November 1999, as part of the
equity partnership, the Company will receive $10.9 million for the sale of
OneStep, LLC to RioPort.com, Inc.

In November 1999, the Company announced the establishment of a joint venture
to bring high-performance integrated graphics and core logic chip sets to the
volume OEM desktop and notebook PC markets. The newly formed S3-VIA Inc. will
have joint funding, exclusive access to both company's technology and
distribution rights for developed products between S3 and VIA. The Company owns
50.1% of the voting common stock of the joint venture. Accordingly, the Company
will consolidate the accounts of S3-VIA Inc. in its consolidated financial
statements.

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PART I. CONDENSED CONSOLIDATED FINANCIAL INFORMATION

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

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 "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Factors That May
Affect Our 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.

OVERVIEW

S3(R) Incorporated ("S3" or the "Company") is a leading supplier of
multimedia acceleration hardware and its associated software for the personal
computer ("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 from
the first 32-bit and 64-bit graphics accelerator families to the first 128-bit,
full-featured integrated two-dimensional ("2D") and three-dimensional ("3D")
graphics and video accelerator specifically designed for today's 3D and digital
versatile disc ("DVD")-based applications. 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.

The Company purchased Diamond Multimedia Systems, Inc. ("Diamond") on
September 24, 1999. Diamond is a supplier of graphics and multimedia accelerator
subsystems for PCs and multimedia and connectivity products for the digital
home, enabling consumers to create, access and experience compelling new media
content from their desktops and through the Internet. Diamond products include
the Rio line of Internet music players, the Stealth and Viper series of video
accelerators, the Monster series of gaming accelerators, the Fire series of NT
workstation 3D graphics accelerators, the Supra series of modems and the
HomeFree line of home networking products.

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RESULTS OF OPERATIONS

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

THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------- --------------------
1999 1998 1999 1998
------ ------ ------ ------

Net sales 100.0% 100.0% 100.0% 100.0%
Cost of sales 77.7 116.7 75.3 92.2
------ ------ ------ ------
Gross margin 22.3 (16.7) 24.7 7.8
Operating expenses:
Research and development 24.2 41.8 30.6 32.8
Selling, marketing and administrative 13.3 21.2 15.0 18.1
Other operating expense 9.5 12.9 3.9 7.7
Amortization of goodwill and
intangibles 1.3 -- 0.5 --
------ ------ ------ ------
Total operating expenses 48.3 75.9 50.0 58.6
------ ------ ------ ------
Loss from operations (26.0) (92.6) (25.3) (50.8)
Gain on sale of shares of joint venture 10.6 -- 8.5 14.5
Other income (expense), net (0.3) 0.2 0.2 (2.2)
------ ------ ------ ------
Loss before income taxes and equity
in net income of joint venture (15.7) (92.4) (16.6) (38.5)
Benefit for income taxes -- -- -- (6.5)
------ ------ ------ ------
Loss before equity in net income of joint
venture (15.7) (92.4) (16.6) (32.0)
Equity in net income of joint venture
(net of tax) -- 17.5 2.7 8.6
------ ------ ------ ------
Net loss (15.7)% (74.9)% (13.9)% (23.4)%
====== ====== ====== ======

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 upon, the personal computer industry with sales
primarily in the U.S., Asia and Europe. Net sales were $70.5 million for the
three months ended September 30, 1999, a 49.0% increase from the $47.3 million
of net sales for the three months ended September 30, 1998. Net sales were
$172.0 million for the nine months ended September 30, 1999, a 6.1% decrease
from the $183.1 million of net sales for the nine months ended September 30,
1998. Net sales for the three months and nine months ended September 30, 1999
consisted primarily of the Company's 3D, Mobile, video accelerators, graphics
accelerators and modem products while net sales for the three months and nine
months ended September 30, 1998 consisted primarily of the Company's 2D and 3D
products. The Company acquired Diamond on September 24, 1999. Included in the
net sales for the three and nine months ended September 30, 1999 are the
Company's video accelerators, graphics accelerators and modems. The Company
commenced volume shipments of its Savage4 product during the quarter ended June
30,1999. Net sales for the three months ended September 30, 1999 increased
primarily as a result of higher unit average selling prices of Savage4 products
and the additional sales of Diamond Multimedia products. Net sales for the nine
months ended September 30, 1999 decreased primarily as a result of a shift from
the Company's strong 2D product family to a 3D product family which was less
competitive for the Company. Unit volumes decreased approximately 20% and 29%
for three months and nine months ended September 30, 1999, respectively, from
the three months and nine months ended September 30, 1998. 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.

Prices for graphics accelerators tend to decline over time, and prices for
newly introduced products are under significant pricing pressures due in part to
aggressive pricing from some of our competitors. The Company has experienced and
anticipates that it will continue to experience increased pricing pressures on
average selling prices for the Company's ViRGE, Trio and Savage families of
accelerators as well as Diamond's graphics and video accelerator products.

The graphics accelerator market has transitioned from 2D acceleration to 3D
acceleration and products that compete in the high performance segment of that
market have higher gross margins than products in the mainstream PC or in the
sub-$1,000, or "segment zero," PC market. The Company commenced shipment of its
Savage3D product during the third quarter of 1998. This product was intended to
address the high performance 3D acceleration market. However, the Savage3D
failed to achieve significant market acceptance. The Company commenced volume
shipments of its Savage4 product in the second quarter of 1999. Savage4 is
designed to compete in multiple performance segments of the commercial and
consumer PC markets of the 3D acceleration market. If the

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Company does not continue to introduce and successfully market higher
performance products, our gross margin and profitability could be negatively
affected.

Export sales accounted for 67% and 94% of net sales for the three months
ended September 30, 1999 and 1998, respectively. Export sales accounted for 58%
and 88% of net sales for the nine months ended September 30, 1999 and 1998,
respectively. Approximately 63% and 35% of export sales for the three months
ended September 30, 1999 and 1998, respectively, were to affiliates of United
States customers. Approximately 52% and 35% of export sales for the nine months
ended September 30, 1999 and 1998, respectively, were to affiliates of United
States customers. The Company expects that export sales will continue to
represent a significant portion of net sales, although there can be no assurance
that export sales as a percentage of net sales will remain at current levels.
All sales transactions were denominated in U.S.
dollars.

Significant customer concentration as a percentage of net sales is summarized
below:

THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ -----------------
1999 1998 1999 1998
------ ------ ------ ------

Customers:
IBM Corporation 28% 27% 26% --
Diamond Multimedia Systems, Inc.
(sales occurred prior to merger) 13% -- -- --
Distributors:
Synnex Technology, Inc. -- 37% 16% 37%
Promate Electronic Co. -- 15% -- 13%

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. From the date of the merger, all sales to Diamond have been,
and will be, eliminated in consolidation. The occurrence of any such events or
the loss of a strategic customer could have a material adverse effect on the
Company's operating results.

GROSS MARGIN

Gross margin (loss) percentage increased to 22.3% for the three months ended
September 30, 1999 from (16.7)% for the three months ended September 30, 1998.
Gross margin percentage increased to 24.7% for the nine months ended September
30, 1999 from 7.8% for the nine months ended September 30, 1998. The increase in
gross margin for the three and nine months ended September 30, 1999 versus the
three and nine months ended September 30, 1998 was the result of unanticipated
sales of certain inventory formerly reserved by the Company, and, to a lesser
extent, licensing revenues associated with 29 patents licensed to United
Microelectronics Corporation ("UMC"). The Company had previously recorded
reserves for some of its 2D and 3D products related to excess and obsolete
inventory and it also experienced yield losses in its Savage 3D product related
to its production ramp in the third quarter of 1998. The Company recorded fewer
inventory reserves in the three and nine months ended September 30, 1999 versus
the three and nine months ended September 30, 1998 as the result of better
inventory management.

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 extent to which
the Company forfeits or utilizes its production capacity rights with Taiwan
Semiconductor Manufacturing Company ("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 expects gross margin
in the fourth quarter of 1999 to experience some pressure due to price increases
in components, DRAM and graphics accelerators.

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 $17.1 million for the three
months ended September 30, 1999, a decrease of $2.7 million from $19.8 million
for the three months ended September 30, 1998. This decrease was the result of
lower depreciation expense as a result of write offs for idle, excess and
obsolete capital equipment associated with terminated projects in the third
quarter of 1998. Research and development expenses were $52.6 million for the
nine

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months ended September 30, 1999, a decrease of $7.6 million from $60.2 million
for the nine months ended September 30, 1998. The decrease in research and
development expenses for the three months and nine months ended September 30,
1999 was the result of reductions in engineering staff which occurred as part of
the Company's implementation of a restructuring plan in July 1998 and certain
one time engineering costs incurred during the first quarter of 1998 associated
with the discontinued audio and communications products line. The Company
expects research and development expenses to increase in absolute dollars in the
fourth quarter of 1999.

SELLING, MARKETING AND ADMINISTRATIVE EXPENSES

Selling, marketing and administrative expenses were $9.4 million for the
three months ended September 30, 1999, a decrease of $0.6 million from $10.0
million for the three months ended September 30, 1998. Selling, marketing and
administrative expenses were $25.7 million for the nine months ended September
30, 1999, a decrease of $7.5 million from $33.2 million for the nine months
ended September 30, 1998. Selling, marketing and administrative expenses for the
three and nine months ended September 30, 1999 decreased from the prior year
primarily as a result of headcount reductions offset in part by Diamond selling,
marketing and administrative expenses incurred subsequent to the acquisition
date and lower commission related payouts. Selling, marketing and administrative
headcount decreased 28% from the three months ended September 30, 1998 to the
three months ended September 30, 1999. As part of the Company's July 1998
restructuring plan, the number of consultants working on various projects was
also reduced. In addition, year to date commissions were lower in the first nine
months of 1999 versus 1998 as a result of the overall decrease in net sales for
the same period.

OTHER OPERATING EXPENSE

The Company recorded a non-recurring charge of $6.7 million related to the
purchase of Diamond on September 24, 1999. This was determined through valuation
techniques generally used by appraisers in the high-technology industry and was
immediately expensed in the period of acquisition because technological
feasibility had not been established and no alternative use had been identified.
The charge is discussed in more detail in Note 2 to the Unaudited Condensed
Consolidated Financial Statements contained herein. As discussed in Note 2,
restructuring related to Diamond was accrued as liabilities assumed in the
purchase in accordance with EITF 95-3.

In January 1998, the Company entered into a $40.0 million technology exchange
with Cirrus Logic, Inc. to obtain graphic functionality technologies. As a
result of the exchange, the Company acquired the technology covered by 10
graphic patents and 25 graphic patent applications, as well as cross-licensed
Cirrus Logic's remaining patents. Under the terms of the cross-licensing
provisions, the Company and Cirrus Logic have a perpetual license to each
other's graphic patents and additional licenses with respect to the other
party's patents for agreed upon periods of time. The Company wrote-off $8.0
million of the acquired technologies in the first quarter of 1998 that were not
realizable based on estimated cash flows from the sale of products currently
sold by the Company. The remaining $32.0 million intangible asset was being
amortized to cost of sales based on the lives of the currently utilized core
technologies, which was generally five years until the fourth quarter of 1998.

During the fourth quarter of 1998, management reevaluated the carrying value
of the intangible assets recorded in connection with the technology exchange
with Cirrus Logic, Inc., and related to the patents obtained from Brooktree
Corporation ("Brooktree"), as well as other long-lived assets, including
property and equipment. This revaluation was necessitated by management's
determination based on recent results of operations and that the future expected
sales and cash flows for the Company's operations would be substantially lower
than had been previously expected by management. Expected undiscounted future
cash flows were not sufficient to recover the carrying value of such assets.
Accordingly, an impairment loss of $27.2 million, representing the excess of the
carrying value over the estimated fair value of the assets, was recognized for
write-downs of a substantial portion of the intangible assets. The estimated
fair value of the intangible assets was based on management's best estimate of
the patent portfolio based on a comparison to other graphics technology
portfolios in the marketplace. The Company determined that no write-down of
property and equipment was necessary at December 31, 1998 based on its estimate
of the fair value of such assets. Due to technological changes in the graphics
marketplace, the Company concluded it should accelerate its amortization of its
remaining patent portfolio, of approximately $4.0 million, over the current
estimated life of the currently utilized core technologies, which is two years.

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facilities. Restructuring expense of $6.1 million was recognized in the third
quarter of 1998. As of September 30, 1999, all severance packages have been paid
and there is no remaining balance in the restructuring reserve.

GAIN ON SALE OF SHARES OF JOINT VENTURE

On December 31, 1997, the Company entered into an agreement to sell to UMC 80
million shares of stock of United Semiconductor Corporation ("USC") stock for a
purchase price of 2.4 billion New Taiwan dollars. The Company received the
purchase price (approximately $68.0 million in cash) in January 1998 upon
closing. The gain on the sale of stock of USC was $26.6 million.

In June 1999, the Company amended its agreements with UMC. Under the terms of
the amended agreements, UMC has agreed to pay the Company, subject to certain
conditions, 1.4 billion New Taiwan dollars (approximately $43.3 million in cash)
and the Company has agreed to release UMC from contingencies associated with the
sale of 80 million shares of stock of USC in January 1998 and to grant a license
to patents covering multimedia products and integrated circuit manufacturing
technology for use in products manufactured by UMC. Payments will be received
over five fiscal quarters beginning in the quarter ended June 30, 1999.

ACQUISITION OF DIAMOND

The Company recorded goodwill as a result of consideration paid in excess of the
fair value of net tangible and intangible assets acquired in the merger with
Diamond on September 24, 1999. Goodwill and identified acquisition related
intangible assets are amortized on a straight-line basis. The Company recorded
$0.9 million for amortization of goodwill and intangibles from the date of
acquisition through September 30, 1999. Amortization of goodwill and intangibles
for the fourth quarter of 1999 and the year ended December 31, 2000 will be
approximately $10.7 million and $43.0 million, respectively.

OTHER INCOME (EXPENSE), NET

Other expense was $0.2 million for the three months ended September 30, 1999,
a decrease of $0.3 million from other income of $0.1 million for the three
months ended September 30, 1998. Other income was $0.3 million for the nine
months ended September 30, 1999, an increase of $4.4 million from other expense
of $4.1 million for the nine months ended September 30, 1998. The decrease in
other income for the three months ended September 30, 1999 was primarily
associated with interest expense related to the Company's notes payable. The
increase in other income for the nine months ended September 30, 1999 was the
result of sublease income.

INCOME TAXES

The Company's effective tax rate for the three months ended September 30, 1999
and 1998 is 0%. The Company's effective tax rates for the nine months ended
September 30, 1999 and 1998 are 0% and 22%. The effective tax rate for 1999
reflects net operating losses with no realized tax benefit. The 1998 effective
tax rate reflects the expected benefit of the year's loss carryback and the
establishment of a valuation allowance against the 1998 opening balance of net
deferred tax assets.

EQUITY IN NET INCOME OF JOINT VENTURE

As discussed in "Liquidity and Capital Resources," the Company entered into
an agreement with other parties to form a separate Taiwanese company, USC. This
investment was accounted for under the equity method of accounting in reporting
the Company's share of results for the entity until June 1999. Equity in net
income of joint venture for the nine months ended September 30, 1999 reflects
the Company's share of income earned by USC through June 1999. The Company
reported $8.3 million of equity in net income of joint venture, net of tax for
the three months ended September 30, 1998. The Company reported $4.6 million and
$15.8 million of equity in net income of joint venture, net of tax for the nine
months ended September 30, 1999 and 1998, respectively.

In June 1999, the Company announced an agreement with UMC, the terms of which
included that S3 would release UMC from contingencies associated with the sale
of 80 million shares of USC stock in January 1998. The Company agreed to waive
rights to its

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board seat and determined that it could no longer exercise significant influence
over the financial and operating decisions of USC. Accordingly, the Company
ceased accounting for its investment in USC using the equity method of
accounting effective June 1999.

LIQUIDITY AND CAPITAL RESOURCES

Cash provided by operating activities for the nine months ended September 30,
1999 was $8.8 million, as compared to $8.4 million of cash used for operating
activities for the nine months ended September 30, 1998. The Company's net loss
for the nine months ended September 30, 1999 was partially offset by
depreciation, amortization and write-off of acquired in-process research and
development. In addition, cash provided by operations for the nine months ended
September 30, 1999 was favorably impacted by decreases in prepaid taxes, prepaid
expenses and increases in accounts payable and accrued liabilities, partially
offset by increases in accounts receivable and inventories and decreases in
deferred revenue. The changes in prepaids, accounts payable and accrued
liabilities are the result of timing of payments. The Company's net loss for the
nine months ended September 30, 1998 was offset by a number of non-cash items
including deferred taxes, depreciation and amortization and the write-off of
acquired technologies. These were offset by the gain on the sale of shares of
joint venture and equity in income from the joint venture. Changes in assets and
liabilities include decreases in accounts receivable, inventories, accounts
payable and deferred revenue. The decrease in accounts receivable for the nine
months ended September 30, 1998 was the result of lower net sales. The decrease
in inventories and accounts payable for the nine months ended September 30, 1998
were attributable to reductions in inventory procurement resulting from
softening demand and the Company's efforts to reduce inventory balances in its
distribution channel. Deferred revenue for the nine months ended September 30,
1998 decreased as distributors sold through inventory to their end user
customers.

Investing activities provided cash of $4.9 million for the nine months ended
September 30, 1999 and consisted primarily of sales of short-term investments,
net, cash received from UMC related to the sale of shares and cash received from
the sale of investment in real estate partnership, offset by acquisition of
OneStep, LLC, the acquisition of Diamond, net of cash acquired and purchases of
property and equipment, net. Investing activities used $17.1 million during the
nine months ended September 30, 1998 and consisted primarily of cash received
from the sale of USC shares, offset by cash used in the technology exchange with
Cirrus Logic, Inc. and the purchase of short term investments, net.

Financing activities provided cash of $28.2 million and used cash of $10.1
million for the nine months ended September 30, 1999 and 1998, respectively.
Sales of common stock, net, including $23.4 million received from the sale of
stock to two foreign investors, and the sale of a warrant to Intel were the
financing activities generating cash during the nine months ended September 30,
1999 which were offset partially by repayments of notes payable. Repayment on
the line of credit and equipment financing were the principal financing
activities that used cash for the nine months ended September 30, 1998.

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. 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 totaled $9.6 million as of September 30, 1999.

Working capital at September 30, 1999 and December 31, 1998 was $113.7
million and $152.2 million, respectively. At September 30, 1999, the Company's
principal sources of liquidity included cash and equivalents of $72.8 million
and $74.7 million in short-term investments. The Company's principle sources of
liquidity at December 31, 1998 included cash and equivalents of $31.0 million
and $88.6 million of short-term investments. As of September 30, 1999, the
Company had short-term lines of credit and bank credit facilities totaling $56.2
million, of which approximately $3.1 million was unused and available. At March
31, 1999, June 30, 1999 and September 30, 1999, the Company was in default with
its loan covenants regarding liquidity. The Company obtained waivers for this
violation as of March 31, 1999 and June 30, 1999 and is seeking to obtain
waivers for this violation as of September 30, 1999. 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.

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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
issuance 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 Company is currently a party to certain legal proceedings. Litigation
could result in substantial expense to the Company. See "Part II- Item 1.
Legal Proceedings."

Year 2000 Compliance

As a result of computer programs being written using two digits, rather than
four, to represent year dates, the performance of the Company's computer systems
and those of its suppliers and customers in the Year 2000 is uncertain. Any
computer programs that have time-sensitive software may recognize a date using
"00" as the year 1900 rather than the year 2000. This could result in a system
failure or miscalculations causing disruptions of operations, including, among
other things, a temporary inability to process transactions, send invoices or
engage in other normal business activities.

The Company's plans to address the Year 2000 issue involve the following
phases: (i) inventory/risk assessment, (ii) remediation, (iii) testing and (iv)
full compliance and/or the creation of contingency plans. The Company has
completed an inventory and assessment of its systems for Year 2000 readiness.
The assessment indicated that most of the Company's significant information
technology systems could be affected, particularly the general ledger, billing
and inventory systems. That assessment also indicated that software and hardware
(embedded chips) used in development, production and manufacturing systems also
are at risk. Based on a review of its product line, the Company believes that
its products do not require remediation to be Year 2000 compliant. Accordingly,
the Company believes that the Company's products will not expose the Company to
material Year 2000 related liabilities. The Company has also queried its
significant suppliers and subcontractors that do not share information systems
with the Company ("external agents"). Although the Company is not aware of any
external agent with a Year 2000 issue that would materially affect the Company's
results of operations or financial condition, the failure of an external agent
to be Year 2000 compliant could have a material adverse effect on the Company's
results of operations or financial condition. The Company intends to
periodically review its external agents to monitor their progress toward
completion of their Year 2000 compliance.

The Company has completed the remediation phase for its information
technology systems and has completed software reprogramming and replacement. To
date, the Company has completed 100% of its testing. Completion of the testing
phase for all remediated systems was completed in September 1999, with all
remediated systems fully tested and implemented by the end of October 1999. The
Company's order entry system interfaces directly with significant third party
vendors. The Company has completed the process of working with third party
vendors to ensure that the Company's systems that interface directly with third
parties are Year 2000 compliant.

The Company will utilize both internal and external resources to reprogram,
or replace, test and implement its software and operating equipment for Year
2000 modifications. The Company believes that costs for remediation, testing and
implementation are not expected to exceed $0.3 million.

The Company has completed 100% of its contingency plans in the event it does
not complete all phases of the Year 2000 program. The failure of either the
Company's critical systems or those of its material third parties to be Year
2000 compliant would result in the interruption of its business, which could
have a material adverse affect on the results of operations or financial
condition of the Company.

Diamond has also addressed the Year 2000 issue for the significant systems
which are used to operate, monitor and manage Diamond's business activities.
Diamond has completed its risk assessment, remediation and testing phases as of
June 1999. The implementation of fully tested remediated systems will occur by
the end of November 1999. Diamond continues to identify external agents such as
service providers, vendors, suppliers and customers and attempts to determine
their ability to manage the Year 2000 issue. Contingency plans will be developed
if it appears Diamond or its key external agents will not be Year 2000
compliant, and if such noncompliance will have a material adverse impact on
operations. The failure to correct a material Year 2000 problem or to anticipate
or mitigate a problem with an external agent could result in an interruption in
or failure of normal business activities or operations. These failures could
materially and adversely affect the results of operations or financial condition
of the Company.

FACTORS THAT MAY AFFECT OUR RESULTS

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The Expected Benefits Of Our Merger with Diamond Multimedia May Not Be Realized.
If That Happens, Our Operating Results and the Market Price For Our Common Stock
May Decline.

We merged with Diamond Multimedia in September 1999 expecting that the merger
between the two companies would result in benefits to us including faster time
to market with new products and increased cost efficiencies.

We will not realize the full benefits of the merger if we do not effectively
integrate Diamond's technologies, operations and personnel with ours in a timely
and efficient manner. The difficulties, costs and delays involved in integrating
Diamond, which may be substantial, may include:

~ Distracting management and other key personnel, particularly senior engineers
involved in product development and product definition, from focusing on our
business;

~ Perceived and potential adverse changes in business focus or product
offerings;

~ Potential incompatibility of business cultures;

~ Costs and delays in implementing common systems and procedures, particularly
in integrating different information systems; and

~ Inability to retain and integrate key management, technical, sales and
customer support personnel.

If we do not timely and efficiently integrate our technologies, operations
and personnel, our operating results may suffer and the price of our common
stock may decline.

As A Result Of the Merger, We Expect That Some Of Our Suppliers May Not Do
Business With Us, Which Could Cause A Decline In Our Sales.

The merger may result in disruptions in relationships with other graphics
chips suppliers who compete with us. If we lose one or more of these suppliers,
we may lose those customers who demand products that contain other companies'
graphic chips. For example, a significant portion of Diamond's graphics
accelerator boards incorporate graphics chips supplied by NVIDIA Corporation.
NVIDIA is one of our direct competitors and may not continue to supply us with
its products. To the extent that these relationships are terminated or curtailed
and we cannot persuade our existing customers who purchase products containing
any of those suppliers' graphics chips to purchase products containing our
graphics chips, the revenue contributed by Diamond could be reduced
significantly.

The consummation of the merger is expected to cause some of our add-in card
and motherboard customers to end or curtail their relationships with us. The
loss of these customers could cause a decline our sales unless new sales
resulting from the integration of Diamond have an offsetting effect. For
example, Creative Technology Ltd., a competitor of Diamond and previously an S3
customer, has discontinued its relationship with us. Additional customers may
discontinue their relationships with us in the future. This may occur because
our products comprise of both graphics chips and graphics boards. Thus, as a
result of the merger, we are competing with those of our current customers,
which are graphics board manufacturers. As a result, we expect that sales to
some of our existing customers will be reduced significantly from prior levels
and that these customers will no longer continue to be significant customers.
Unless we are able to offset the loss of these sales with new customers or sales
of alternative products, our revenues may decline.

We Are Dependent On A Limited Source Of Graphics Chips and Graphics Boards
Because S3 and Diamond Are Each Suppliers To Each Other, Resulting In Heightened
Risks Because One Company's Suppliers May Not Meet the Other Company's
Requirements.

As a result of the merger, we will become significantly dependent on our
graphics chip design and development capabilities and significantly dependent on
Diamond's graphics board design, manufacturing and marketing capabilities. This
will occur because we will be more restricted in our ability to select and use
products produced by our competitors prior to the merger. If either our graphics
chips or Diamond's graphics boards fail to meet the requirements of the market
and our customers, our relationship with those customers could be hurt,
negatively affecting our financial performance. In addition, we will be highly
dependent on our ability to provide graphics chips on a timely basis meeting the
rigid scheduling and product specification requirements of OEMs. If our

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graphics chips are not competitive or not provided on a timely basis, we will
most likely not be able to readily obtain suitable alternative graphics chips,
which would result in our loss of revenue and customers.

There Is Substantial Expense Resulting From the Merger That Could Divert
Resources From Other Productive Uses.

We estimate that the aggregate costs and expenses related to the merger will
be approximately $12.8 million. These expenses will prevent us from spending
those amounts on other uses which may be more productive. These costs primarily
relate to costs associated with the payment of involuntary employee separation
benefits, costs associated with facilities consolidation and the fees of
financial advisors, attorneys and accountants. Although we believe that the
final costs will not exceed the estimate, the estimate may be incorrect or
unanticipated contingencies may occur that substantially increase the costs of
combining our operations.

Our Quarterly Operating Results Are Subject To Fluctuations Caused By Many
Factors, Which Could Result In Failing To Achieve Our Revenue Or Profitability
Expectations Resulting In a Drop in the Price of our Common Stock.

Our quarterly and annual results of operations have varied significantly in
the past and are likely to continue to vary in the future due to a number of
factors, many of which are beyond our control. Any one or more of the factors
listed below or other factors could cause us to fail to achieve our revenue or
profitability expectations. The failure to meet market expectations could cause
a sharp drop in our stock price. These factors include:

~ the industry in which we compete is always changing with the constant
introduction of new technologies, products and methods of doing business;

~ our ability to develop, introduce and market successfully new or enhanced
products;

~ our ability to introduce and market products in accordance with specialized
customer design requirements and short design cycles;

~ changes in the relative volume of sales of various products with sometimes
significantly different margins;

~ changes in demand for our products and our customers' products;

~ rapid changes in electronic commerce on which we or our customers may not
capitalize or which erode our traditional business base;

~ frequent gains or losses of significant customers or strategic
relationships;

~ unpredictable volume and timing of customer orders;

~ the availability, pricing and timeliness of delivery of components for our
products;

~ the availability of wafer capacity using advanced process technologies;

~ the timing of new product announcements or introductions by us or by our
competitors;

~ product obsolescence and the management of product transitions;

~ production delays;

~ decreases in the average selling prices of products;

~ seasonal fluctuations in sales; and

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~ general economic conditions, including economic conditions in Asia and Europe
in particular, that could affect the timing of customer orders and capital
spending and result in order cancellations or rescheduling.

Some or all of these factors could adversely affect demand for our products and
our future operating results.

Most of our operating expenses are relatively fixed in the short term. We may
be unable to rapidly adjust spending to compensate for any unexpected sales
shortfall, which could harm our quarterly operating results. Because the lead
times of firm orders are typically short in the graphics industry, we do not
have the ability to predict future operating results with any certainty.
Therefore, sudden changes that are outside our control, such as general economic
conditions, the actions or inaction of competitors, customers, third-party
vendors of operating systems software, and independent software application
vendors, may materially and adversely affect our performance.

We generally ship more products in the third month of each quarter than in
either of the first two months of the quarter, with levels of shipment in the
third month higher towards the end of the month. This pattern, which is common
in the semiconductor and multimedia communication industries, is likely to
continue and makes future quarterly operating results less predictable.

As a result of the above factors, you should not rely on period-to-period
comparisons of results of operations as an indication of future performance. The
results of any one quarter are not indicative of results to be expected for a
full fiscal year.

We Experienced A Net Loss For Several Recent Quarters and We May Continue To
Experience Net Losses In the Future.

We had a net loss of $23.9 million for the nine months ended September 30,
1999 and for all of 1998. These results occurred primarily because we did not
offer competitive products in the high end of the graphics and multimedia
accelerator market. As a result, our sales consisted of primarily older
generation and lower price products that were sold into markets that had
significant price competition. To the extent that we continue to experience net
losses in the future, our operating results will be adversely affected.

In addition, Diamond had a net loss of $9.4 million for the six months ended
June 30, 1999. Diamond's net sales decreased 24% for the six months ended June
30, 1999 as compared to the six months ended June 30, 1998. The decrease in net
sales was primarily attributable to reduced shipments of Diamond's graphics
accelerator products. The decrease was partially offset by increased shipments
of sound cards, as well as revenues from new products such as the Rio Internet
music players and the HomeFree line of home networking products. Revenues from
graphics accelerators declined in part due to continued reductions in demand for
entertainment specific products. In particular, Diamond is no longer building
and selling high performance 3D-only products. In addition, demand and pricing
for graphics accelerators that combine 2D and 3D display and are targeted
specifically for game enthusiasts declined. Further, revenue for low-end graphic
accelerators continued to decline significantly as more of these market
requirements were met by the direct installation of graphics chips onto PC
motherboards. To the extent that Diamond continues to experience net losses
after the merger, our operating results may be adversely affected. We may also
incur net losses in the short term while we integrate Diamond's operations with
our operations. We cannot assure you that we will be able to achieve or maintain
profitability.

If We Do Not Continue To Develop and Market New and Enhanced Products, We Will
Not Be Able To Compete Successfully In Our Markets.

The markets for which our products are designed are intensely competitive and
are characterized by short product life cycles, rapidly changing technology,
evolving industry standards and declining average selling prices. As a result,
we cannot succeed unless we consistently develop and market new products. We
believe this will require expenditures for research and development in the
future consistent with our historical research and development expenditures. To
succeed in this environment, we must anticipate the features and functionality
that customers will demand. We must then incorporate those features and
functionality into products that meet the design, performance, quality and
pricing requirements of the personal computer market and the timing requirements
of PC OEMs and retail selling seasons. For example, we recently finalized a
joint venture with VIA Technologies to bring high-performance integrated
graphics and core logic chip sets to the OEM desktop and notebook PC markets.
There can be no assurance that the joint venture will be successful or that our
existing products will be compatible with new products. We have in the past
experienced delays in completing the development and introduction of new
products, as well as compatibility issued with integrated products and we cannot
assure you that we will not experience similar delays in the future. In the
past, our business has been seriously harmed when

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we developed products that failed to achieve significant market acceptance and
therefore were unable to compete successfully in our markets. Such a failure
could occur again in the future.

The Demand For Our Products Has Historically Been Weaker In Certain Quarters.

Due to industry seasonality, demand for PCs and PC related products is
strongest during the fourth quarter of each year and is generally slower in the
period from April through August. This seasonality may become more pronounced
and material in the future to the extent that:

~ a greater proportion of our sales consist of sales into the retail/mass
merchant channel;

~ PCs become more consumer-oriented or entertainment-driven products; or

~ our net revenue becomes increasingly based on entertainment-related
products.

Also, to the extent we expand our European sales, we may experience relatively
weak demand in third calendar quarters due to historically weak summer sales in
Europe.

We Operate In Markets That Are Intensely and Increasingly Competitive, and We
Are In Constant and Increasing Risk Of Losing Customers and Being Subject To
Decreasing Product Prices and Profit Margins.

The personal computer multimedia and communications markets in which we
compete are intensely competitive and are likely to become more competitive in
the future. Because of this competition, we face a constant and increasing risk
of losing customers to our competitors. The competitive environment also creates
downward pressure on prices and requires higher spending to address the
competition, both of which tend to keep profit margins lower. We believe that
the principal competitive factors for our products are:

~ product performance and quality;

~ conformity to industry standard application programming interfaces, or
APIs;

~ access to customers and distribution channels;

~ reputation for quality and strength of brand;

~ manufacturing capabilities and cost of manufacturing;

~ price;

~ product support; and

~ ability to bring new products to the market in a timely manner.

Historically, the gross profit margins on Diamond's products have been lower
than the margins on our products. As a result of the merger, our average gross
margins will likely be lower than they were prior to the merger thereby
decreasing our average gross margins.

Many of our current and potential competitors have substantially greater
financial, technical, manufacturing, marketing, distribution and other
resources. These competitors may also have greater name recognition and market
presence, longer operating histories, greater market power and product breadth,
lower cost structures and larger customer bases. As a result, these competitors
may be able to adapt more quickly to new or emerging technologies and changes in
customer requirements. In addition, some of our principal competitors offer a
single vendor solution because they maintain their own semiconductor foundries
and may therefore benefit from certain capacity, cost and technical advantages.

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In some markets where we are a relatively new entrant, such as modems, home
networking, sound cards and consumer electronics, including Internet music
players, we face dominant competitors that include 3Com (home networking and
modems), Creative Technologies (sound cards, modems and Internet music players),
Intel (home networking) and Sony (consumer electronic music players). In
addition, the markets in which we compete are expected to become increasingly
competitive as PC products support increasingly more robust multimedia functions
and companies that previously supplied products providing distinct functions
(for example, companies today primarily in the sound, modem, microprocessor or
motherboard markets) emerge as competitors across broader or more integrated
product categories.

In addition to graphics board manufacturers, our competitors include OEMs
that internally produce graphics chips or integrate graphics chips on the main
computer processing board of their personal computers, commonly known as the
motherboard, and makers of other personal computer components and software that
are increasingly providing graphics or video processing capabilities.

We Operate In the Personal Computer and Graphics and Video Chip Markets,
Which Are Rapidly Changing, Highly Cyclical and Vulnerable To Sharp Declines
In Demand and Average Selling Prices.

We operate in the personal computer and graphics/video chip markets. These
markets are constantly and rapidly changing and have in the past, and may in the
future, experience significant downturns. These downturns are characterized by
lower product demand and accelerated product price reductions. In the event of a
downturn, we would likely experience significantly reduced demand for their
products. Substantially all of our revenues are currently derived from products
sold for use in or with personal computers. In the near term, we expect to
continue to derive almost all of our revenues from the sale of products for use
in or with personal computers. Changes in demand in the personal computer and
graphics/video chip markets could be large and sudden. Since graphics board and
personal computer manufacturers often build inventories during periods of
anticipated growth, they may be left with excess inventories if growth slows or
if they have incorrectly forecasted product transitions. In such cases, the
manufacturers may abruptly stop purchasing additional inventory from suppliers
like us until the excess inventory has been used. This suspension of purchases
or any reduction in demand for personal computers generally, or for particular
products that incorporate our products, would negatively impact our revenues and
financial results. We may experience substantial period-to-period fluctuations
in results of operations due to these general semiconductor industry conditions.

We Have Only Recently Started To Offer Products Intended To Address All
Performance Segments Of the Commercial and Consumer PC Market.

The desktop graphics accelerator market has recently transitioned from 2D
acceleration to 3D acceleration and has recently added video and TV processing
capabilities. Products that compete in the high performance segment of that
market have higher gross margins than products in the mainstream PC or in the
sub-$1,000, or "segment zero," PC market. We commenced shipment of our Savage3D
product during the third quarter of 1998. This product was intended to address
the high performance 3D acceleration market. The Savage3D failed to achieve
significant market acceptance. As a result, our products only addressed the
lower margin segments of the market, which contributed to our net losses in
recent periods. We recently commenced shipments of our Savage4 product, which is
designed to compete in multiple performance segments of the commercial and
consumer PC markets and to satisfy multiple-function market needs, such as
graphics, video and DVD support. We do not know whether Savage4 will be able to
compete successfully in those segments. If we are not able to introduce and
successfully market higher performance products, our gross margin and
profitability could be negatively affected.

Demand For Our Products May Decrease If the Same Capabilities Provided By Our
Products Become Available In Operating Systems Or Embedded In Other Personal
Computer Components.

A majority of our net sales are derived from the sale of graphics boards and
multimedia accelerators for PC subsystems. However, there is a trend within the
industry for lower performance graphics and video functionality to migrate from
the graphics board to other personal computer components or into operating
systems. We expect that additional specialized graphics processing and general
purpose computing capabilities will be integrated into future versions of 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 and others
have announced plans to develop chips that integrate graphics and processor
functions to serve the lower-cost PC market. These could significantly reduce
the demand for our products. Graphics boards are

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usually used in higher-end personal computers offering the latest technology and
performance features. However, as graphics functionality becomes technologically
stable and widely accepted by personal computer users, it typically migrates to
the personal computer motherboard. We expect this trend to continue, especially
with respect to low-end graphics boards. In this regard, the MMX instruction set
from Intel and the expanded capabilities provided by the DirectX applications
programming interface from Microsoft have increased the capability of
Microsoft's operating systems to control display features that have
traditionally been performed by graphics boards. As a result of these trends of
technology migration, our success largely depends on our ability to continue to
develop products that incorporate new and rapidly evolving technologies that
manufacturers have not yet fully incorporated onto personal computer
motherboards or into operating systems.

We have not previously offered integrated graphics/core logic accelerator
products that provide these functions, which have traditionally been provided by
separate single function chips or chipsets. We have and intend to continue to
expand the scope of our research and development efforts to provide these
functions, which will require that we hire engineers skilled in these areas and
promote additional coordination among our design and engineering groups.
Alternatively, we may find it necessary or desirable to license or acquire
technology to enable us to provide these functions, and we cannot assure you
that any such technology will be available for license or purchase on terms
acceptable to us.

We believe that a large portion of the growth in the sales of personal
computers may be in sealed systems that contain most functionality on a single
systems board and are not upgradeable in the same manner as are most personal
computers. These sealed computers would contain a systems board that could
include CPU, system memory, graphics, audio and Internet or network connectivity
functionality on a single board. Although Diamond acquired Micronics Computers
in 1998 for the purposes of obtaining technical and marketing expertise and
brand acceptance in CPU motherboard design and developing integrated multimedia
system board products, we cannot assure you that a significant market will exist
for low-cost fixed system boards or that the acquisition of Micronics will
enable us to compete successfully in this emerging market or in the current
motherboard market.

If We Are Unable To Continue To Develop and Market New and Enhanced Products,
Our Average Selling Prices and Gross Profits Will Likely Decline.

We must continue to develop new products in order to maintain average selling
prices and gross margins. As the markets for our products continue to develop
and competition increases, we anticipate that product life cycles will shorten
and average selling prices will decline. In particular, average selling prices
and, in some cases, gross margins for each of our products will decline as
products mature. A decline in selling prices may cause the net sales in a
quarter to be lower than those of a preceding quarter or corresponding quarter
in a prior year, even if more units were sold during that quarter than in the
preceding or corresponding quarter of a prior year. To avoid that, we must
successfully identify new product opportunities and develop and bring new
higher-end and higher-margin products to market in time to meet market demand.
The availability of new products is typically restricted in volume early in a
product's life cycle. If customers choose to wait for the new version of a
product instead of purchasing the current version, our ability to procure
sufficient volumes of these new products to meet higher customer demand will be
limited. If this happens, our revenues and operating margins could be harmed.

Our Products Have Short Product Life Cycles, Requiring Us To Manage Product
Transitions Successfully In Order To Remain Competitive.

Our products have short product life cycles. If we fail to introduce new
products successfully within a given time frame, our competitors could gain
market share, which could cause us to lose revenue. Further, continued failure
to introduce competitive new products on time could also damage our brand name,
reputation and relationships with our customers and cause longer-term harm to
our financial condition. Also, we anticipate that the transition of the design
of Diamond's boards based on new graphics chip architectures by us will require
significant effort. Our major OEM customers typically introduce new computer
system configurations as often as twice a year. The life cycles of Diamond's
graphics boards typically range from six to twelve months and the life cycles of
our graphic chips typically range from twelve to eighteen months. Short product
life cycles are the result of frequent transitions in the computer market in
which products rapidly incorporate new features and performance standards on an
industry-wide basis. Our products must be able to support the new features and
performance levels being required by personal computer manufacturers at the
beginning of these transitions. Otherwise, we would likely lose business as well
as the opportunity to compete for new design contracts until the next product
transition. Failing to develop products with required features and performance
levels or a delay as short as a few months in bringing a new product to market
could significantly reduce our revenues for a substantial period.

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We May Face Inventory Risks That Are Increased By A Combination Of Short
Product Life Cycles and Long Component Lead Times.

The short product life cycles of our board-based products also give rise to a
number of risks involving product and component inventories. These risks are
heightened by the long lead times that are necessary to acquire some components
of our products. We may not be able to reduce our production or inventory levels
quickly in response to unexpected shortfalls in sales. This could leave us with
significant and costly obsolete inventory. Long component lead times could cause
these inventory levels to be higher than they otherwise would be and may also
prevent us from quickly taking advantage of an unexpected new product cycle.
This can lead to costly lost sales opportunities and loss of market share, which
could result in a loss of revenues. For example, the timing and speed of the
PCI-to-AGP bus transition and the SGRAM-to-SDRAM memory transition led to an
excess inventory of PCI and SGRAM-based products at Diamond and in its
distribution channel, which in turn resulted in lower average selling prices,
lower gross margins, end-of-life inventory write-offs, and higher price
protection charges during the second and third quarters of 1998. Further,
declining demand for an excess supply of Monster 3D II and competitive 3D gaming
products in the channel during the third quarter of 1998 resulted in rapidly
declining revenue and prices vis-a-vis the second quarter of 1998, and resulted
in price protection charges for this class of product in the third quarter of
1998. We estimate and accrue for potential inventory write-offs and price
protection charges, but we cannot assure you that these estimates and accruals
will be sufficient in future periods, or that additional inventory write-offs
and price protection charges will not be required. The impact of these charges
on Diamond's operating results in 1998 and the first quarter of 1999 was
material. Any similar occurrence in the future could materially and adversely
affect our operating results because as our subsidiary, Diamond's charges will
be included in our operating results on a going forward basis.

We Depend On Third Parties For the Manufacture Of Our Products.

We currently rely on two independent foundries to manufacture all of our
products either in finished form or wafer form. We have a "take or pay" contract
with Taiwan Semiconductor Manufacturing Company ("TSMC") and a joint venture
foundry, United Semiconductor Corporation ("USC"). Our agreement with TSMC
provides capacity through 2002 and requires us to make annual advance payments
to purchase specified capacity to be applied against the following year's
capacity or to forfeit advance payments against those amounts. In the fourth
quarter of 1998, we wrote off approximately $4.0 million of the 1998 prepaid
production capacity because it did not fully utilize the capacity related to the
advance payment. As of September 30, 1999, our note payable to TSMC was $9.6
million. If we purchase excess inventories of particular products or choose to
forfeit advance payments, our operating results could be harmed.

In June 1999, we entered into an agreement with United Microelectronics
Corporation ("UMC"), the majority owner of the USC foundry joint venture, under
which we gave up our right to elect a director to USC's board. UMC has also
announced plans to merge USC with UMC, with USC shareholders, including us, to
receive UMC shares. If the merger of UMC and USC occurs, we will lose our
ability to influence the USC board and any veto power we had over actions to be
taken by USC. As a result, our relationship with USC will be based on a foundry
capacity agreement rather than a joint venture. Although we are currently
unaware of any changes that UMC may propose in the future to the foundry
relationship, we will have less ability to influence USC if changes adverse to
us are made in the future.

We conduct business with one of our current foundries by delivering written
purchase orders specifying the particular product ordered, quantity, price,
delivery date and shipping terms. This foundry is therefore not obligated to
supply products to us for any specific period, in any specific quantity or at
any specific price, except as may be provided in a particular purchase order. To
the extent a foundry terminates its relationship with us or our supply from a
foundry is 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, we may not have a sufficient amount of time to
replace the supply of products manufactured by that foundry. We may be unable to
obtain sufficient advanced process technology foundry capacity to meet customer
demand in the future. From time to time, we may evaluate 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. Accordingly, there can be no assurance that such sources will
be able or willing to satisfy our requirements on a timely basis or at
acceptable quality or per unit prices.

TSMC and USC are both located in the Science-Based Industrial Park in Hsin
Chu City, Taiwan. We currently expect these foundries to supply the substantial
portion of our products in 1999 and 2000. Disruption of operations at these
foundries for any reason, including work stoppages, political or military
conflicts, earthquakes or other natural disasters, could cause delays in
shipments of our products which could have a material adverse effect on our
operating results. In September 1999, Taiwan

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experienced a major earthquake. The earthquake and its resulting aftershocks
caused power outages and significant damage to Taiwan's infrastructure. The
result could be a delay of shipments of our products from the TSMC and USC
foundries in Taiwan. Such delays could have a material adverse effect on our
operating results.

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 our foundries' ability to supply our
products, which could have a material adverse effect on operating results.

We rely on independent surface mount technology subcontractors to
manufacture, assemble or test certain of our products. We procure our
components, assembly and test services and assembled products through purchase
orders and we do not have specific volume purchase agreements with each of our
subcontractors. Most our subcontractors could cease supplying the services,
products or components at any time with limited or no penalty. If we need to
replace a key subcontractor, we could incur significant manufacturing set-up
costs and delays. Also, we may be unable to find suitable replacement
subcontractors. Our emphasis on maintaining low internal and channel inventory
levels may exacerbate the effects of any shortage that may result from the use
of sole-source subcontractors during periods of tight supply or rapid order
growth. Further, some of our subcontractors are located outside the United
States, which may present heightened process control, quality control,
political, infrastructure, transportation, tariff, regulatory, legal, import,
export, economic or supply chain management risks.

We Have Significant Product Concentration and Significantly Depend On the Health
Of the Graphics and Multimedia Accelerator Market, Which Means That A Decline In
Demand For A Single Product, Or In the Graphics and Multimedia Accelerator
Market In General, Could Severely Impact Overall Revenues and Financial Results.

Our revenues are dependent on the markets for graphics/video chips for PCs
and on our ability to compete in those markets. Our business would be materially
harmed if we are unsuccessful in selling these graphic chips. Historically, over
75% of the net sales of our subsidiary, Diamond, have come from sales of
graphics and video accelerator subsystems. Although Diamond has introduced audio
subsystems, has entered the PC modem and home networking markets, and has
entered into the PC consumer electronics market with its Rio Internet music
player, graphics and video accelerator subsystems are expected to continue to
account for the majority of our sales for the foreseeable future. A decline in
demand or average selling prices for graphics and video accelerator subsystems,
whether as a result of new competitive product introductions, price competition,
excess supply, widespread cost reduction, technological change, incorporation of
the products' functionality onto personal computer motherboards or otherwise,
would have a material adverse effect on our sales and operating results.

Our Sales Are Concentrated Within A Limited Number Of Customers.

We expect a significant portion of our future sales to remain concentrated
within a limited number of strategic customers. If we lose one or more of these
customers, our operating results would be harmed.

One customer, IBM Corporation, accounted for 26% of net sales for the nine
months ended September 30, 1999. One distributor, Synnex Technology, Inc.
("Synnex"), accounted for 16% of net sales for the nine months ended September
30, 1999. Two distributors, Synnex and Promate Electronic Co., accounted for 37%
and 13% of net sales, respectively, for the nine months ended September 30,
1998, respectively. We expect a significant portion of our future sales to
remain concentrated within a limited number of strategic customers, who we may
be unable to retain. Our strategic customers may cancel or reschedule orders.
Canceled orders may not be replaced by other sales, adversely impacting our
operating results.

The Manufacturers On Which We Depend May Experience Manufacturing Yield
Problems That Could Increase Our Per Unit Costs and Otherwise Jeopardize the
Success Of Our Products.

Our products, graphics chips, are difficult to manufacture. The production of
graphic chips requires a complex and precise process that often presents
problems that are difficult to diagnose and time-consuming or expensive to
solve. As a result, companies like us often experience problems in achieving
acceptable wafer manufacturing yields. Our chips are manufactured from round
wafers made of silicon. During manufacturing, each wafer is processed to contain
numerous individual integrated circuits, or chips. We may reject or be unable to
sell a percentage of wafers or chips on a given wafer because of:

~ minute impurities,

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~ difficulties in the fabrication process,

~ defects in the masks used to print circuits on a wafer,

~ electrical performance,

~ wafer breakage, or

~ other factors.

We refer to the proportion of final good chips that have been processed,
assembled and tested relative to the gross number of chips that could be
constructed from the raw materials as our manufacturing yields. These yields
reflect the quality of a particular wafer. Depending on the specific product, in
the past, we negotiated with our manufacturers to pay either an agreed upon
price for all wafers or a price that is typically higher for only wafers of
acceptable quality. If the payment terms for a specific product require us to
pay for all wafers, and if yields associated with that product are poor, we bear
the risk of those poor manufacturing yields.

We Are Subject To Risks Relating To Product Returns and Price Protection.

We often grant limited rights to customers to return unsold inventories of
our products in exchange for new purchases, also known as "stock rotation." We
also often grant price protection on unsold inventory, which allows customers to
receive a price adjustment on existing inventory when our published price is
reduced. Also, some of our retail customers will readily accept returned
products from their own retail customers. These returned products are then
returned to us for credit. We estimate returns and potential price protection on
unsold inventory in our distribution channel. We accrue reserves for estimated
returns, including warranty returns and price protection, and since the fourth
quarter of 1998, we reserve the gross margin associated with channel inventory
levels that exceed four weeks of demand. We may be faced with further
significant price protection charges as our competitors move to reduce channel
inventory levels of current products, such as our Master Fusion, as new product
introductions are made.

We Depend On Sales Through Distributors. If Relationships With Or Sales
Through Distributors Decline, Our Operating Results Will Be Harmed.

A substantial percentage of our products are distributed through add-in card
manufacturers that in turn sell to value-added resellers, system integrators,
OEMs and distributors. Accordingly, we depend on these add-in card manufacturers
to assist it in promoting market acceptance of our products. The board
manufacturers that purchase our products are generally not committed to making
future purchases of our products and, therefore, could discontinue incorporating
our products into their graphics boards in favor of a competitor's product or
for any other reason.

We sell our products through a network of domestic and international
distributors, and directly to major retailers/mass merchants, value-added
resellers and OEM customers. Our future success is dependent on the continued
viability and financial stability of our customer base. Computer distribution
and retail channels historically have been characterized by rapid change,
including periods of widespread financial difficulties and consolidation and the
emergence of alternative sales channels, such as direct mail order, telephone
sales by PC manufacturers and electronic commerce on the worldwide web. The loss
of, or a reduction in, sales to certain of our key distribution customers as a
result of changing market conditions, competition or customer credit problems
could materially and adversely affect our operating results. Likewise, changes
in distribution channel patterns, such as:

~ increased electronic commerce via the Internet,

~ increased use of mail-order catalogues,

~ increased use of consumer-electronics channels for personal computer sales,
or

~ increased use of channel assembly to configure PC systems to fit customers'
requirements

could affect us in ways not yet known. For example, the rapid emergence of
Internet-based e-commerce, in which products are sold direct to consumers at low
prices, is putting substantial strain on some of our traditional distribution
channels.

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Inventory levels of our products in the two-tier distribution channels
generally are maintained in a range of one to two months of customer demand.
These channel inventory levels tend toward the low end of the months-of-supply
range when demand is stronger, sales are higher and products are in short
supply. Conversely, during periods when demand is slower, sales are lower and
products are abundant, channel inventory levels tend toward the high end of the
months-of-supply range. Frequently, in these situations, we attempt to ensure
that distributors devote a greater degree of their working capital, sales and
logistics resources to our products instead of to our competitors. Similarly,
our competitors attempt to ensure that their own products are receiving a
disproportionately higher share of the distributors' working capital and
logistics resources. In an environment of slower demand and abundant supply of
products, price declines and channel promotional expenses are more likely to
occur and, should they occur, are more likely to have a significant impact on
our operating results. Further, in an event like this, high channel inventory
levels may result in substantial price protection charges. These price
protection charges have the effect of reducing net sales and gross profit.
Consequently, in taking steps to bring our channel inventory levels down to a
more desirable level, we may cause a shortfall in net sales during one or more
accounting periods. These efforts to reduce channel inventory might also result
in price protection charges if prices are decreased to move product out to final
consumers, having a further adverse impact on operating results. We accrue for
potential price protection charges on unsold channel inventory. We cannot assure
you, however, that any estimates, reserves or accruals will be sufficient or
that any future price reductions will not seriously harm our operating results.

Our products are priced for and generally aimed at the higher performance and
higher quality segment of the market. Therefore, to the extent that OEMs and
value added resellers focus on low-cost solutions rather than high-performance
solutions, an increase in the proportion of our sales to OEMs may result in an
increase in the proportion of our revenue that is generated by lower-selling
price and lower-gross-margin products, which could adversely affect our future
gross margins and operating results.

We Rely On Intellectual Property and Other Proprietary Information That May Not
Be Adequately Protected and That May Be Expensive To Protect.

The industry in which we compete is characterized by vigorous protection and
pursuit of intellectual property rights. We rely heavily on a combination of
patent, trademark, copyright, and trade secret laws, employee and third-party
nondisclosure agreements and licensing arrangements to protect our intellectual
property. If we are unable to adequately protect our intellectual property, our
business may suffer from the piracy of our technology and the associated loss of
sales. Also, the protection provided to our proprietary technology by the laws
of foreign jurisdictions, many of which offer less protection than the United
States, may not be sufficient to protect our technology. It is common in the
personal computer industry for companies to assert intellectual property
infringement claims against other companies. Therefore, our products may also
become the target of infringement claims. These infringement claims or any
future claims could cause us to spend significant time and money to defend our
products, redesign our products or develop or license a substitute technology.
We may be unsuccessful in acquiring or developing substitute technology and any
required license may be unavailable on commercially reasonable terms, if at all.
In addition, an adverse result in litigation could require us to pay substantial
damages, cease the manufacture, use, sale, offer for sale and importation of
infringing products, or discontinue the use of certain processes. Any of those
events could materially harm our business. Litigation by or against us could
result in significant expense to us and could divert the efforts of our
technical and management personnel, regardless of the outcome of such
litigation. For example, in October 1995, Brooktree Corporation alleged that
some of our products infringed a Brooktree patent. Defending the resulting
lawsuit caused us substantial expense and diverted the efforts of our technical
and management personnel. In a settlement of that suit, we agreed to pay to
Brooktree a license fee and royalties relating to certain product revenues over
a five-year period. However, even if claims do not have merit, we may be
required to dedicate significant management time and expense to defending
ourselves if we are directly sued, or assisting our OEM customers in their
defense of these or other infringement claims pursuant to indemnity agreements.
This could have a negative effect on our financial results. For example, Intel
Corporation is currently in litigation with VIA with which we recently entered
into a joint venture to bring high-performance integrated graphics and core
logic chip sets to the volume OEM desktop and notebook PC markets. The result of
such litigation could have an adverse effect on the Company.

Our Products Depend Upon Third-party Certifications, Which May Not Be Granted
For Future Products, Resulting In Product Shipment Delays and Lost Sales.

We submit most of our products for compatibility and performance testing to
the Microsoft Windows Hardware Quality Lab because our OEM customers typically
require our products to have this certification prior to making volume
purchases. This certification typically requires up to several weeks to complete
and entitles us to claim that a particular product is "Designed for

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Microsoft Windows." We may not receive this certification for future products in
a timely fashion, or at all, which could result in product shipment delays and
lost sales.

We May Not Be Able To Retain Or Integrate Key Personnel, Which May Prevent Us
From Succeeding.

We may not be able to retain our key personnel or attract other qualified
personnel in the future. Our success will depend upon the continued service of
key management personnel. The loss of services of any of the key members of our
management team or our failure to attract and retain other key personnel could
disrupt our operations and have a negative effect on employee productivity and
morale, decreasing production and harming our financial results. In addition,
the competition to attract, retain and motivate qualified technical, sales and
operations personnel is intense. We have at times experienced, and continue to
experience, difficulty recruiting qualified software and hardware development
engineers.

We May Encounter Year 2000 Compliance Problems Involving Business and
Administrative Systems, Including Phone and Other Communications and
Administrative Support Systems, That Could Negatively Affect Their Operations
and Financial Results.

We use a significant number of computer software programs and operating
systems in our internal operations. These include applications used in financial
business systems and various administration functions, including phone and other
communications and administrative support systems, and also software programs in
our products. If these software applications are unable to interpret
appropriately dates occurring in the upcoming calendar year 2000, some level of
modification or replacement of such software may be necessary. We have conducted
year 2000 compliance testing and we believe that all of our existing products
are year 2000 compliant. Despite this belief, our products may not be year 2000
compliant. If our products fail to perform, including failures due to the onset
of calendar year 2000, our product sales and financial results will suffer. We
are currently evaluating our information technology for year 2000 compliance.
This evaluation includes reviewing what actions are required to make all
internally used software systems year 2000 compliant as well as actions
necessary to make us less vulnerable to year 2000 compliance problems associated
with third parties' systems. These measures may not solve all year 2000
problems. Any year 2000 problems could have a negative effect on our operations
and financial results. In addition, our customers and suppliers may not be year
2000 compliant, which could also negatively affect us. Our suppliers may be
unable to supply necessary goods to us as a result of their year 2000 problems.
Such interruptions, if material may have an adverse effect. If our customers
experience year 2000 problems, demand for our products may decrease which, if
material, may have an adverse effect.

We Depend On A Limited Number Of Third Party Developers and Publishers That
Develop Graphics Software Products That Will Operate With and Fully Utilize the
Capabilities Of Our Products To Generate Demand For Our Products.

Only a limited number of software developers are capable of creating high
quality entertainment software. Because competition for these resources is
intense and is expected to increase, a sufficient number of high quality,
commercially successful software titles compatible with our products may not be
developed. We believe that the availability of numerous high quality,
commercially successful software entertainment titles and applications
significantly affects sales of multimedia hardware to the PC-based interactive
3D entertainment market. We depend on third party software developers and
publishers to create, produce and market software titles that will operate with
our 3D graphics accelerators. If a sufficient number of successful software
titles are not developed, our product sales and revenues could be negatively
impacted. In addition, the development and marketing of game titles that do not
fully demonstrate the technical capabilities of our products could create the
impression that our technology offers only marginal or no performance
improvements over competing products. Either of these effects could have an
adverse effect on our product sales and financial results.

We Depend On A Limited Number Of Suppliers From Whom We Do Not Have A Guarantee
Of Adequate Supplies, Increasing the Risk That A Loss Of Or Problems With A
Single Supplier Could Result In Impaired Margins, Reduced Production Volumes,
Strained Customer Relations and Loss Of Business.

We obtain several of the components used in our products from single or
limited sources. If component manufacturers do not allocate a sufficient supply
of components to meet our needs or if current suppliers do not provide
components of adequate quality or compatibility, we may have to obtain these
components from distributors or on the spot market at a higher cost. We have no
guaranteed supply arrangements with any of our suppliers, and current suppliers
may not be able to meet our current or future component requirements. If we are
forced to use alternative suppliers of components, we may have to alter our
product designs to accommodate these components. Alteration of product designs
to use alternative components could cause significant delays and could require
product recertification by our OEM customers or reduce our production of the
related products. In addition, from time to time

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we have experienced difficulty meeting certain product shipment dates to
customers for various reasons. These reasons include component delivery delays,
component shortages, system compatibility difficulties and component quality
deficiencies. Delays in the delivery of components, component shortages, system
compatibility difficulties and supplier product quality deficiencies will
continue to occur in the future. These delays or problems have in the past and
could in the future result in impaired margins, reduced production volumes,
strained customer relations and loss of business. For example, DRAM and flash
memory components, which are used in our graphics boards, have significantly
increased in price over the last six weeks due in part to supply interruptions
arising from the earthquake in Taiwan. These price increases may have an adverse
impact on our gross margin in future periods. Also, in an effort to avoid actual
or perceived component shortages, we may purchase more of certain components
than we otherwise require. Excess inventory resulting from such over-purchases,
obsolescence or a decline in the market value of such inventory could result in
inventory write-offs, which would have a negative effect on our financial
results as happened in the first and second quarters of 1998. Similarly,
Diamond's perception of component shortages caused Diamond to over-purchase
certain components and pay surcharges for components that subsequently declined
in value in the second, third and fourth quarters of 1998. In addition, our
inventory sell-offs or sell-offs by our competitors could trigger channel price
protection charges, further reducing our gross margins and profitability, as
occurred with the Monster 3D II product line in the third and fourth quarters of
1998.

We May Experience Product Delivery Delays Due To The Inadequacy Or
Incompatibility Of Software Drivers, Such Delays Could Hurt Our Sales.

Some components of our products require software drivers in order for those
components to work properly in a PC. These software drivers are essential to the
performance of nearly all of our products and must be compatible with the other
components of the graphics board and PC in order for the product to work. Some
of these products that include software drivers are among those products based
on components, including software drivers, that are supplied by a limited number
of suppliers. From time to time, we have experienced product delivery delays due
to inadequacy or incompatibility of software drivers either provided by
component suppliers or developed internally by them. These delays could cause us
to lose sales, revenues and customers. Software driver problems will continue to
occur in the future, and those problems could negatively affect our operating
results.

Our Entry Into New Product Markets Could Divert Resources From Our Core Business
and Expose Us To Risks Inherent In New Markets.

Our business historically has focused primarily on the design, manufacture
and sale of graphics boards. However, Diamond from time to time undertook new
product initiatives, such as the Rio line of Internet music players, the
launching of the RioPort.com music website and entry into the home networking
market. There are numerous risks inherent in entering into new product markets.
These risks include the reallocation of limited management, engineering and
capital resources to unproven product ventures, a greater likelihood of
encountering technical problems and a greater likelihood that our new products
will not gain market acceptance. The failure of one or more of such products
could negatively impact our financial results. Adverse effects of new products
may also inure our reputation in our core business and also could negatively
impact our financial results.

We Have Significant Exposure To International Markets.

Export sales accounted for 89%, 70% and 58% of our net sales in 1998, 1997
and 1996, respectively. We expect 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. Diamond's
net sales in Europe accounted for 36%, 26% and 22% of total net sales during
1998, 1997 and 1996, respectively. Diamond's other international net sales
accounted for 10%, 12% and 16% of total net sales for it during 1998, 1997 and
1996, respectively. In addition, a substantial proportion of our products are
manufactured, assembled and tested by independent third parties in Asia. As a
result, we are 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 price in local
currencies of our products in foreign markets or increase the cost of wafers
and components purchased by us;

~ delays resulting from difficulty in obtaining export licenses for certain
technology;

~ tariffs and other trade barriers and restrictions;

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~ potentially longer payment cycles;

~ greater difficulty in accounts receivable collection;

~ potentially adverse tax treatment;

~ the burdens of complying with a variety of foreign laws; and

~ year 2000 computer malfunctions.

In the past, we have experienced an adverse impact associated with the
economic downturn in Asia that contributed to decreases in net sales. In
addition, our international operations are subject to general geopolitical
risks, such as political and economic instability and changes in diplomatic and
trade relationships. The People's Republic of China and Taiwan have in the past
experienced and are currently experiencing strained relations, and a worsening
of relations or the development of hostilities between them could disrupt
operations at our foundries and affect our Taiwanese customers.

We Are Parties To Legal Proceedings Alleging Securities Violations That Could
Have A Negative Financial Impact On Us.

Diamond has been named as a defendant in several putative class action
lawsuits that were filed in June and July 1996 and June 1997 in the California
Superior Court for Santa Clara County and the U.S. District Court for the
Northern District of California. Some of Diamond's executive officers and
directors are also named as defendants. The plaintiffs purport to represent a
class of all persons who purchased Diamond common stock between October 18, 1995
and June 20, 1996, referred to as the "class period." The complaints allege
claims under the federal securities laws and California law. The plaintiffs
allege that Diamond and the other defendants made various material
misrepresentations and omissions during the class period. The complaints do not
specify the amount of damages sought. Diamond believes that it has good defenses
to the claims alleged in the lawsuits and will defend itself vigorously against
these actions. No trial date has been set for any of these actions. The ultimate
outcome of these actions cannot be presently determined. Accordingly, we have
not made any provision for any liability or loss that may result from
adjudication of these lawsuits.

In addition, we have been named, with Diamond, as defendants in litigation
relating to the merger. On August 4, 1999, two alleged stockholders of Diamond
filed a lawsuit, captioned Strum v. Schroeder, et al., in the Superior Court of
the State of California for the County of Santa Clara. Plaintiffs, on behalf of
themselves and a class of all Diamond stockholders similarly situated whom they
purportedly represent, challenge the terms of the merger. The complaint names
Diamond, the directors of Diamond and us as defendants. The complaint alleges
generally that Diamond's directors breached their fiduciary duties to
stockholders of Diamond and seeks rescission and the recovery of unspecified
damages, fees and expenses. We believe, as do the individual defendants, that we
have meritorious defenses to the lawsuit and we and the individual defendants
intend to defend the suit vigorously.

We Have A Significant Level Of Debt.

At September 30, 1999, we had total debt outstanding of $166.2 million. The
degree to which we are leveraged could adversely affect our ability to obtain
additional financing for working capital or other purposes and could make us
more vulnerable to economic downturns and competitive pressures. Our significant
leverage could also adversely affect our liquidity, as a substantial portion of
available cash from operations may have to be applied to meet debt service
requirements. In the event of a cash shortfall, we could be forced to reduce
other expenditures to be able to meet such debt service requirements.

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Our Stock Price Is Highly Volatile and We Expect That Our Stock Price Will
Continue To Be Highly Volatile.

The market price of our common stock has been highly volatile, like that of
the common stock of many other semiconductor companies. We expect our common
stock to remain volatile. This volatility may result from:

~ general market conditions and market conditions affecting technology and
semiconductor stocks generally;

~ actual or anticipated fluctuations in our quarterly operating results;

~ announcements of design wins, technological innovations, acquisitions,
investments or business alliances, by us or our competitors; and

~ the commencement of, developments in or outcome of litigation.

The market price of our common stock also has been and is likely to continue
to be significantly affected by expectations of analysts and investors,
especially if our operating results do not meet those expectations. Reports and
statements of analysts do not necessarily reflect our views. The fact that we
have in the past met or exceeded analyst or investor expectations does not
necessarily mean that we will do so in the future.

In the past, following periods of volatility in the market price of a
particular company's securities, securities class action litigation has often
been brought. This litigation could result in substantial costs and a diversion
of our management's attention and resources. Litigation was brought against us
in 1994, and we are currently involved in securities class action litigation.
Diamond is also involved in similar proceedings.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

INVESTMENT PORTFOLIO

The Company does not use derivative financial instruments in its investment
portfolio. The Company places its investments in instruments that meet high
credit quality standards, as specified in the Company's investment policy. The
Company also limits the amount of credit exposure to any one issue, issuer or
type of investment. The Company does not expect any material loss with respect
to its investment portfolio.

The table below summarizes the Company's investment portfolio. The table
represents principal cash flows and related average fixed interest rates by
expected maturity date. The Company's policy requires that all investments
mature within twenty months.

Principal (Notional) Amounts Maturing in 1999 in U.S. Dollars:

FAIR VALUE AT
SEPTEMBER 30, 1999
----------------------
(IN THOUSANDS,
EXCEPT INTEREST RATES)

Cash and equivalents ............................. $ 72,796
Weighted average interest rate ................... 4.59%
Short-term investments ........................... $ 74,656
Weighted average interest rate ................... 5.41%
Total portfolio .................................. $147,452
Weighted average interest rate ................... 5.01%

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 _% 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.

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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 fair value
of the convertible subordinated notes at September 30, 1999 was approximately $
92.6 million.

IMPACT OF FOREIGN CURRENCY RATE CHANGES

The Company invoices its customers in US dollars for all products. The
Company is exposed to foreign exchange rate fluctuations as the financial
results of its foreign subsidiaries are translated into US dollars in
consolidation. The foreign subsidiaries maintain their accounts in the local
currency of the foreign location in order to centralize the foreign exchange
risk with the parent company. To date this risk has not been material.

The effect of foreign exchange rate fluctuations on the Company's financial
statements for the three and nine months ended September 30, 1999 and 1998 was
not material. Since foreign currency exposure increases as intercompany
receivables grow, from time to time the Company uses foreign exchange forward
contracts as a means for hedging these balances. As of September 30, 1999, the
Company held the following forward exchange contracts:

MATURITY DATE NOTIONAL FAIR VALUE
------------- -------- ----------
(IN THOUSANDS)

Foreign Currency Forward Exchange Contracts:
275,905,000 New Taiwan Dollars October 5, 1999 $8,476 $(187)
275,905,000 New Taiwan Dollars December 17,1999 8,516 (141)
275,905,000 New Taiwan Dollars April 3, 2000 8,489 (149)
275,905,000 New Taiwan Dollars July 5, 2000 8,466 (161)

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

On August 4, 1999, a purported class action complaint was filed against the
Company, Diamond and the members of Diamond's Board of Directors. The complaint
purports to be brought on behalf of all the stockholders of Diamond. The
complaint arises out of the merger of Diamond with S3. The complaint alleges
that Diamond and the members of the Board of Directors breached their fiduciary
duties to the stockholders by failing to obtain reasonable consideration for
Diamond's stockholders in the S3 transaction. The complaint seeks an injunction
against the transaction, rescission of the transaction, compensatory damages,
and other remedies. The defendants have not yet responded to the complaint. No
trial date or other schedule has been established in this matter. While
management intends to defend the actions against Diamond 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.

On April 23, 1999, 3Dfx Interactive, Inc. ("3Dfx") filed a lawsuit against
Diamond for breach of contract based upon unpaid invoices in the amount of
$3,895,225. On June 4, 1999 Diamond filed an answer and cross-complaint alleging
breach of contract, breach of the covenant of good faith and fair dealing,
breach of implied warranty and negligence, and thereafter amended the
cross-complaint to include a claim for accounting. Diamond's cross-claim seeks
offsets totaling $4,868,035 for (1) 3Dfx's breach of an agreement to provide
price advantages and other "most favored customer" terms to Diamond; (2)
defective 3Dfx product and (3) an accounting of 3Dfx's business records to
facilitate the determination of Diamond's damages. These damages offset the
amount claimed by 3Dfx for unpaid invoices and result in a net claim of $941,155
by Diamond. At the time it filed its complaint, 3Dfx sought to attach Diamond
assets worth $3,895,225. On June 16, 1999 the court issued a right to attach
order in the amount of $2,859,035. Diamond thereafter substituted a bond for the
attached property, and all attached assets were released. Diamond intends to
file a motion to set aside the writ of attachment with a hearing in early
January 2000. Discovery has commenced and is ongoing. The parties have also
conducted mediation of their dispute and may continue to pursue mediation. No
trial date has been set.

In October 1998, the Company was named as a defendant in a lawsuit filed in
the United States District Court for the Central District of California.
Plaintiffs were the Recording Industry Association of America, Inc. (the
"RIAA"), a trade organization representing recording companies and the Alliance
of Artists and Recording Companies (the "AARC") an organization controlled by
the RIAA which exists to distribute royalties collected by the copyright office.
The complaint alleged that the Company's Rio product, a portable music player,
is subject to regulation under the Audio Home Recording Act (the "AHRA") and
that the device did not comply with the requirements of the AHRA. On August 2,
1999, Diamond and RIAA entered into a settlement, pursuant to which the lawsuit
filed by the RIAA against Diamond and Diamond's counterclaims are to be
dismissed. Diamond and the RIAA have announced the mutually satisfactory
resolution of outstanding legal issues. The terms of the settlement are
confidential.

Item 2. Changes in Securities

(c) On September 24, 1999, the Company sold 1.0 million shares of S3 common
stock to a foreign private investor for an aggregate purchase price of
$9,375,000. The Company relied upon the exemption from registration provided by
either (i) Section 4(2) of the Securities Act and Regulation D thereunder,
because (1) the sale was made without general solicitation or advertising, (2)
the purchaser represented its intention to acquire the securities for investment
only and not with a view to distribution thereof, (3) appropriate legends were
affixed to the stock certificate, (4) the purchaser was an accredited investor
as such term is defined under Rule 501 of Regulation D, and (5) the purchaser
was provided with or had access to or otherwise had adequate information about
the Company; or (ii) Regulation S of the Securities Act, because (1) the
purchaser certified that it is not a U.S. Person and was not purchasing the
shares for the account or benefit of any U.S. Person, (2) the sale was made in
an offshore transaction, (3) no directed selling efforts were made in the United
States by the Company, a distributor, any of their respective affiliates, or any
person acting on behalf of any of the foregoing, (4) the purchaser agreed to
resell the shares only in accordance with Regulation S, or pursuant to an
available exemption from registration under the Securities Act, (5) the
purchaser agreed not to engage in any hedging transactions with regard to the
shares except as permitted by the Securities Act, (6) the stock certificate
representing the shares contains a legend to the effect that transfer is
prohibited except pursuant to an available exemption from registration, and that
hedging transactions involving the shares may not be conducted unless in
compliance with the Securities Act, and (7) the Company is required by contract
to refuse to register any transfer of the shares not made (A) in accordance with
Regulation S, (B) pursuant to registration under the Securities Act, or (c)
pursuant to an available exemption from registration under the Securities Act.

On September 20, 1999, the Company sold 1.35 million shares of S3 common
stock to a foreign private investor for an aggregate purchase price of
$14,065,650. The Company relied upon the exemption from registration provided by
Section 4(2) of the Securities Act of 1933 and Regulation D thereunder, because
(1) the sale was made without general solicitation or advertising, (2) the
purchaser

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represented its intention to acquire the securities for investment only and not
with a view to distribution thereof, (3) appropriate legends were affixed to the
stock certificate, (4) the purchaser was an accredited investor, and (5) the
purchaser was provided with or had access to or otherwise had adequate
information about S3.

Item 4. Submission of Matters to a Vote of Security Holders

(a) A Special Meeting of Stockholders was held September 20, 1999.

(1) Issuance of shares of S3 common stock under the terms of a merger
agreement between S3 and Diamond Multimedia Systems, Inc.

Votes For Against Abstain
---------- ------- -------

27,766,307 546,539 108,027

(2) Amendment to the Restated Certificate of Incorporation to increase the
number of authorized shares of common stock from 120,000,000 to
175,000,000

Votes For Against Abstain
--------- ------- -------

27,539,780 765,309 115,784

(3) Election of Directors

Votes For Withheld
--------- --------

William J. Schroeder 28,302,627 583,741
Gregorio Reyes 28,324,203 562,165
James T. Schraith 28,310,153 576,215

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits

Exhibit
Number Notes Description of Document
- ------ ----- -----------------------

2.1 (2) Agreement and Plan of Merger, dated as of June 21, 1999, by and between the Registrant and Diamond

2.2 (3) Amendment No. 1 to Agreement and Plan of Merger, dated as of September 15, 1199, by and among the
Registrant, Diamond and Denmark Acquisition Sub, Inc., a Delaware corporation and wholly owned
subsidiary of the Registrant

3(i).1 (1) Restated Certificate of Incorporation

3(i).2 (4) Certificate of Amendment of Restated Certificate of Incorporation

3(i).3 (5) Certificate of Designation of Series A Participating Preferred Stock

3(i).4 (6) Certificate of Amendment of Restated Certificate of Incorporation

3(i).5 Certificate of Amendment of Restated Certificate of Incorporation

27.1 Financial Data Schedule (filed only with the electronic submission of Form 10-Q in accordance with the
EDGAR requirements)

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

(2) Incorporated by reference to Appendix A to the Joint Proxy
Statement/Prospectus, dated August 16, 1999, that forms a part of the
Registrant's Registration Statement on Form S-4 filed August 16, 1999
(File No. 333-85323).

(3) Incorporated by reference to exhibit of the same number to the
Registrant's Current Report on Form 8-K filed September 30, 1999.

(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,
1995.

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

(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,
1998.

(b) Reports on Form 8-K:

The following report on Form 8-K was filed by the Company during the three
months ended September 30, 1999:

On September 30, 1999, the Company filed a Current Report on Form 8-K dated
September 24, 1999 with the Securities and Exchange Commission that disclosed
that the Company completed its merger with Diamond Multimedia Systems, Inc.
("Diamond") pursuant to the Agreement and Plan of Merger, dated as of June 21,
1999, as amended, by and among the Company, Diamond and Denmark Acquisition Sub,
Inc., a Delaware corporation. Following consummation of the merger, Diamond
became a wholly-owned subsidiary of the Company. The following financial
statements were incorporated by reference therein: (i) the balance sheets of
Diamond at December 31, 1998 and 1997 and the statements of operations,
stockholders' equity and cash flows of Diamond for each of the three years in
the three-year period ended December 31, 1998, including the report of
independent auditors thereon, (ii) the unaudited balance sheet of Diamond at
June 30, 1999 and the statements of operations and cash flows of Diamond for the
six months ended June 30, 1999 and 1998, and (iii) unaudited pro forma combined
condensed financial information of the Company and Diamond, including the
statements of operations for the year ended December 31, 1998 and the six months
ended June 30, 1999, the balance sheet as of June 30, 1999, and notes thereto.

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SIGNATURES

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

S3 INCORPORATED
(Registrant)

/s/ WALTER D. AMARAL
--------------------------------------------
WALTER D. AMARAL
Senior Vice President Finance
and Chief Financial Officer
(Principal Financial and Accounting Officer)

November 12, 1999

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INDEX TO EXHIBITS